More than 15 years after the financial market collapse in 2008 it is worth asking whether one of the market’s umpires--namely, the credit ratings agencies--have improved their performance.
While there is no shortage of actors with some modicum of culpability in the financial crisis of 2008-2009, the reluctance of S&P and Fitch--which provide the market with credit ratings for a wide variety of debt instruments--to anger their clients by daring to issue unfavorable ratings ultimately led to hundreds of billions of dollars flowing into collateralized debt securities and other ostensibly safe instruments that were anything but, which contributed greatly to the morass that ensued.
In the aftermath of the financial crisis, the federal government devoted considerable effort to studying the causes and consequences of the crisis in an attempt to ensure that nothing similar occurs again: I worked for one of the members of the committee that wrote the Financial Crisis Inquiry Committee report, and the Committee highlighted the behavior of the credit rating agencies as one of the factors contributing to the crisis.
The crisis increased the scrutiny given to the credit ratings agencies, and by most accounts they have improved their behavior; no one seems to be accusing them of making systemic missteps as in 2008. Still, the agencies have maintained their oligopolistic grip on the industry, and the reliability of the credit ratings market still depends to some degree on the ability of external observers to remain diligent in their oversight of the ratings agencies. While talk of having the federal government take over the industry has largely died down, future failures would no doubt resurrect such a discussion.
Besides its failures during the Great Recession to identify risky assets, credit rating agencies both here and abroad regularly get attacked by sovereign governments for their opacity. For instance, India’s economic advisor recently published a paper that questioned the ratings agencies’ sovereign scores and alleged a collective bias toward advanced economies, and the African Union announced plans to launch its own African ratings agency in 2024, citing a bias against African nations.
The sovereign objections to the actions of the credit rating agencies goes beyond the developing world: U.S. Treasury Secretary Janet Yellen recently slammed Fitch for downgrading the U.S. credit rating to AA+ because it “ignored improvements in governance metrics.” Each of these complaints stems from a belief that the opaque methodology and oligopolistic market power of the Big Three can lead to flawed ratings, which can have significant implications in financial markets as well as across the broader economy.
Such complaints are not limited to powerful sovereign actors or their representatives. The insurance industry, supported by The Justice Department and a bipartisan chorus in Congress, levied strong criticism of S&P’s monopolistic behavior in 2022. The criticism actually contributed to S&P reversing course on a proposed rule change.
Some private sector experts have complained about its activities as well. For instance, SoftBank recently objected to what it termed to be a “hugely problematic” rating of the Japanese investor, which tied to the recent Arm IPO (Arm constitutes nearly one-third of the investment fund’s $200 billion of assets and has doubled in value since October) and a ratings methodology it perceives as opaque and at odds with ratings from other agencies.
In most cases, individual companies do not have the power to push back on a problematic assessment that they believe is based on faulty data or procedures. As such, they can struggle to reverse faulty assessments from agencies that tend to be quick to downgrade but slow to upgrade – and have far less power than sovereign nations or bigger industry groups.
Blaming the credit rating agencies for being unduly conservative when people can still see the Great Recession in the rearview mirror may seem a bit pedantic, but the point is that the market power of an oligopoly that operates somewhat opaquely opens them up to criticism from all sides.
The debate over the structure and oversight of the rating agencies is not new, but it only tends to arise in times of crisis, as happened in 2008 and most recently during the upheaval precipitated by the COVID pandemic. But a crisis is a terrible time to try to revamp a system that’s supposed to help reduce the impact of an economic downturn on financial markets--just as we learned that it’s impossible to reform our unemployment insurance system during a sharp downturn.
More scrutiny should be paid to the industry during the good times – not just the bad. And while the best time to start paying attention to the credit rating agencies was a decade ago, the second-best time is right now--before the next recession.
