Treasury Select Committee Inquiry into Credit Rating Agencies Memorandum by the Investment Management Association 1 Executive Summary 1. A credit rating only assesses the probability of default of a financial instrument and the potential loss in the case of default. It does not actually say anything about the value or liquidity of the instrument at any point in time. 2. Rating agencies do perform a function as independent commentators. This is an important role and needs to be protected from political interference. 3. As an over-arching point, IMA members believe that the US and EU regulation of the credit rating agencies, and of their processes and governance, actually gives them an imprimatur with some investors. Because of this it is not clear that the EU Commission s current proposals which are aimed in part to reduce reliance by regulators and financial institutions on credit ratings will be met. 4. Despite regulatory authorities desire that credit ratings are less relied upon by investment firms, client mandates, which specify rating thresholds, are rarely chosen by investment managers and have to be adhered to. 5. IMA members believe that the recent rating downgrades of sovereign debt have not been influenced by any of the issues raised. They were simply based on deteriorating public finances in certain countries over a significant period of time which has hurt the ability of those countries to repay outstanding debt. Is the methodology used by rating agencies sound and transparent? 6. IMA members believe that the methodologies used by rating agencies are on the whole sound and transparent and their analysis is generally respected by investors. This is true of sovereign and corporate ratings and members have seen a recent improvement in the transparency of their analyses. 7. It was rather different for structured products in that, before the financial crisis, reliance on what turned out to be flawed models led agencies to rate certain products higher than the sum of the parts which proved to be untenable. 1 The IMA represents the asset management industry operating in the UK, which at the end of 2010, was responsible for the management from the UK of about 3.9 trillion of assets invested globally on behalf of clients drawn from around the world. 65 Kingsway London WC2B 6TD Tel:+44(0)20 7831 0898 Fax:+44(0)20 7831 9975 www.investmentuk.org Investment Management Association is a company limited by guarantee registered in England and Wales. Registered number 4343737. Registered office as above.
Do the rating agencies have the right incentives to do their job properly? Do they have conflicts of interest on either the corporate or sovereign side? If so, what is their cause? Do the agencies face adequate competition? 8. The business model employed by the majority of credit rating agencies in rating corporate bonds is the issuer pays model. This means that the issuer of a bond pays a fee to the agency to rate it. That fee is the agency s revenue stream. These ratings are publicly available, although investors pay the agencies to have access to their analysts and their rating process, to obtain data feeds and when used to satisfy Solvency II obligations. 9. The clear conflict of interest is that, in order to retain the issuer as a client (particularly if the company is a heavy issuer of bonds) the agency might assign a more favourable rating than the fundamentals may warrant. This could suggest that the incentives are the wrong way round and that investors should pay to have access to ratings. On the other hand we understand that frequently issuers instruct their investment bank to argue on their behalf with the agencies that the assigned rating is too low. Therefore the conflict may be more perceived than real. 10. Rating agencies sometimes produce unsolicited ratings on bonds which means that they have not been retained by the issuer to produce a rating and so are not paid a fee. The conflict might arise however in that in order to gain a new client the agency may assign a rating higher than it might otherwise do. Empirically however there are numerous examples of unsolicited ratings being lower than the solicited one. 11. The repeat nature of the structured product business, whereby issuers (banks) bring regular business to the agencies, also has clear conflicts. This was a new and growing revenue stream for the agencies in the years before the financial crisis and they were put under pressure from the banks to provide guidance as to how to structure the issues to generate the required credit rating. This was mainly a problem specific to structured finance and hopefully lessons have been learned. 12. With sovereign issuers the same conflicts do not arise although the rating agencies are likely subject to political pressure. 13. Nevertheless the events of the last 5 years will have taught that any temptation to provide in the short-term a pro-issuer rating can give rise to significant and longer-term reputational damage. 14. By virtue of the dominance of only three global rating agencies then it is certainly the case that they do not face enough competition. More competition would help to increase the quality of credit ratings and if that resulted in more diversity of opinion then volatility due to a rating change might fall. It is however hard to see how to create more competition in what is now a market quite heavily regulated in both the US and Europe which has raised barriers to entry. There have been examples in the past of new agencies being set up but without much success. In the US however Egan Jones has had some success in taking market share with its investor pays model and focus on unconflicted analysis. 2
