How well do rating agencies perform? A Government Agency Should be Formed as a Competitor to Private Credit Rating Agencies as soon as Possible

Credit rating agencies are powerful. Their judgements determine the conditions under which a country can borrow money on international capital markets. Prof. Dr. Michael Schröder, head of the department of International Financial Markets and Financial Management at ZEW, explains how rating agencies work and how they can be better monitored.

Prof. Dr. Michael Schröder is head of the department of International Financial Markets and Financial Management at ZEW. His research interests include the empirical analysis of capital markets, expectation formation in financial markets, sustainable investment, and asset management for charitable foundations. In 2009, he completed his Habilitation at the University of Stuttgart in business administration. Prof. Dr. Schröder teaches at the Frankfurt School of Finance & Management in the area of Asset Management.

If the creditworthiness of a country or firm is downgraded, a much higher price must be paid on capital markets to finance spending or roll over debt. Isn’t it true that a downgraded rating can increase the likelihood of default, thus promoting the very outcome the rating is meant to warn against?

This is undoubtedly a problem. Rating agencies are caught in a dilemma between publicising new information about the default risk of a nation or firm too soon or too late. On the one hand, rating agencies should inform the public about changes in default risk in a timely manner. On the other hand, the downgrading of a rating leads capital market investors to demand higher risk premiums. As a result, financing costs increase and the debt burden on a   country becomes even less sustainable, which can result to another round of lowered ratings and increased risk premiums. In the worst case, a reduced rating can set off a downward spiral that leads directly to the insolvency of a nation or firm.

What information do rating agencies rely on to make their judgements?

Rating agencies conduct their risk assessments based on an analysis of publicly available information as well as data from their own research. The gathered information is processed using a variety of methods and then condensed into a rating. The activities of rating agencies are meant to reduce the transactional costs of information gathering, which can lead to a more efficient capital market. The ratings spare investors the need to conduct their own comprehensive analysis, but of course, investors must then have faith in the reliability of rating assessments.

How can we objectively measure the quality of a rating?

At first glance, measuring the predictive value of ratings seems simple enough: We can compare historical ratings with outcomes. However, what precisely are the outcomes? And what does the rating specifically tell us? Ratings provide an implicit statement of probability – for example, about the chances that interest payments will no longer be serviced for a bond. However, ratings do not tell us when such a payment default might occur. In hindsight, it is possible to calculate how frequently payment defaults have occurred for specific ratings. However, it is not possible to gather precise data about correct or false predictions. Rather, we can only conduct a plausibility test: Higher ratings should be associated with fewer defaults than lower ratings. Furthermore, one must also consider the issue described earlier: In extreme cases, ratings may bring about the very results that they predict. In such cases, the prediction of an event and its occurrence are no longer independent from one another, thus making a measurement of predictive value fundamentally impossible.

Who monitors whether rating agencies are working reliably and accurately?

EU Directive 1060/2009, which deals with the regulation of rating agencies in the European Union, has been in force since the end of 2009. In Germany, the Federal Financial Supervisory Authority (BaFin) is responsible for oversight. The new EU directive primarily seeks to ensure that rating agencies active in the EU are not dependent upon their clients and have no incentives to falsify their ratings on behalf of clients. To achieve this goal, rating agencies have been required to make public their methods, models, and assumptions. This makes it possible for their competitors and for independent experts to critically examine their procedures, and gives investors a chance to form a better picture of the reliability of ratings.

Are these provisions sufficient?

These are useful first steps. Alongside their economic function in credit markets, rating agencies fulfil a quasi-public mission. With regard to minimum capital requirements for banks, for example, ratings serve as the basis for the determination of capital requirements for credit risks. Life insurance companies are only permitted to invest in “investment-grade” securities. Moreover, numerous contracts, including credit default swaps, are directly linked to credit ratings. Nevertheless, in these areas there is hardly any form of monitoring to ensure that rating decisions are sound.

What should be done to make ratings more transparent?

Effective economic monitoring could begin with an independent public ratings agency, potentially financed by the EU. Such a government-funded ratings agency would have different incentives than private agencies in preparing ratings. Thus, the spectrum of available ratings would be expanded by a new variant. Furthermore, over time, a government ratings agency could have a benchmark function for comparing the ratings and rating methods of private agencies.