Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Is this the beginning of the end of credit rating?

A report
by the US President’s Working Group (PWG) on Financial Markets
released on Thursday could well be the beginning of the end of credit
rating. It says

Overseers should ensure that [institutional] investors (and their
asset managers) develop an independent view of the risk
characteristics of the instruments in their portfolios, rather than
rely solely on credit ratings.

The PWG member agencies will reinforce steps taken by the CRAs through
revisions to supervisory policy and regulation, including regulatory
capital requirements that use ratings.

In a different context, the report also says that
“U.S. authorities should encourage other supervisors of global
firms to make complementary efforts to develop guidance along the same
lines.”

There is therefore a serious possibility that global regulators
would wean institutional investors away from the use of ratings and
also reduce the regulatory role of ratings. If that were to happen,
would the rating agencies survive only on the basis of retail
investors relying on the ratings? I doubt that very much. Long ago
when Eurobonds were bought by Belgian dentists, ratings were hardly
influential. Bonds were bought on the basis of name recognition
– companies like IBM, Coca Cola and Walt Disney could borrow
easily because they and their products were well known.

It is true that when the rating agencies began life a century ago,
they did not need a regulatory monopoly to prosper. But that was
before Altman showed that creditworthiness could be easily measured
using econometric models based on accounting information and before
the Merton model showed that the stock price by itself provides
adequate information.

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