13 Sep, 2013

U.N. Forum Cites Role of Credit Rating Agencies as Arbiters of Global Risk

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United Nations, 10 September 2013, Department of Public Information – Reform of the international financial system should include reducing its overreliance on credit rating agencies and increasing competition among them, speakers said today, as the General Assembly held its first ever thematic debate on the role of those institutions as arbiters of creditworthiness.

“Over the past several decades, the importance of credit rating agencies has grown immensely,” Assembly President Vuk Jeremić said, noting that their ratings had become increasingly embedded, or “hardwired”, into investment mandates, banking rules and securities regulations across the globe. He also noted that, as their influence grew, they had come under criticism over their roles in the financial crises in Latin America, Asia and, most recently, in Europe.

He also stressed State responsibility, saying that the instability allegedly created by credit rating agencies was viewed more as a reflection of the failure of some Governments to properly regulate the marketplace. Regardless of the fact that some authority was transferred to private firms, States nevertheless remained ultimately responsible for the consequences of those agencies’ actions, he said.

Citing a proposal by Secretary-General Ban Ki-moon to create a United Nations “observatory” of credit rating service providers to certify products and build consensus on common standards for methodologies, Mr. Jeremić urged Member States to seriously consider the proposal.

Mr. Ban, in his message to today’s debate, delivered by Wu Hongbo, Under-Secretary-General for Economic and Social Affairs, noted that leaders at the recent G-20 (Group of 20) Summit had adopted a declaration calling on national authorities and standard-setting bodies to accelerate progress in reducing reliance on credit rating agencies. They also called for further steps to enhance transparency and competition among them, he added.

Stressing the need to ensure that credit ratings helped to stabilize the international financial system and encourage the investment needed to promote sustainable development, Mr. Ban pointed to several broad challenges, including correcting methodological flaws, guarding against conflicts of interest and enabling developing countries to benefit more from credit ratings.

Several interventions followed the opening remarks, including by Vassily Nebenzia, Deputy Foreign Minister of the Russian Federation, who outlined his country’s contributions to global efforts to improve the credit rating services. The establishment by companies from his country, China and the United States in June of a new rating agency — Universal Credit Rating Group — had been an important step, as it aimed to give greater consideration to the specific needs of developing countries, enhance competition and make credit ratings more objective.

He said that his Government, which held this year’s Group of 20 presidency, had convened a high-level seminar in June on credit ratings and made a series of proposals on cooperation among G-20 members, including the establishment of a global rating platform that would enable investors, regulators and market participants to gain access to all published ratings as well as to all information that issuers had submitted to rating agencies. That way, investors and regulators could immediately compare ratings by various agencies and create their own transfer matrixes.

Paul Taylor, President and Chief Executive Officer of Fitch Ratings, said credit ratings were just “one source for one type of information” and should be used together with other inputs. Conflicts of interest existed “everywhere” in financial markets and products, which demonstrated the importance of a control mechanism. As for the lack of competition, new players had emerged in key markets, but “quality of work is paramount, not number of players”.

He said credit rating agencies were making improvements by drawing lessons from the economic downturn and working their way through regulatory changes worldwide. Although many rules were helpful in improving rating products, some were simply unnecessary or poorly conceived and imposed, he added.

Stephen Pagliuca, Managing Director at Bain Capital, stressed how credit rating agencies had helped borrowers gain access to capital necessary to expand business. When examining the credit rating industry, it was important to look separately at corporate debt, sovereign debt and structured finance.

He said that although detection of all sophisticated corporate fraud was not possible, credit ratings had performed effectively. Nevertheless, many market participants called for standard matrixes. Sovereign debt rating was more complex due to the need to consider public measures, such as monetary policy. It was vital to get more accurate assessments. Structured finance had played a valuable role in matching borrowers and lenders, thus contributing to global economic growth, but rating agencies had so far not kept pace with the growth of that segment.

Doug Peterson, President of Standard & Poors Rating Services, expressed regret that credit rating agencies had not anticipated the United States housing collapse and its overall effect on the economy, saying that great lessons had been learned and the industry was making improvements. “Today there is greater transparency and more accountability and oversight at rating agencies than any time in our history,” with new regulations now in place worldwide including in the United States, the European Union and Japan, he said.

In defence of the “issuer-pays” business model, he pointed out that this model was unique in its transparency compared with the alternatives, such as subscriber-pays or government-sponsored models, as its ratings were available to the public free of charge. That fostered market efficiency, public scrutiny and coverage of emerging companies.

Yves Leterme, Deputy Secretary General of the Organisation for Economic Cooperation and Development (OECD), said that over the past five years, the body had worked to help countries weather the crisis and design effective policies. “We are definitely not out of the woods yet,” but there were signs that the global economy was turning a corner. “Ratings are only as good as their input,” he said, stressing the need to reform methodologies. The use of credit ratings in regulations was another challenge, and OECD was arguing in favour of reforms that addressed those issues.

