I came across this wow paper by NYU Financial Historian, Richard Sylla. It gives a historical perspective on credit rating agencies. There is a lot of criticism on role of CRAs in this crisis (and rightly so; see Urbanomics for a discussion) and this blog has occasionally joined in the criticism as well.
What Sylla tells you is how and why CRA came up. As pointed out by several economic history studies, globalization and financial globalisation (see this for some ideas) was pretty alive and kicking before World Wars occurred.
However rating agencies only started in 1907 (Moody’s to be precise) but US already had a kicking bond market. The main cos that issued bonds were railroad companies. So who managed these bond issues then? He said there were three agencies:
One is the credit-reporting (not rating) agency. Another is the specialized financial press. A third is the investment banker. In a sense, the bond-rating agency innovated by Moody in 1909 represents a fusion of functions performed by these three institutions that preceded it.
Read paper for details.
The author then points that just like U shaped curve of fin globalisation history, rating agencies also declined with World Wars. And then as fin glob picked up in 1970s so did rating agencies. They eventually became superpowers and their upgrades and downgrades mattered quite a bit.
He then reviews all the criticisms of the CRAs and says they really need to seriously look at their operations. In the conclusion he summarises:
There is now nearly a century of experience with independent-agency bond ratings in the United States. Many of this issues that arise in recent discussions came up in earlier studies of the U.S. experience. The ones that seem most relevant now have to do with the use of agency ratings for purposes of financial regulation. If ratings are used, for example, to help in determining the capital adequacy of financial intermediaries, the underlying rationale would rest at least in part on thinking that such a use would help to prevent or alleviate financial crises. In that connection, it is worth recalling Braddock Hickman’s concern that such a use conceivably might make a financial crisis worse than it otherwise might have been, or perhaps even cause a crisis when business contractions lead to ratings downgrades.
Partnoy’s complaint that the use of agency ratings for regulatory purposes puts the agencies into the business of selling regulatory licenses also needs to be taken seriously. The U.S. Comptroller of the Currency in 1936 issued a regulation prohibiting banks from purchasing investment securities with characteristics that were “distinctly or predominantly speculative,” and then added that “ the terms employed…may be found in recognized rating manuals, and where there is doubt as to the eligibility of a security for purchase, such eligibility must be supported by not less than two ratings manuals.” The latter phrasing referring to recognized raters was attacked as placing too much authority in the private rating agencies, and on that ground it was deleted from the regulation in 1938, although in a less formal way it remained in effect with regulators.
The designation of “Nationally Recognized Statistical Ratings Organizations” some four decades later in the United States brought back what had been abandoned in 1938. Should representative governments be in the business of passing out such designations if the designees are thereby allowed to profit from selling regulatory licenses? Or, if ratings are to be incorporated in financial regulations, is it possible that regulatory authorities have a responsibility to come up with, and apply, their own ratings? If the answer is, “No,” then why not contract out other regulatory functions, such as bank examinations, to private contractors?
The same issues are haunting us now. The paper was written in 2001. It was presented at a WB conference on CRA (more papers to read…grrr). We have not done anything at all about the issues raised wrt CRA. Just that they only got bigger and bigger despite conflicts of interest and no real value add (rating agencies mostly follow the events). And the regulatory arbitrage just made them near Gods. As I keep saying in this blog, none of the issues which have beeb raised in this crisis are like out of the blue. They have all been discussed and debated umpteen times but nothing was done.
Citibank chief once (and famouly) said:
When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing. (July 2007)
This applies to all – regulators, economists (the powerful ones who kept ignoring these sort of papers), different kinds of firn firms etc etc.
It is a great paper and has tremendous insights. Must read.