15. In addition the way that the big three s ratings are embedded in, for example, pension fund mandates gives them an entrenched position in that market. Pension consultants are reluctant to advise clients to use different metrics as a risk management tool. 16. A similar situation arises in the case of life assurance companies. Regulators usually require a company to use CRA ratings when calculating capital, even though firms often have their own internal teams of analysts, and are quite capable to assigning ratings themselves. This helps entrench the agencies position. How accountable are the major credit rating agencies? What is the appropriate role for independent ratings agencies? Have the big three agencies become too powerful? 17. Commercial reality makes the agencies accountable for the accuracy of their ratings which can only be assessed over time. Reputational risk provides a strong incentive to produce high quality ratings and offsets to a great extent some of the conflicts cited above. The appropriate role for the agencies is to produce independent and considered opinions. They are however only one opinion amongst many in the market place. Nor do credit rating agencies hold themselves out as in any way guaranteeing their ratings or opinions. As they are often privy to information which is not available to the public however perhaps more weight is put on their opinions than on others. 18. It is worth pointing out that a credit rating only assesses the probability of default of a financial instrument and the potential loss in the case of default. It does not actually say anything about the value or liquidity of the instrument at any point in time. 19. There is no doubt that the big three agencies have significant influence on the market. Many investors however also carry out their own analysis of default risk and institutional investment managers typically employ credit analysts to do this. This plays some part in the observation that market values do at times reflect a different view of a company s prospects than that implied by the rating. Nevertheless, despite the determination of the CRAs not always being conclusive as to the market s view of a rating, there has been over-reliance by some investors on credit ratings as an objective standard of quality e.g. by investors who do not have access to unconflicted credit analysts, in investment regulations and in investment mandates. 20. The position of CRAs as quasi-official entities due to the status they have been given in the US as Nationally Recognised Statistical Rating Organisations (NRSROs) and now being regulated in the EU, together with the fact that they may have privileged information, can lend extra weight to their opinions in the view of some market participants and a rating might be perceived as signalling inside information. The argument that CRAs are merely licensed in the EU and so not advantaged by some official imprimatur does not hold water. 3
What effect do rating agencies have on the efficient allocation of capital? How is investor behaviour affected by rating changes? 21. To the extent that unsophisticated investors might rely on ratings which subsequently prove to be inaccurate then one could say that is not an efficient allocation of capital. This is however no different from making any other investment decision which turns out to be non-optimal. 22. Despite regulatory authorities desire that credit ratings are less relied upon by investment firms, client mandates, which specify rating thresholds, are rarely chosen by investment managers and have to be adhered to. A rating downgrade therefore might result in the client mandate guidelines being breached, necessitating a sale of the instrument, whether or not the manager s own risk assessment suggests that the change was unwarranted. If the security is widely held then this can lead to a cliff edge effect with far more sellers than buyers pushing the price significantly lower than might otherwise be justified. This is a simplification as in practice many managers and clients would expect to talk when there were downgrades and decide when to sell rather than just joining in a firesale; nevertheless the point that mandates will require a sale in the shortterm is still good. Similar considerations apply with life assurance companies where a low CRA rating will make a holding capital intensive, even though the internal investment team do not agree with the agency s opinion. 23. The big three s ratings are the main metric in admitting a bond to a benchmark index. Most investment managers portfolio performance is measured against the return on the benchmark index chosen by the client. If a bond is subsequently removed from an index then managers, in particular those managing indexed funds, will be forced to sell. 24. On the other hand, if a manager s internal credit assessment shows that the rating on a bond which is outside a client s universe, due to its low rating, should be higher, he cannot actually action that view for his client; this suggests there are inefficient allocations of capital from over-reliance in mandates on the public ratings. 25. In a stressed situation an agency downgrade of an issuer s rating can often directly affect the company s borrowing costs and exacerbate its problems. 26. Some corporate managements might seek to structure their finances in such a way that limits too many direct consequences of rating changes, but might not be in the long term best interests of the business. In this way the credit rating consideration is disciplining the company s behaviour. How embedded are agency ratings within the national and international regulatory frameworks? Is this changing under new regulatory frameworks being introduced? 27. Both Basel III and Solvency II contain references to external credit ratings. Some companies can utilise internal risk models but smaller to medium sized firms may not have the resources to do this. The European Central Bank uses credit ratings when calculating haircuts on collateral lodged with them by 4
