Investing In Investment Grade Credit: Too much reliance on quick and dirty signals
Credit ratings will be substantially removed from financial regulations around the world by the end of 2015. Following the Financial Stability Board’s Roadmap of 2012, banks, financial intermediaries and pension funds will reduce their reliance on credit rating agencies and will have to diversify their sources of information for operating in financial markets. The Dodd-Frank Act in the US and the EU CRA III Regulation and accompanying Directive go in this direction.
This sort of regulatory turn, which probably ends the decades-long dominant role of the major rating agencies, has been motivated by the fact that since the Great Recession they have been the target of much criticism for lack of transparency, oligopolistic behaviour, and their inability to provide reliable estimates during crisis periods.
But why did credit ratings become so important in the first place? Why was an alphabet soup of ratings – often later revealed to be erroneous or highly debatable – allowed to influence the borrowing costs of entire nations?
In a recent paper, we have offered theoretical answers to these and other questions on the basis of the following idea. The ex-ante probability of a national default is partly uncertain (in the sense described by John Maynard Keynes and Frank Knight) and the value of sovereign
debt assets is influenced by both known and unknown elements. In the presence of uncertainty, credit ratings provide summary information to investors on the probability of country risk of default and rating grades assume the status of valuable information for uncertainty-averse decision makers. Such a situation becomes particularly relevant during periods of greater uncertainty, which explains the rising obsession with rating announcements during and since the crisis in international financial markets since 2008.
When a decision-maker is unable to fully attribute measurable probabilities to the event of country default, the distinction between risk and uncertainty is clear. On the one side, risk implies defining subjective and objective numerical probabilities for a given event; on the other side, uncertainty implies an incomplete knowledge of all the possible future situations and their probabilities.
While uncertainty-neutral investors make decisions only by looking at the riskiness of a sovereign asset, uncertainty-averse investors are also influenced by the presence of uncertainty. Simply put, in financial markets two categories of investors may coexist, with only one of them interested in receiving additional information for reducing exposure to uncertainty. Both investor types decide to invest after having acquired information on the known contents of the value of the asset, which mostly derive from the observation of economic fundamentals. Uncertainty-averse investors, however, are willing to acquire further information in order to overcome their sensitivity to the unknown.
For the latter, credit ratings act as summary signals providing ex-ante condensed information on the value of an asset, by combining both known and unknown elements. As a consequence, they are attractive for those investors interested in reducing their exposure towards uncertainty, which prefer this sort of quick and dirty aggregated information rather than more detailed disaggregated information.
The legal authority of ratings had important effects in the international financial markets. Firstly, it led to the introduction of significant distortions. In the run-up to the European Monetary Union, for instance, six out of the 12 founding members of the single currency – Greece, Finland, Ireland, Italy, Portugal and Spain – saw their ratings improve, from one level in the case of Ireland to five levels for Greece.
Of the other six, only Belgium was not already rated AAA. Among other factors, this contributed to the convergence of euro-zone bond yields, before the strains of the global financial crisis precipitated the reversal of this rating inflation.
Secondly, the surge of rating-dependent regulations since mid-1970s made the international financial environment easier and more attractive for uncertainty-averse investors. By incorporating rating grades in formal rules, financial
(de)regulators were able to widen the spectrum of potential financial investors interested in sovereign bonds. In particular, rating information became progressively valuable for international investors and non-professional investors, which are likely to show a higher degree of uncertainty aversion than domestic and professional investors, respectively.
Again, the euro-zone provides insightful evidence on this regard. Other things being equal, the provision of more homogenous ratings for euro-zone countries favoured rising cross-border investments. Although other factors were operative, it is significant that foreign holdings of debt securities rose with the rating grades and, after the crisis, fell with them as well: the percentage of cross-border holdings of debt securities by European investment funds stood at 39% at the end of 2013, after the peak of about 48% reached in 2009.
Thirdly, the force of law attained by the three prominent rating agencies (Moody’s, Standard & Poor’s and Fitch) has created a sort of de jure bias in favour of their activities that has contributed to the overconfidence of uncertainty-averse investors.
This force of law was attained in several ways. Credit ratings from these agencies are needed to determine capital requirement ratios of financial institutions, with highly-rated instruments demanding less capital. Refinancing operations conducted by central banks depend on these ratings as well, since collateral eligibility is determined on that basis. Moreover, the suitability of investments for a number of financial institutions, such as pension funds, is based on the ratings awarded to debtors and their issued instruments.
The progressive removal of the regulatory overreliance on credit ratings will therefore likely have consequences on financial markets in the near future, although at the moment it is difficult to assess whether this will imply less cross-border and less non-professional sovereign bond investment in Europe and elsewhere.
In the US, the SEC has proposed to replace references to credit ratings in its rules governing the operation of money market funds. In Europe, the recent Omnibus II Directive – which amends the Solvency II Directive – explicitly limits the use of external credit ratings for the calculation of the Solvency Capital Requirement formula for insurance and reinsurance companies. Specific EU directives, such as the IORP Directive for Occupational Retirement Provision and the UCITS Directive for Collective Investments, push strongly for the adoption of own credit risk assessments by investment funds. By 1 January 2020, pursuant to the FSB’s Roadmap, all references to credit ratings in EU law in the investment fund management sector are expected to be removed.
Since 2007, citizens and policymakers have heard more about rating agencies and their actions than ever before. Redefining financial regulations to take out the over-reliance on credit ratings will reduce some of the distortions in today’s financial markets. After four decades, policymakers are realising that free information in financial markets needs to be protected, not distorted.
Paolo Di Caro is a post-doctoral research fellow in the Department of Economics and Business at the University of Catania and a research associate with the Centre for Applied Macro-Finance at the University of York; Belmiro Oliveira is an independent economist