Bank of England Discusses Role of Credit Rating Agencies

Geez, I was just locking up when I saw a story on Bloomberg – BOE Says Intervention May Be Required Over Credit Ratings. The third paragraph is considerably less emphatic than the first:

Credit-rating firms should face “public sector intervention” if they don’t overhaul the way they grade so-called structured debt products and provide more information to investors, the Bank of England said.

“These actions might occur voluntarily in the light of recent market experience,” the Bank of England said in the report. “Without this market evolution, there might be a case for public sector intervention to specify and encourage higher and common standards of assessment and disclosure.”

The BoE news release doesn’t mention the agencies; but I’ll include some quick snippets from the actual report:

Some end-investors and fund managers may have mistakenly assumed that the credit ratings of these products provided information on other risks. Many of these instruments are ‘buyand hold’ securities for which there is not always a readily available secondary market. A single rating does not capture adequately all of the risks inherent in these products — for example, liquidity risk — as reflected in the differential pricing of products within a similar ratings band.

The controversial stuff is in box 6 on page 56 of the report. Five suggestions for possible improvements are made – and I’m not going to comment on them now. However, these suggestions are inspired by a false premise:

These suggestions aim to facilitate a more sophisticated use of credit ratings by investors.

To which – as one last sally before switching off – I’ll say:

  • If a more sophisticated use of credit ratings by investors is desired, then it would appear more appropriate to concentrate any regulatory action on such investors. Yank a few licenses for imprudent conduct such as unsophisticated use of credit ratings, for instance. Make it clear that CEO’s who play at being Portfolio Managers with shareholder money are civilly liable if found negligent or reckless.
  • investors – taken as a group, with plenty of exceptions – do not want to use credit ratings in a more sophisticated way. They want one number that doesn’t need to be thought about in order to offload their responsibilities

Update, 2007-10-25: I must admit to some confusion regarding one of the Bank’s recommendations:

In moving forward, there are several areas in which further work is needed by market participants and the authorities in the United Kingdom and internationally to restore confidence in the financial system

The smooth functioning of markets in complex instruments depends on clarity about their content and construction. As discussed in Box 6 on page 56, rating agencies should support this process by clarifying the information available to investors on the risks inherent in products and the uncertainties around their ratings assessments. Recent events have demonstrated to investors the dangers of using ratings as a mechanical input to their risk assessment.

Why is it the ratings agencies’ job to clarify “the information available to investors on the risks inherent in products”? Just coming up with an assessment of credit risk is a pretty big job, and quite enough for one army of specialists. There is a very real danger here that the current fad for blaming the ratings agencies will lead to a situation in which they are held accountable for making market recommendations. That’s the job of investors! And if there are “risks inherent in products”, these are supposed to be disclosed in the prospectus – you know, around page 400, along with risks of meteorites wiping out head office.

Fans of the Black Swan model of Nassim Taleb will be gratified by the Bank’s note that:

It is striking that a market as small as US sub-prime RMBS, with a size of around $700 billion, had such pervasive effects on much deeper and more liquid markets, such as the asset-backed securities (ABS) markets (with a size of $10.7 trillion).

I prefer to think of financial markets as a chaotic system … which might be criticized as mere definitional quibbling, but even fat-tailed distributions strike me as being too deterministic. The universe is an unfriendly place; there is no telling which part of it is going to swoop down and kick you next.

Update, 2007-10-26: I became so interested in Box 2 of the report, Valuing sub-prime RMBS that I had to create a post dealing specifically with the issue! Default probabilities for lower grade retail credits are highly correlated – responding as they do to broader economic conditions – and the degree of correlation has important implications for pricing the various tranches of RMBS.

2 Responses to “Bank of England Discusses Role of Credit Rating Agencies”

  1. […] This post was originally intended to be part of the report of the BoE Financial Stability Report … but it got too interesting and too long! So here it is … an introduction to Loan Default Correlation: […]

  2. […] (ii) Do these results tie in with other work that seeks to analyze bond yields in terms of risk-free rate, liquidity and default risk? The Bank of England has published some of the results of such work, but (a) they’re more interested in junk credits, and (b) I haven’t seen their source data, or (I am ashamed to admit) thoroughly read their source documents. […]

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