Among those, he said that credit rating agencies must be registered and supervised, and their methodology must be made public. Their ratings history, including preliminary reports, must also be made available. There was also a need for much better cooperation between competition and regulatory agencies, and stock exchanges, which had been operating independently of each other.

Several Member States also participated in the debate, including the representative of Fiji, who, on behalf of the Group of 77 and China, described how developing nations had sacrificed their scarce resources for development to meet high debt servicing costs. The debt sustainability could be impacted by credit ratings agencies, he said, stressing the need for industry reform.

The representative of the European Union delegation shared the lessons learned from the sovereign debt crisis in the region, saying that the revised rules had entered force in June, with an emphasis on reducing excessive reliance on ratings. The requirement for banks to carry out their own risk analysis was strengthened, she said, adding that banks should not rely on external ratings in an automatic and mechanistic way.

Also speaking were delegates from the United Kingdom, Argentina, China and Ecuador.

In the afternoon, the Assembly held two panel discussions, respectively, on “The Issues and Current Challenges” and “Policies and Proposals for Solutions”.

Panel Discussion I

Moderating the first panel discussion was Angus Armstrong, from the National Institute of Economic and Social Research, and Centre for Macroeconomics in the United Kingdom. He was joined by Michael Kanef, Chief Regulatory and Compliance Officer, Moody’s; Christopher Towe, Deputy Director, Monetary and Capital Market Department, International Monetary Fund; Kevin Buehler, senior partner, McKinsey & Company; Merli Baroudi, Director and Chief Credit Officer, the World Bank Group; and Tobias Schmidt, Chief Executive Officer of Feri Rating & Research AG.

Mr. TOWE described the role of credit rating agencies in triggering the financial crisis, stressing that they were by no means solely to blame. He pointed to weak oversight of the investment banking and insurance industries, the build-up of mortgage debt and the entry of the euro in countries ill-equipped to cope with the ensuing economic changes. The response to the crisis had been broad-based and focused on reform and regulation.

He said it had been difficult to secure consensus and to ensure implementation, but there had been some progress. Least impressive, however, had been the performance of credit ratings agencies, but those could not and should not be eliminated owing to their contribution to assessing credit risk and reducing overall systemic risk. He called for a greater focus on the hardwiring of credit ratings, which were most damaging.

Mr. BUEHLER shared a number of metrics used in relation to credit rating agencies and debt markets. Rating agencies, he said, were vital to the support of debt markets and were part of a much broader credit analysis “ecosystem”. He discussed the use of the Gini coefficient in providing analysis of credit risk, particularly in terms of rating the likelihood of a default. He also touched on the ratings of sovereigns, saying that, overall, those had been slightly better than corporate ratings. He added that performance of credit rating agencies had been reasonably good in their provision of cost effective and useful assessments.

Ms. BAROUDI provided the perspective from developing and emerging economies, saying ratings were important to anyone seeking private capital and particularly important to reducing poverty and generating growth in developing countries. Rating agencies could play a great role, he said, pointing to evidence that they promoted foreign direct investment and local capital markets. Some emerging economies did have concerns, many of which had come to the fore as a result of the sub-prime crisis. Despite the possible benefits and some recent improvements, many developing countries remained unrated.

Mr. KANEF said the financial system played a simple role, with credit ratings providing a “language” for assessing risk. No agency, bank or Government should be the sole arbiter of credit risk; they should contribute to market dialogue, and not end it. He understood that the opinions of rating agencies were considered to be authoritative, but to function effectively, credit markets must remain independent. Their ratings had to serve the needs of market participants, and not be used for public policy objectives by policy-makers and regulators. Mechanistic, regulatory use of ratings was also bad for the market. Against that backdrop, ratings had been criticized as pro-cyclical, but credit ratings were actually fairly stable and long-term in focus, and changes reflected enduring rather than short-lived qualitative changes. He said he supported competition among ratings agencies, as diversity of opinion benefitted the market.

Mr. SCHMIDT said competition and over-reliance on credit ratings still needed solving, and soon. There were strong doubts about the current situation, which constituted a natural oligopoly. The principle problem was lack of competition, and the three big market players had little interest in increasing it. Moreover, issuers liked to stay with ratings agencies with which they were familiar. The problem could be tackled through the political process. Some areas had already been addressed, but much work remained to be done.

Contributions from the floor followed, with speakers touching on the impact of regulation on increasing competition and outlining areas for further review. Broad agreement emerged that, despite regulation, there remained a lack of diversity and competition, with a reliance on larger ratings agencies causing market volatility. There was also a call for international harmonization of the rules governing the agencies and on the use of ratings in private investments.

Mr. ARMSTRONG then posed a question to the panel about disclosure, sparking discussion on the barriers to increasing competition. Panellists noted the power of “name brands” in attracting customers as a key reason for the small number of major ratings agencies.

In response to a question about how the ratings process unfolded, panellists described the quantitative methodologies used for generating ratings and forecasts, noting recent improvements. Mr. Buehler said that quantitative data on “default behaviour” was important, but most ratings processes included a qualitative element, and up to 25 per cent of those cases could have a different outcome compared to those generated solely by a quantitative approach.

