Is this the beginning of the end of credit rating?

A report by the US President’s Working Group (PWG) on Financial Markets released on Thursday could well be the beginning of the end of credit rating. It says

Overseers should ensure that [institutional] investors (and their asset managers) develop an independent view of the risk characteristics of the instruments in their portfolios, rather than rely solely on credit ratings.

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The PWG member agencies will reinforce steps taken by the CRAs through revisions to supervisory policy and regulation, including regulatory capital requirements that use ratings.

In a different context, the report also says that “U.S. authorities should encourage other supervisors of global firms to make complementary efforts to develop guidance along the same lines.”

There is therefore a serious possibility that global regulators would wean institutional investors away from the use of ratings and also reduce the regulatory role of ratings. If that were to happen, would the rating agencies survive only on the basis of retail investors relying on the ratings? I doubt that very much. Long ago when Eurobonds were bought by Belgian dentists, ratings were hardly influential. Bonds were bought on the basis of name recognition – companies like IBM, Coca Cola and Walt Disney could borrow easily because they and their products were well known.

It is true that when the rating agencies began life a century ago, they did not need a regulatory monopoly to prosper. But that was before Altman showed that creditworthiness could be easily measured using econometric models based on accounting information and before the Merton model showed that the stock price by itself provides adequate information.

Posted at 10:26 am IST on Sat, 15 Mar 2008         permanent link

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