The Case for Public Sector Credit Rating Agencies

While the eyes of the world are now focused on the measures that the various governments have taken to protect their banking systems, attention to the causes of the current crisis seems to have shifted to the background.

However, this crisis should be seized as an opportunity to provide the financial system with structural improvements, because once the crisis is over politicians will no longer perceive any need for improvements. Improvements concern financial supervision as well as the collaboration among countries in a situation of international financial unrest. They also concern, in my opinion, a change in the system of rating the creditworthiness of financial institutions.

The role of credit rating agencies, such as Moody’s and Standard and Poor’s, has been one of the sources of the current malaise. These firms rate the creditworthiness of financial institutions and the quality of their products. Often those agencies had no clue about the true riskiness of the products they were dealing with. In particular, they have underestimated the likelihood of a downturn in the entire financial sector. Insurance against the risk of certain products is worthless if the insurer itself may go bankrupt. However, the question is to what extent sectorwide risks could have been foreseen and so to what extent the credit rating agencies can be blamed in this regard. Hopefully, the current crisis has taught them to be more careful in assessing risks. However, what is objectionable is the conflict of interest that rating agencies face when judging the quality of financial firms and their products.[1] To obtain a rating, financial institutions often pay large sums of money to these agencies. Obviously, it is important for the rating agencies to maintain a good relationship with their customers. This relationship will not benefit from a too critical attitude towards the creditworthiness of these customers. This will in particular not be the case when the rating agencies assist in the construction of the products that they themselves have to provide a rating for. There exists only one solution to this conflict of interest, which is to have the public sector rate financial institutions and their products. To this end, governments should set up a public rating agency (PRA). The PRA can be funded with taxpayers’ money or with a supplementary tax on financial institutions that set up business within a country. The key feature of the PRA is that it does not aim at making a profit and that it is does not have an interest in providing overly generous ratings. In the case of Europe, the PRA should preferably be organised at the European level,[2] because rating financial institutions is a public good that benefits market participants in all countries. Moreover, it might be difficult to organise the required financial expertise at the national level. Financial expertise is expensive and the payment of market based salaries will be inevitable. Hence, it will not be cheap to set up a PRA. However, these costs are negligible in comparison with the consequences of biased ratings. Ideally, in Europe the PRA would be combined with a European Financial Services Authority (EFSA) that guarantees uniform financial sector supervision throughout Europe and that is responsible for all financial supervision in Europe. The EFSA will be familiar with the situation of individual financial institutions and this information can be used for official credit ratings. Should we force the current credit rating agencies to stop their activities? No, because they will simply be driven out of business if the PRA does its job properly. The independence of the PRA implies that its ratings are more reliable than those of the commercial rating agencies. Hence, the official PRA ratings will sooner or later become the standard that will guide the decisions of investors. Another important question is whether financial institutions should be obliged to obtain an official rating. It will be difficult to impose this obligation for products traded over the counter and developed in countries outside the geographical domain of the PRA. However, if a product does not have an official rating this will be taken as a negative sign and, hence, it will become more difficult to sell this a product to potential investors. The additional uncertainty about the quality of the product will translate into a lower price of this product.

[1] See, for example, New York Times (2008), Triple-A failure, April 27, http://www.nytimes.com/2008/04/27/magazine/27Credit-t.html. See also Partnoy (2006), Assessing the current oversight and operations of credit agencies, Hearings before the United States Senate Committee on Banking, Housing, and Urban Affairs, March 7, http://banking.senate.gov/public/_files/partnoy.pdf .

[2] Preferably, there would be a world rating agency. However, this might be more difficult to organise than a rating agency at the European level or at the national level in the U.S.