Panel Discussion II

Michael Casey, editor and columnist, The Wall Street Journal, moderated the second panel discussion, which also featured the following panellists: Thomas Wieser, President of the Euro Working Group, Council of the European Union; Thomas J. Butler, United States Securities and Exchanges Commission, Director of the Office for Credit Ratings; Shaukat Aziz, former Prime Minister and Finance Minister of Pakistan; Makoto Utsumi, President and CEO of Japan Credit Rating Agency; and John Coffee, Professor at Columbia Law School.

The moderator outlined regulatory changes that had taken place worldwide, but noted that the industry structure, dominated by a handful of institutions, had not changed. In many countries, 90 to 98 per cent of all ratings had been handled by the United States’ “Big Three” players.

Mr. WIESER said that in the past couple of years some European Union members had voiced concerns over sovereign credit rating, as, in some cases, it had deepened the debt problems within the Euro area. A number of European Union member States had experienced significant rating impact on their funding cost and even access to markets. In certain instances, publication of ratings came at “very untimely” moments, increasing market pro-cyclicality and volatility.

He noted that the European Union had started with regulatory efforts, which clearly reduced the reliance of large investors on ratings, but said it would be “quite some years” for all the efforts to take effect. He stressed that the International Organization of Securities Commission and the Financial Stability Board should continue their efforts to ensure the basis for an objective and reliable international rating system. Regarding the lack of any credit rating in some developing countries, he suggested the possibility of establishing a United Nations-sponsored programme. He also called on the United Nations to play a strong role in promoting global discussion on related topics.

Mr. BUTLER, speaking in his personal capacity, recalled that in 2006, the United States had adopted the Credit Rating Agency Reform Act, providing the Securities and Exchange Commission with the authority to establish a registration and oversight programme for credit rating agencies. Prior to that, the industry had been unregulated. In 2010, the Dodd-Frank Act significantly bolstered the Commission’s oversight authority and added a requirement for annual examinations of each registered credit rating agency.

Those agencies, he went on, were required to file annually with the Securities and Exchange Commission and publicly disclose certain information, including performance measurement statistics for credit ratings, a description of methodologies and any conflicts of interest, and written procedures to manage them. Proposed new rules had been issued for public comment, which would include a certification requirement for third-party due diligence services, and a requirement on issuers and underwriters of asset-backed securities.

Mr. AZIZ noted that in recent years improvements had been made to the rating process and the functioning of credit rating agencies, but “more needs to be done”. Oversight of the agencies should be strengthened to ensure better transparency and more accountability, he said, adding that the agencies’ structural models should also be examined to see whether they were adequately independent and their quality up to standard. He pointed out that rating agencies tended to be “too carried away” by models and detailed financial information, but to some extent lacked systematic risk analyses and judgement.

The assessments from credit rating agencies should be forward-looking and reflect future development; “lagging indicators are no help to anybody”, he said. While acknowledging that those agencies were one important source of information for investors, he stressed that they were not the only source and investors should also have their own credible risk analyses.

Mr. UTSUMI said that about 99 per cent of United States corporate bond issues had been rated by the three biggest credit rating agencies. The problem was that, in other countries, the “Big Three” enjoyed oligopoly. Stressing the importance of fully understanding the political and social structure, as well as corporate culture of a country or a region, he said that in Japan, two national rating agencies were competing with the United States’ players. “Many friends of mine among policy-makers in Europe are envious of Japan having its own credit ratings agencies competing with the Anglo-Saxon giants,” he said.

Moody’s had downgraded Toyota Motor Corp., perceiving its lifetime employment system as a weakness, he said, noting that later, Toyota had become the world’s leading automaker, demonstrating that that system was a strength. During the economic crisis in Japan, the United States’ rating agencies had downgraded some major Japanese trading firms, like Marubeni and Itochu, to non-investment grade, while his agency maintained investment grade for them. Without Japanese rating agencies, those trading firms, which were prosperous now, would have disappeared. Lastly, he proposed the creation of an international organization to harmonize national and regional efforts to ensure sound rating practices in the competitive environment.

Mr. COFFEE said that the definition of the problems associated with credit rating agencies differed from place to place. In the United States, the problem was inflated ratings for some structured finance. In Europe, it was the downgrading of sovereign debt. Worldwide, reform focused on holding the agencies more accountable for misconduct, increasing competition, downsizing their roles and changing the business model. One feasible reform was to give a third party chosen by investors the right to select a rating agency for an issuer. That way, competition worked in favour of investors.

In the brief interactive dialogue that followed, some Member States and other participants posed questions related to some of the proposals made by the panellists, including the establishment of a debt management office within a ministry of finance or treasury and the switch to an assigned rating system.

In closing, the Assembly President noted that the debate had highlighted several shortcomings of the credit rating industry as well as some promising proposals to improve the industry, including the creation of a United Nations observatory of credit rating service providers, the establishment of a global rating platform based on a uniform scale, initiatives for investors to better understand the role of ratings, as well as suggestions to set up public agencies.