The following is the 12th in a series of articles analyzing the major problems that the G20 leaders should tackle to stabilize the global financial markets and rebalance the world economy. -- Ed.

Credit rating downgrades can have significant negative effects on financial markets.

This month, the euro dropped against the U.S. dollar to its lowest level since 2006. The fall of the common European currency occurred amidst market uncertainty about the effects of a $1 trillion rescue package designed to shore up Greek and Eurozone markets as well as global financial stability. At the same time, there has been a growing criticism of the role of credit rating agencies and renewed calls for their regulation.

Indeed, the judgment that the Greek budget deficit for 2009 would be significantly higher than expected led to rating downgrades of Greece’s government debt by all three major rating agencies, starting in December 2009 (to BBB+ for Fitch and S&P and A2 for Moody’s). As credit markets punished Greece with higher borrowing costs, credit rating agencies downgraded Portugal and Spain’s debt. By April 2010, Portuguese spreads reached their highest level since 1997 following its downgrade to A- from A+ while spreads for Spain increased as S&P downgraded credit rating to AA.

Criticism of credit rating agencies is a recurrent theme during episodes of market turbulence. Unanticipated and abrupt credit rating downgrades -- rating crises -- are quite common. Prior to the subprime and the Eurozone debt crisis, there has been about one rating crisis every three years in the past 22 years. These include the downgrades of a number of Asian countries in 1998 and large corporates such as Enron, Parmalat, the California utilities, Worldcom, Global Crossing and AT&T Canada.

Sharp rating downgrades can lead to large market losses, fire sales, a dry up of liquidity and have knock-on effects on a number of systemically important market participants, either through legislation, regulations and supervisory policies, contractual arrangements or investment practice.

For instance, starting in mid-2007 in the U.S., defaults of subprime loans have led to abrupt and unanticipated rating downgrades of a number of rated securities, issuers and bond insurers. These downgrades, in turn, led to larger market losses by investors, including banks’ off-balance sheet entities (such as conduits and SIVs). They also led to larger funding needs from banks sponsoring these entities and larger collateral calls from insurers in the CDS markets such as AIG. Some of these channels, such as rating-triggers were also present in the case of the market disruptions following the fall of Enron and WorldCom. An additional problem with rating downgrades is that first round effects can lead to further downgrades.

Credit ratings can, nonetheless, play a useful role in financial markets.

Previous crises have also shown the central role that credit ratings play in the investment decisions of financial market participants. For instance, issuers of securities seek credit ratings to improve the marketability or pricing of their securities, or to satisfy investors, lenders, or counterparties who want to enhance management responsibility.

Buy-side firms, such as mutual funds, pension funds and insurance companies, are substantial users of credit ratings, even though they claim to typically conduct their own credit analysis for risk management purposes or trading operations. Buy-side firms use credit ratings to comply with internal by-law restrictions or investment policies that require certain minimum credit ratings. Finally buy-side firms use credit ratings to ensure compliance with various regulatory requirements.

Sell-side firms also use credit ratings in addition to their own credit analysis for risk management and trading purposes. Many broker-dealers maintain rating advisory groups which generally assist underwriting clients in selecting appropriate credit rating agencies for their offerings and help guide those clients through the rating process. In addition, sell-side firms often act as dealers in markets that place significant importance on credit ratings. For instance, in the OTC derivatives market, broker-dealers tend to use credit ratings (when available) to determine acceptable counterparties, as well as collateral levels for outstanding credit exposures. Finally, large broker-dealers themselves frequently obtain credit rating ratings as issuers of long-and short-term debt.

Credit ratings even play a key role in private contracts, which in turn enhance their importance to the marketplace. “Ratings triggers” in financial contracts are contractual provisions that terminate credit availability or accelerate credit obligations in the event of specified rating actions, with the result that a rating downgrade could lead to an escalating liquidity crisis for issuers subject to ratings triggers.

Regulators have, in the past, increased the role of credit ratings in financial markets.

A recent international stocktaking exercise conducted by the Joint Forum (2009) reveals that credit ratings are generally used in member jurisdictions for five key purposes, especially in their legislation, regulation, supervision and supervisory policies (LRSPs) covering the banking and securities sectors: (i) determining capital requirements; (ii) identifying or classifying assets, usually in the context of eligible investments or permissible asset concentrations; (iii) providing a credible evaluation of the credit risk associated with assets purchased as part of a securitization offering or a covered bond offering; (iv) determining disclosure requirements’ and (v) determining prospectus eligibility. (Joint Forum, 2009, “Stocktaking on the Use of Credit Ratings,” Basel Committee on Banking Supervision, June, BIS)

Using only micro-prudential measures to address the risk of credit rating downgrades, as is currently the plan, will not suffice.

Efforts are underway both in the Eurozone and the U.S. to implement the regulation of credit rating agencies. Under the new EU regulation, credit rating agencies will have to register in the EU and European regulators will supervise and sanction them if needed. Under the US Senate recently approved new rules for credit rating agencies, the Securities and Exchange Commission (SEC) would establish and oversee a credit-rating board that would act as a middleman between issuers seeking ratings and the rating agencies. The board would select which agency provides the “initial rating” for certain securities known as structured bonds.