commercial banks seeking secured loans. This has caused considerable uncertainty at time when a Member State s sovereign debt has been downgraded below the level of acceptable collateral. On these occasions the ECB has been forced to revise its eligible collateral rules. See next question for changes in the EU. Are the proposals put forward by the European Commission with respect to ratings agencies based on the right objectives? Will they achieve the Commission s aims? 28. As an over-arching point, IMA members believe that the EU regulation of the credit rating agencies, and of their processes and governance, actually gives them an imprimatur with some investors which is probably not the Commission s intention. Because of this it is not clear that the EU Commission s current proposals which are aimed in part to reduce reliance by regulators and financial institutions on credit ratings will be met. 29. The Commission s proposals appear to be unduly heavy-handed when the main problem with the agencies ratings in the past was in the structured finance area. Their processes for rating corporate bonds and sovereign debt have proven to be reasonably robust through a difficult period. 30. As for specific proposals: Financial institutions requirement to do own risk assessment, with processes to be supervised by competent authorities: the obligation not to over-rely on credit ratings issued by the agencies is not the same thing as imposing on firms the requirement to do their own credit risk assessment. It should be worded so that firms were obliged to have their own clear investment process (appropriate to size and type of firm) which then should lead them not to rely mechanistically on ratings. This would impose a positive duty on managers to have a clear investment process rather than placing too much weight on a negative duty to not rely on external ratings. CRA Rotation: IMA members are not convinced that forced rotation of agencies engaged by issuers will increase the quality of those ratings. Indeed when a new agency takes over from the incumbent this is likely to cause more volatility rather than less as the market waits to see whether the existing rating might change or not. It is also the case that the incumbent agency is likely to have a far better understanding of the issuer than the new agency which will take time to do a thorough analysis. The Commission s intention is to make way for new entrants although this is unlikely to be an effective way of doing so. Submission of methodologies to ESMA: IMA members are concerned that this will result in the standardisation of methodologies across agencies, which is clearly counter-productive. In addition the fact that a new methodology or a change to the existing one should be approved by ESMA could well lead to a delay in the new rating or to withdrawal of the rating leading to market disruption and uncertainty. Civil Liability: this is likely to result in the agencies accompanying their ratings with a plethora of health warnings and disclaimers. 5
The sovereign rating methodology of agencies includes an assessment of national and international political factors. Do the agencies influence the political process in any way? What are the appropriate limits to credit rating agency political influence? For example, do credit ratings have an impact on national fiscal planning and budget planning cycles and therefore, potentially, economic growth paths? If so, is this appropriate? 31. It is doubtful that CRAs have had a significant effect on the political process during the Eurozone crisis or the US debt ceiling negotiations. Rating agencies do perform a function as independent commentators. This is an important role and needs to be protected from political interference. 32. Where CRAs have influence on sovereign states political processes is where it is government policy to maintain or to achieve a particular credit rating from them. This can have an effect on its fiscal and monetary policies and therefore on the rate of economic growth. 33. Nevertheless sovereign states are always free to ignore ratings which they believe might constrain the government s ability to pursue policies which they deem to be more appropriate. Have recent downgrades of sovereign debt by the credit rating agencies (e.g. the downgrades of the United States and a number of Eurozone sovereigns) illustrated any of the issues raised by these terms of reference? Are the downgrades supported by the evidence? 34. If a sovereign nation has its own currency then it should always be able to repay its debt albeit in the worst case in a heavily debased currency. This makes the concept of default risk unclear and this kind of default could be characterised as a soft default. Clearly when a country does not have its own currency and cannot print money, then default becomes hard. In the case of troubled Eurozone countries this is what the agencies are now assessing in their ratings. 35. During the crises referred to, the rating agencies have helped to highlight the underlying problems, rather than being the problem themselves. In the case of the Eurozone, it is worth noting that the market pricing of some sovereign debt has been markedly more pessimistic than might be expected from the agencies assessments. 36. The recent rating downgrades of sovereign debt were simply based on deteriorating public finances in certain countries over a significant period of time which has hurt the ability of those countries to repay outstanding debt and which may make a hard default more likely. It is notable that Moody s downgraded Greece initially in 2004. Other 37. A number of IMA members have raised the issue of the big three agencies exploiting their monopolistic position by dramatically increasing the costs of the 6
licence if their data is to be used for regulatory purposes. Contractual agreements which had been in place for many years were deemed insufficient by one agency to cover the services and requirements of the fund management business, an insurance client and its regulator. The manager was forced to sign a revised contract at a significantly increased cost. The insurance client in question could not risk being in a position whereby they were unable to report the credit ratings of their investment portfolio. For further information please contact: Mona Patel, Head of Communications mpatel@investmentuk.org or 020 7831 0898 7