Thursday, June 10, 2010

Conflicted credit ratings

Problem: ratings agencies conflicted by their issuer-pays business model

Solution: fund agencies through a levy on security purchases, distributed according to demand

The conflict that ratings agencies have between offering objective advice and being paid by issuers has inspired a number of proposals.

Most recently, the head of European credit research at Schroders, D. Patrick McCullagh, suggested that investors pay their investment managers to assess credit quality as part of buy-side research, consistent with the caveat emptor principle, with the cost picked up as a management fee borne by investors, in whose interests the rating is conducted. But is it the best solution?

The Schroders idea would eliminate third party ratings agencies completely by moving the function in-house (toss them out like a "torn, charred and mangled" comfort blanket, in the words of the Schroders’ guy). This would not, however, eliminate the potential for conflicts of interest, since buy-side analysts will still be exposed to price incentives, just as agency analysts were by their close relationship to issuers. When a security is on the cusp of a downgrade, buy-side analysts will have obvious incentives to protect their own investors, and colleagues holding the security in their fund.

This is the same problem that McCullagh pointed out about another reform idea proposed by academic Larry Harris, which was that ratings agencies should be paid according to the performance of the securities they rate (similar to yet another idea that agencies take subordinated tranches of each security they rate in order to have “skin in the game”). Under both these proposals, agencies would be still be loathe to issue a downgrade, since they would take a hit on their own earnings.

Another problem with the Schroder’s suggestion is that in-house research would create more management fees at the expense of end-investors, creating a huge duplication of effort and cost if each buy-side house had to fund its own research team.

(These funding proposals, by the way, are completely separate from sensible suggestions to unburden ratings from their regulatory roles under Basel and SEC rules)

A third funding solution that McCullagh mentions is to leave ratings to independent agencies such as Egan-Jones that charge investors by subscription. This at least removes the conflict of interest. The downside is that it keeps ratings behind a paywall, restricting the distribution of key credit information.

A better answer is for the ratings agencies to stay independent and be funded from an industry levy on credit purchases, as with stamp duty on UK equities, under the control of a central body. Quality could be maintained by allowing the agencies to compete, with their revenue controlled by the central body to reflect investor demand and feedback.

This would limit the duplication of work while allowing competition on quality. It would avoid keeping ratings behind a paywall and put the analysts safely at arm’s length from both sell- and buy-side pressures.

The idea could apply equally well to equity analysis, which is famously skewed by bank relationships and brokerage favours.

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