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Monday, July 25, 2011
Policymakers must reduce reliance on credit ratings
What is the appropriate role of independent credit ratings in the financial system? That is the question raised by recent events in the eurozone and one that has prompted a flurry of suggestions from European policymakers, from intervening in ratings methodologies to suspending certain sovereign ratings.
Eurozone governments are making strenuous efforts to tackle the very serious challenges facing the bloc and to secure near term liquidity support for those most affected. But moves to limit the independence of credit ratings would be counter-productive.
As many commentators have pointed out, such steps would reduce transparency, exacerbate uncertainty, further damage confidence in European markets, and potentially raise the risk premium demanded by investors. They also detract from efforts to improve economic competitiveness and growth and secure longer term solvency of certain eurozone sovereigns.
What is needed is a more thoughtful way to reduce what some perceive as the excessive influence of ratings in financial markets and the financial policy process.
First, let’s recall that sovereign ratings exist to give investors an independent and globally consistent view of the creditworthiness of governments’ debt. Their purpose is to provide an opinion to investors on the effect of policy initiatives on creditworthiness but not to support or undermine particular policy initiatives.
Likewise, ratings are not, as some officials have suggested, biased against Europe. That would be self-defeating for Standard & Poor’s. Our sovereign ratings are based on our published criteria that are applied consistently to more than 120 governments globally. Investors want us to apply the same criteria across our sovereign ratings, so they can obtain a comparable view of credit risk around the world.
Understanding local factors is important too. Robust ratings benefit not just from consistent methodology, but also a sound understanding of local and regional issues. Hence, ratings decisions are made locally. S&P has been in Europe for over 25 years and all the lead analysts for its European sovereign ratings are European nationals based in Europe.
The credibility of sovereign ratings is not the issue at stake here; studies repeatedly confirm that sovereign ratings have an excellent record. The International Monetary Fund, in a study of sovereign ratings published last October, found that ratings provide a robust ranking of sovereign default risk and noted that all sovereigns that have defaulted since 1975 had speculative grade ratings at least a year before default.
In the eurozone, sovereign ratings have been consistently more stable than market prices over time. We started downgrading countries such as Greece and Portugal in 2004, at a time when the market valued their bonds on a par with Germany’s. And while market sentiment has swung to the opposite extreme more recently, our ratings for sovereigns such as Italy and Spain remain well above the speculative levels that market movements may suggest.
Rating agencies do not claim to be the sole voice expressing reasoned views about the future. The bigger question for the financial system is how ratings are used by regulators and policymakers. Their reliance on ratings in determining regulatory and policy decisions may be encouraging excessive focus on rating agency opinions.
For instance, the recent Greek debt rollover proposal from the French Banking Federation was made conditional on rating agencies determining whether it amounted to a default. Likewise, the European Central Bank has emphasised the need for any Greek restructuring initiative to avoid a default as defined by rating agencies. And it continues to consider independent ratings when determining which collateral it will accept and on what terms. Such behaviour places ratings into the heart of policymaking, a role that rating providers did not seek.
A better approach is to drop regulatory mandates to use ratings and avoid making ratings the sole criteria for policy decisions. That would reduce their impact on markets and on public policy. And it would free rating firms to compete entirely on quality.
Investors, in turn, would have the discretion to choose which are useful and which are not, without being compelled to refer to particular benchmarks by regulatory or policy measures.
We want investors and others to use our ratings and measure our success on the benefits our ratings provide. If ratings are valuable, people will use them. If not, market participants should not be forced to refer to them by mandates from the official sector.
This is a more constructive way forward than measures that risk undermining the independence, comparability and value of ratings themselves.