Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Stocktaking on the use of credit ratings

Earlier this week, the Basel Committee (along with IOSCO and IAIS
– the Joint Forum) published a report entitled “Stocktaking on
the use of credit ratings
” which documents the use of credit
rating in banking, securities and insurance regulations in several
major countries around the world. What struck me while reading the
report is the fact that the US appears as an outlier in its pervasive
use of credit rating in all aspects of its financial regulations.

Surprisingly, the UK uses credit ratings very little apart from
what is mandated by Basel-II. In particular, the UK does not use
credit ratings at all in determining what securities a regulated
entity can or cannot invest in. (Just in case, one worries that
somebody in the FSA might have made a mistake while checking boxes in
the survey questionnaire, the report states categorically, “ the
United Kingdom Financial Services Authority (UK FSA) noted that credit
ratings are not used in any of its three financial sectors for asset
identification.”)

For a country like India whose regulations use ratings quite
extensively, this is an opportunity for a hard rethink. The current
global crisis has shown that rating agencies can horribly wrong. More
importantly, the crisis has reminded us that even when ratings measure
idiosyncratic risk well, they are a poor signal of systemic risk.

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