Earth to Regulators: Keep Out!

Willem Buiter’s excellent blog, Maverecon, brings to my attention two reports prepared in the UK:

Willem Buiter is frequently mentioned in PrefBlog: he has, for example, prepared a very good summary of Lessons from the 2007 Financial Crisis. I sharply disagreed with his prescription for reform of the Credit Rating Agencies and also with his current statement:

The Report also mentions the need to improve the functioning of securitisation markets, including improvements in valuation and credit rating agencies but offers very little beef in these areas. It is clear that the credit rating agencies will have to be ‘unbundled’, and that the same legal entity should not be able to sell both ratings and advice on how to structure instruments to get a good rating. The conflict of interest is just too naked. Rating agencies will have to become single-product firms, selling just ratings.

… but for now I’ll let that go. In this post I will discuss the Official Position.

Section 2.61 of the Financial Stability report states:

The Authorities believe that the preferred approach to tackling such issues is through market action, and where appropriate through changes to the IOSCO Code of Conduct on Credit Rating Agencies. However, it is important to recognise that prudential credit ratings are a regulatory tool, in that supervision within the CRD/Basel II framework places reliance on the use of rating opinions to determine risk weightings for capital purposes. Therefore regulators have a strong interest in ensuring that ratings are viewed as reliable and that the information content of ratings is sufficient. If the issues summarised above are not adequately addressed by the markets, alternative measures to remedy these issues should be considered.

… while Section 2.62 continues:

Investors also need to learn lessons from recent events. In particular, investors need to develop a more sophisticated use of ratings. Market participants that consider investing in new asset classes, such as structured products, should not use ratings as a substitute for appropriate levels of due diligence, nor draw – potentially misplaced – inferences from ratings that the behaviour of structured securities share the same characteristics, including liquidity characteristics, as more familiar comparably-rated corporate securities. Recent losses and illiquidity in such asset classes have ensured these issues are in the forefront of investors’ minds, and market practice is already adapting rapidly in response. There will be a role for coordinating bodies – such as industry groups and international fora – in clarifying and codifying new practice.

And, finally, I note that the authorities are requesting, inter alia, the following feedback:

2.6) Have the Authorities correctly identified the issues on which international work on credit rating agencies should focus?

2.7) Do you agree with the Authorities’ proposals to improve the information content of credit ratings?

2.8) Do you agree with the Authorities that the preferred approach to restoring confidence in ratings of structured products is through market action and, where appropriate, changes to the IOSCO Code of Conduct on Credit Rating Agencies?

First, let’s look at a little history. Remember the Panic of 1825? I will remind Assiduous But Sometimes Forgetful Readers of the bailout of the banking house of Sir Peter Pole, as related and analyzed by Larry Neal, professor of economics at the University of Illinois at Urbana-Champaign:

The first mention of the crisis occurs on December 8, 1825, when “The Governor [Cornelius Buller] acquainted the Court that he had with the concurrence of the Deputy Governor [John Baker Richards] and several of the Committee of Treasury afforded assistance to the banking house of Sir Peter Pole, etc.”44 This episode is described in vivid detail by the sister of Henry Thornton Jr., the active partner of Pole, Thornton & Co. at the time. On the previous Saturday, the governor and deputy governor counted out £400,000 in bills personally to Henry Thornton, Jr., at the Bank without any clerks present.45 All this was done to keep it secret so that other large London banks would not press their claims as well. A responsible lender of last resort would have publicized the cash infusion to reassure the public in general. Instead, the run on Pole & Thornton continued unabated, causing the company to fail by the end of the week. Then the deluge of demands for advances by other banks overwhelmed the Bank’s Drawing Office.

The analysis makes perfect sense to me. The lender of last resort should enjoy the utmost confidence of the investing public, with an unparalleled reputation for probity and bottomless pockets.

However, the Treasury Committee report on Northern Rock referenced above provides extensive detail about the urge of the lender of last resort to provide covert assistance only and why it was finally decided that any support had to be made public (paragraphs 123-142, inclusive). Paragraph 165 states as a conclusion of the committee:

We accept that the consequences of an announcement of the Bank of England’s support operation for Northern Rock were unpredictable. There was a reasonable prospect that the announcement would have reassured depositors rather than having the opposite effect, particularly prior to the premature disclosure of the operation. However, after the premature disclosure of the support, and against the background of the market reaction to Barclays use of lending a fortnight earlier, it seems surprising that the issues were not urgently revisited. It is unacceptable, that the terms of the guarantee to depositors had not been agreed in advance in order to allow a timely announcement in the event of an adverse reaction to the Bank of England support facility.

In this case it was the announcement that the Lender of Last Resort had been called upon that actually caused the run.

I will also note the acknowledgement of Prof. Buiter in Paragraph 164:

Professor Buiter took a rather different view:

If [the Tripartite authorities] were not quite convinced that the public would believe them—and in these days you cannot be sure of that—then the immediate creation of a deposit insurance scheme that actually works and is credible would have been desirable. To wait three days was again an unnecessary delay.

In other words, there is good agreement that the authorities have squandered the trust of the public. The quote seems to have been lost in a revision, but I recall reading at the time that one woman queuing up for her money at a Northern Rock branch told a reporter at the time – who was puzzled as to why she was concerned – that ‘they lied to us about Iraq. Why shouldn’t they lie to us now?’

My thesis can be stated very simply: given that distrust of regulatory and other official bodies is so deeply ingrained into the public psyche, how can there be any contemplation of the idea that increased regulation and official oversight of the Credit Rating Agencies will improve public trust in the ratings?

The proponents of increased regulation also appear to be completely unable to provide any evidence that a credit rating analyst required to fill in forms and tick off boxes will provide estimates and advice that are any better than he would have produced without filling in forms and ticking off boxes.

Sadly however, those investment advisors, both licensed and unlicenced, who persuaded clients/employers/investors that the ability to write a big cheque equated to investment management skill desperately need someone to blame, now that their delusions have blown up in their clients faces. There is also pressure from subscription-based agencies for the regulators to get them more clients. And, of course, the supreme test of one’s ability as a regulator is total faith in the proposition that everything be regulated by a wise regulator.

So … there’ll be changes, for sure. Mostly cosmetic, assuredly costly, definitely useless. But after all, nobody must ever lose money on an investment, or take responsibility for their own actions, right?

And, sadly, once any plan is implemented it will meet its unstated purpose of creating a well-defined scapegoat for any blow-up. As Scotia is proving in the course of its battle with David Berry: if you want to get somebody, and are prepared to spend enough money on enough lawyers to check through things carefully enough, you can “get” anybody … and pretend to be shocked at what you’ve found.

One Response to “Earth to Regulators: Keep Out!”

  1. […] Authoritative references to the Northern Rock fiasco may be found in my post Earth to Regulators: Keep Out!. […]

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