Pity the under-paid – and typically sedate – sovereign rating analyst, who has emerged as regulators’ new whipping boy.
The European Securities and Markets Authority (ESMA) this week announced it had uncovered alleged bad practice and the involvement of unwarranted participants in the sovereign rating process. Given the carpet-bombing of eurozone sovereigns with negative rating actions during the past three years, EU officials effectively bestowed ESMA with a mandate to discover flaws in the sovereign rating process at the big three firms, Fitch, Moody’s and Standard & Poor’s.
In any case, if ESMA’s investigation is a pre-cursor to further intrusive regulatory oversight of the European ratings-business, market participants would do well to take note of the allegations – including a lack of confidentiality in ratings decisions before publication, violating procedures to curb conflicts of interest and bestowing excessive responsibility to junior staff members.
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The most damaging allegation centres on the claim that in one instance, senior management, even board members, with apparent commercial interests, influenced sovereign decisions, rather than the lead analyst or independent members of the ratings committee. The rest of the critique is largely micro in nature, relating to processes and supervision, rather than an assessment of how ratings are calculated through models.
The report raises more questions than it answers. Were senior managers biased towards taking a more sanguine approach to eurozone sovereign ratings, to avoid the political fallout? If so, this would undermine the spirit of ESMA’s mandate – to whiplash credit rating agencies (CRAs) for being pro-cyclical through negative ratings actions.
It’s feasible, of course, that senior management had a relatively benign agenda, say analysts.
Jeremy Weltman, an economist for Euromoney Country Risk, which acts as a competitor to the main agencies, says: “Senior management might have sought involvement to avoid mistakes, through oversight and their experience, and to keep control of the process.”
Samuel Theodore, who heads the fledging London-based agency Scope Ratings, agrees, citing the contentious use of ratings during the negative sovereign-bank feedback loops that have roiled the eurozone in recent years.
“Given the stress witnessed in recent years, it’s not a surprise if important decisions were made by senior management given the associated challenges facing the ratings business.”
The investigations also note the unwarranted involvement of communication teams in influencing – presumably the timing of – rating decisions.
In addition, in one instance, a rating agency was guilty of the age-old problem: a market leak, though EU officials themselves are guilty of market-moving ratings’ leaks in recent years, including that of France and Austria in January 2012. (In any case, bond mandates benchmarked to ratings typically require at least two agencies to shift positions before triggering a shift in allocations.)
Is the confidentiality issue especially damaging to CRAs’ market credibility? Weltman has his doubts.
“I am not so bothered by the confidentiality problem,” he says. “It might move markets, but as long as the rating is accurate it is not particularly damning. Besides, the agencies signal using the negative or positive watch approach, so changes can be anticipated.
“ESMA also criticizes release delays, but these are sometimes to check information so it can’t have it both ways (doesn’t it want accuracy?).”
Other conflicts of interest were also apparently noted, such as lack of independence of rating review panels before publication. The investigation also castigates rating analysts for apparently wasting time penning thematic pieces, though it surely broadens their macro perspective.
ESMA then sounds the alarm on the apparent critical role of junior analysts in driving rating decisions, though junior staff are inevitably tapped, given the need for in-house number-crunching and research work while senior analysts travel to meet policymakers, and staff turnover can be high given the relatively modest industry pay.
In sum, there appears, at this stage, no smoking gun in the investigation, according to Weltman.
“The combination of analysis, on-site inspection and discussion with staff is similar to a Competition Authority investigation into market infringements,” he says. “Despite this, ESMA admits that it doesn’t know whether any of its findings actually constitute an infringement of its own regulations. Moreover, there is no blame levied against any particular agency [at this stage].”
After unveiling regulations that restrict the timing of rating actions, and publishing three reports into the industry, a more intrusive supervisory regime could be on the cards, ESMA’s report concludes.
“As of the date of this document, ESMA has not determined whether any of the findings in this report constitute a breach of the provisions of the regulation,” it states. “The report is therefore published without prejudice to the possibility of further investigations which could lead to supervisory or enforcement actions.”
As previous Euromoney critiques lay bare, CRAs, especially Moody’s, are already on the path of upping the quality and transparency of their sovereign ratings model.
What’s more, the irony is sovereign ratings are typically pretty decent in reflecting the discrete event of default. For example, between 1983 and 2012, no sovereign defaulted within a year of being bestowed an investment-grade status by Moody’s, and outperform the accuracy of ratings in other asset classes.
What’s more, investors typically retort that EU officials are dramatizing the importance of sovereign ratings. Some analysts go so far as claiming sovereign ratings are dead in the water, with the exception of emerging markets.
“Sovereign ratings do more harm than good for market insight and confidence,” says Theodore, who says Scope has no plans to introduce sovereign ratings.
However, investors might be overstating their case. A May 2013 paper by the University of California, Santa Cruz, for example, concluded that a dynamic panel model suggests a credit rating upgrade decreases CDS spreads by about 45 basis points on average for EU countries, though the association between rating changes and spreads follows a complex, non-linear pattern dependent on the level of the rating.
More importantly, a joint committee of European regulators has conducted a consultation on how to undercut the mechanistic use of ratings in regulatory and market standards. For good reason.
The institutionalization of sovereign ratings distorts markets, through the hardwiring of ratings in bond portfolio mandates, the dependence of CRAs in Dodd-Frank legislation and risk-modelling of banks’ sovereign debt portfolios, and the mechanistic boosting of bank-ratings thanks to sovereign support.
However, ESMA’s report, uncovering the process of decision-making, seems to be a less-contentious issue, with its flaws reflecting a now-obvious fact: ratings are not the result of some automated, scientific process.
A Moody’s spokesperson tells Euromoney: “Moody’s is committed to complying with the European regulation and effectively managing any potential conflicts of interest as we continue to enhance the performance, processes and transparency that underpin our ratings.”
An emailed statement from Fitch states: “While we are confident that all our policies and procedures meet regulatory standards, we are moving swiftly to address any issues identified in the report.”
While a Standard & Poor’s spokesperson says: “We are committed to the highest standards in our ratings activities, and are continually enhancing our analytics and operations with that in mind.”
If you are looking for more juicy critiques of rating agencies than ESMA’s report, you could do a lot worse than read this failed rapprochement between the CEO of Jefferies and head of Egan-Jones agency.