However, both U.S. and EU regulation focus on reducing conflicts of interests and addressing informational issues. These are key to understand why such rating crises occur, but it is also critical to identify the different facets of risks in “rated market,” how they can lead to systemic crises and how to measure them and manage them. Yet, a key finding of a stocktaking exercise by the Joint Forum (2009) was that policymakers do not conduct formal assessments of the impact of the use of credit ratings on financial markets.

A macro-prudential approach is needed to address the systemic risk of credit rating downgrades.

Policymakers should better assess the nature and extent of the use of credit ratings in financial markets as well as their potential impact on financial stability. Such an approach will require analysis both at the micro and macro level, include all market participants and take a global approach.

The determinants of the supply and demand for “rated assets,” especially in “good times” and the implications of unanticipated abrupt downgrades in “bad times” should be assessed carefully. Such an approach requires also an assessment of the systemic effects of rating downgrades. Key questions include: (i) the type of institutions and markets which would be affected by downgrades, whether directly or indirectly and how systemic and interconnected they are; (ii) the consequences for financial markets and the economy in terms of market losses, liquidity shortages, loss of access to credit and reduced liquidity; (iii) the factors that can increase downgrade risk, including idiosyncratic and systemic ones; (iv) the measurement of systemic downgrade risk; and (iv) the management of downgrade risk at the systemic level through increased capital requirements or liquidity buffers, or other means.

A 3-step approach can help address the system risk of credit ratings. (Sy (2010), “The Systemic Regulation of Credit Ratings Agencies and Rated Markets,” World Economics, http://www.world-economics-journal.com/) As a first step, policymakers should have a good grasp of the risk inherent to credit ratings. In particular, policymakers should use “rating maps” to identify the different channels through which rating downgrades can lead to systemic risk.

Given the risk that credit rating agencies can assign more than warranted high ratings in “good times” as was the case with structured products, questions will also need to be asked during boom cycles. Credit ratings can encourage the growth of the rated market where rated securities are transacted. This growth can also be accompanied by a higher volume of highly rated securities. This “rating inflation” was a key development prior to the current crisis and policymakers will need to get a full grasp of its determinants of “rating inflation.” Questions will need to be asked about market participants’ incentives and the methodology used to justify substantially larger volumes of highly rated securities.

Second, policymakers will need to measure risks inherent to ratings once they are identified. A useful method to measure the systemic exposure to downgrade risk during boom cycles, would be for regulators and institutions to stress test their balance sheet and off-balance sheet positions. Risk managers have long been aware of the risks of credit downgrades, especially for fixed income portfolios. The current crisis has put to the fore the need for policy makers to manage the risks of such downgrades but, this time, at the systemic level. One first step would be to conduct scenario analysis in which the consequences of ratings downgrades for systemically important institutions and different types of rated securities are analyzed. Such an approach will depend on increased transparency in the rated markets. For instance, it will be key to have a clear sense of “rating triggers” and other contractual arrangements, where ratings downgrades can lead to systemically important market portfolio rebalancing or a dry-up of liquidity. Finally, systemic institutions that are vulnerable to abrupt ratings downgrades may have to hold more capital or liquidity buffers.

Concerns about over-regulation and the costs of reducing financial innovation are, not surprisingly, put on hold at the moment. However, policymakers will have to strike a delicate balance between the benefits and costs of systemic regulation. This challenge is, however, not specific to CRAs and rated markets.

Beyond regulation, investors need to ask themselves tough questions when using credit ratings. Credit rating downgrades can have serious consequences for investors and it is therefore important for investors, risk managers and their management and regulators to fully understand what type of risk credit ratings attempt to capture, the methodology and the data credit rating agencies use and the systemic effects of credit ratings.

As Turnbull (2009) rightly suggests, investors and risk managers ask themselves four questions: (i) what criteria do credit rating agencies use? (ii) What methodology do credit rating agencies use? (iii) What data do credit rating agencies use? (iv) What use is a rating? (Turnbull, Stuart, 2009 “Work In Progress: Measuring and Managing Risk in Innovative Financial Instruments” mimeo, Bauer College of Business, University of Houston) I would add to this list a fifth question: (v) what are the systemic effects of credit ratings?

Correct answers to these questions will also not suffice and at least two challenges will remain for investors and risk managers. First, even if risk managers appropriately identify the risks from ratings downgrades, it is important that managerial incentives are designed so as to act upon such information. This is no trivial task, especially in times of plenty when profits are high. Second, rapid financial innovation puts investors and risk managers in unchartered territory as a new methodology is used and new financial instruments are marketed in illiquid markets with little history.

In conclusion, it is not a risky proposition to say that the regulation of credit rating agencies is an unfinished business!

By Amadou N. R. Sy



Amadou N.R. Sy is deputy division chief at the IMF Institute in Washington D.C. Amadou received his Ph.D. in finance from McGill University. He is also a CFA charter holder and has obtained a Financial Risk Management certification from GARP. At the IMF Institute, he teaches macroeconomics and finance. The views expressed herein are those of the author and should not be attributed to the IMF, its Executive Board, or its management.