Who needs rating agencies?

In September, the UN General Assembly in collaboration with the European Union intends to discuss the impact of international rating agencies on the global economic crisis. This announcement was made in late May by head of the General Assembly Vuk Jeremic. Talks about insidious activities of rating agencies have been ongoing for a long time, but they will be investigated on such a high level for the first time.

It seems that politicians got fed up with the actions of rating agencies that often make their verdicts contrary to even relatively rational logic. Head of the UN General Assembly Vuk Jeremic, a Serbian diplomat, after a recent visit with his colleagues in Brussels, told a Belgrade news agency Tanjug that in September the General Assembly of the UN and the EU would jointly discuss the role of the leading international rating agencies in the global financial crisis.

At the September summit diplomats will gather to hear the opinions of experts and economists. For years, experts have been drawing attention to the ranking monsters, confidently declaring that their reckless credit assessment of the ability of different organizations, countries and even regions have a direct impact on proliferation of the global financial crisis. The EU has already listened to this assessment of the role of the leading rating agencies and tightened the rules for the use of international credit ratings. European financial institutions are now required to enhance their own mechanisms for assessing credit risk so as not to depend entirely on the opinion of outside experts.

The BRICS countries at the March summit in Durban also decided to establish their own credit rating agency that would provide assessments free from the opinion of influencers. Incidentally, an alliance of three agencies of Russia, China and the United States established in October of last year may become the foundation of the organization. According to the head of the Chinese party of the alliance, the Dagong agency, the mission of the new organization should include assistance in the establishment of an independent, global regulatory rating system.

The question arises why politicians are suddenly so up in arms against the experts who are seemingly just doing their job analyzing the current state of various organizations, countries, etc. All they do is make certain predictions for the future based on this analysis. Are politicians in their indignation trying to shift the responsibility for their mistakes on someone else's shoulders?

Rating agencies appeared by accident. In the middle of the 19th century the U.S. railroad market developed rapidly. Companies were growing like mushrooms after the rain, some survived and evolved, some quickly disappeared. Railways are an expensive enterprise, and companies borrowed money not only from banks, but generally from everyone who was willing and able to invest in them. Yet, there was no way to distinguish between those who would survive and pay back their loan with interest from those who would go bankrupt. The situation was complicated by a great number of swindlers who had no intention to deal with railways but simply disappeared with the investors' money.

Under the circumstances, the publisher of the trade magazine American Railroad Journal Henry Poor had an idea to review the status of the railway companies of the country. He developed a detailed questionnaire, sent it out to various companies, and then published the results accompanied with his comments. As a lawyer and financier, Poor had a good knowledge of the industry. His brother John owned a railway company and built roads in Maine (he also owned the magazine). Henry published very sarcastic comments about those who sent frankly fake data  or simply refused to respond.

The venture was successful beyond expectations. Despite the price of the magazine copies, comparable to the cost of a week-long rent of a room in New York, all copies were sold out. The main readers and fans of Poor were European banks. In the 19th century the majority of capital was concentrated in Europe, but it was much more difficult to distinguish offenders from prospective businessmen from across the ocean. With a tool like Poor's list, especially with qualifying comments, European bankers rushed to invest in American railroads.

This affected the viability of Poor's idea more than anything. Realizing that honesty and openness could bring profit, businesses began to make efforts to achieve favorable comments. By the beginning of the 20th century, when the stock market began to emerge, the technology of rating and its practical benefits were already clear. Poor and his son organized, perhaps, the first rating agency (now known as the Standard & Poor's). In 1900, they were followed by John Moody (Moody's), and in 1913 - Jon Fitch (Fitch Ratings).

Despite such a long history, credit rating agencies remained a local phenomenon of the United States until late 1980s. Only by the end of the twentieth century, in parallel with the development of globalization, formation of a single currency and financial markets, development of information and communication technologies, the demand for rating agencies became global. Then, strange things started to happen. 

Many remember the behavior of the largest rating agencies prior to the crisis of 2008 that began with the collapse of the U.S. derivatives market (secondary-tertiary securities). They continued to hold the highest reliability ratings of U.S. mortgage banks, the principal owners of most of these derivatives. There are more recent examples. The other day a fierce scandal broke out, initiated by the head of the authoritative agency Fitch. Representatives of a very wealthy institution approached Fitch with a request to assign a high rating to a certain suspicious establishment. Fitch refused, while other agencies accepted the offer. Now Fitch complains that they observe transactions where higher ratings than actual are assigned to companies. If this continues, the situation will soon get worse, because every time agencies would lower the standards of quality assessment.

"The invisible hand of the market" clearly interfered with the the work of experts. If Poor could afford to be completely independent of the generosity of those he assigned ratings to, modern agencies mainly assign ratings as requested by customers (in some countries, companies are required by law to receive a rating), and their agents. While the capital of the rating agencies is the reputation of their predictors, if the customer is willing to offer serious money, the reputation takes a back seat.

Sometimes it is not even about money. Experts and politicians have increasingly accused the "big three" - Moody's, Fitch Ratings and Standard & Poor's that their ratings and outlooks surprisingly coincide with the current policy of the White House. In 2003, the German government accused the U.S. rating agencies of deliberately understating the country's rating due to the differences with Washington over the war in Iraq. When in 2011 against the background of a severe crisis Standard & Poor's dared to lower the U.S. credit rating from the highest to high, the authorities immediately initiated an investigation of the agency (they looked for a leak of the insider information punished by a considerable jail time and a solid fine under the U.S. law). As a result of the investigation, head of the S & P Deven Sharma was forced to resign.

It so happened that in a hundred fifty years of their history, the rating agencies turned from the guides of the stock market and investors' assistants into a tool of political and economic pressure. The saddest thing is that this tool is primarily in one hands. The list of international rules for rating agencies developed by the Basel Committee on Banking Supervision (international organization that develops standards for banking activities) includes three of the five items related to the requirements of objectivity and independence. But formally, the entire forecasts are no more than a private expert opinion, and who is to blame that investors eagerly listen to it?

Of course, the easiest solution would be to simply ban the activities of credit rating agencies, or oblige investors to think for themselves, as it was done in the EU. The problem is that this step in an already apparent globalization may cause a decrease in the mobility of capital, narrow financial flows, and cause a multitude of other very unpleasant problems. This is why the attempt to create an alternative international rating agency that would consistently adhere to the Basel rules, as done by the BRICS countries, appears clearly preferable.

Ilya Nikonov

Pravda.Ru 

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