March 19, 2013

More important than how accurate credit ratings are, is how these are used.

Sir, Brooke Master’s reported “Regulators exposes big three rating agencies’ shortcomings”, March 19, referring to the European Securities Markets Authority’s (Esma) year-long examination of Moody’s, Standard and Poor’s and Fitch. Two comments:

First, when they hold that one agency was not giving the markets sufficient notice that it was reconsidering the ratings of a large group of banks, they should never forget that the credit ratings, when predicting the bettering or worsening of credit ratings, can also help to catalyze these.

In this respect I would suggest reading the US GAO Report in 2003, subtitled “Challenges Remain in IMF’s Ability to Anticipate, Prevent, and Resolve Financial Crises” It stated: “Internal assessment of the Fund’s EWS (Early Warning System) models shows that they are weak predictors of actual crisis. The models’ most significant limitation is that they have high false-alarm rates. In about 80 percent of the cases where a crisis was predicted over the next 24 months, no crisis occurred. Furthermore, in about 9 percent of the cases where no crisis was predicted, there was a crisis.”

From that report it is easy to understand that one of IMF’s problems is that what it opines, becomes a political and an economic risk too. And the same goes for the credit rating agencies.

And please, let us also never forget that it would be just as wrong of a credit rating agency to underrate the creditworthiness, of for instance a bank, than to overrate it.

Second, worse than a badly awarded credit rating, is a badly used credit rating. And of that bank regulators are guilty. Let me explain, again.

Banks normally cleared for perceived (ex-ante) risk, that which for instance is given by the credit ratings, by means of interest rate (risk-premiums), size of exposure and other term; let us call that “in the numerator”.

But our current bank regulators, those in the Basel Committee and the Financial Stability Board told the banks they needed also to clear, I would call it re-clear, for exactly the same perceived (ex-ante risk) risk, “in the denominator”, by means of different capital requirements, more risk more capital, less risk less capital.

That was, and is, loony, and only guarantees the banks did and will overdose on perceived (ex-ante) risks.

And that only guarantees that when bank crises will finally occur, as they always only result from excessive exposures to what is believed “absolutely safe” but that ex-post turned out risky, we will find the banks standing their naked with too little capital to cover up with.

And that only guarantees that those perceived as “risky”, and which could in fact be those our real economy most need to keep it moving forward, and create jobs for our young, will have their access to bank credit made more scarce and expensive than ordinary.

And so much more important than having Esma examining credit rating agencies would be having Esma, and all others too, examining first how the bank regulators use the credit ratings.

Please, never forget, that even the most accurate credit rating is made wrong, when excessively considered.

In January 2003 in a letter published by the Financial Times I had written: “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds”. Where was Esma then?