Andrea Miglionico, The Governance of Credit Rating Agencies: Regulatory Regimes and Liability Issues
| Pages | 156-158 |
| Date | 01 January 2020 |
| DOI | 10.3366/elr.2020.0616 |
| Published date | 01 January 2020 |
Credit rating agencies (CRAs) are ubiquitous in financial markets. For those wanting to obtain a better insight into their market, operations, regulatory framework and potential liabilities, Miglionico's new book provides essential reading. The book is split into three parts: the business of credit rating, regulation of CRAs and liability of CRAs. The first part provides the reader with background knowledge of the operation of CRAs. In theory, CRAs play a key, dual role in financial markets. Firstly, they provide metrics for investors to establish the creditworthiness of the issuer/originator of the financial product which is rated. In such capacity, they act as a gatekeeper to the financial markets by rating the relevant securities by forecasting the probability of default. Their ability to fulfil this role is based on their accumulated “reputational capital”. This has, in turn, led to a second key function developing. Generally, the capital adequacy of financial institutions is tested by reference to the ratings of the assets that they hold, with riskier assets requiring more regulatory capital to be maintained. Under the Basel II accord, the method of ascertaining the riskiness of these assets was by reference to CRA rating (this has been mitigated under the Basel III accord). CRAs have, ultimately, performed important roles in three recent market crises (the corporate governance crisis encapsulated by Enron and WorldCom, the global financial crisis and the European sovereign debt crisis) and global responses to these crises.
Miglionico flags that CRAs suffer from four structural issues. Firstly, they mostly operate on the “issuer pays” model of ratings. This leaves them with conflicts of interest: investors rely on the data, yet the issuer pays (and accordingly picks) the CRA. Secondly, the market exists as an oligopoly in which the three principal CRAs (Moody's, Fitch and Standard & Poor's (“S&P”)) operate with limited competition due to the high barriers of market entry arising from the difficult task of needing to accumulate reputational capital prior to being able to expend it. Thirdly, they are frequently slow in changing their ratings, and especially reticent to downgrade ratings once issued. Fourthly, they are “pro cyclical” – they tend to downgrade ratings when the market is generally in a downturn, and the downgrading exacerbates the economic downgrading. These are all exacerbated by the importance of CRA ratings in the regulatory landscape...
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