Monday, 12 June 2017

Credit Rating Agencies Warn of the Risks to the U.K. in Politically Uncertain Times: Another Example of the “Scant Informational Value” Produced by Rating Agencies

Today’s post picks up on the news that Moody’s has determined that the uncertainty that has resulted from the recent General Election in the U.K. ‘poses a risk to Britain’s credit rating’, whilst S&P has noted that ‘this latest bit of instability can only weaken the business environment and consumer confidence’. In this short post, we will examine the ‘findings’ of the rating agencies more closely but, importantly, we will have the following criticism – from leading CRA critic Professor Frank Partnoy – in mind: ‘there is overwhelming evidence that credit ratings are of scant informational value’.

To begin with, the report from Moody’s, which is available here, details a number of elements which Moody’s analysts believe are important pieces of information for investors. The report discusses how the ‘inconclusive election outcome will complicate and probably delay Brexit negotiations’, and how fiscal risks will increase because of a lack of political consensus; the report does mention, however, that the likelihood of a ‘softer’ Brexit post-election means that there is a ‘credit positive’ outlook, in that particular regard. S&P noted how Britain’s economic growth is likely to be damaged by political instability which, when these two credit rating powerhouses’ ‘opinions’ are combined, has already resulted in a drop in the value of the Pound. The media have been quick to make a point of this negative news coming from the agencies, but in reality, what are the agencies actually saying?

Professor Partnoy, writing as far back as 2001, noted quite emphatically that ‘numerous academic studies show that rating changes lag the market and that the market anticipates ratings changes’, which he goes on to label as the ‘paradox’ of credit rating – the ‘continued prosperity of credit rating agencies in the face of declining informational value of ratings’. In attempting to explain this ‘paradox’, Partnoy attributes regulatory reliance as the problem – which he labels as regulators giving ‘regulatory licences’ – which essentially describes regulators enforcing the usage of ratings upon the marketplace. In 2001 this was certainly the case, but after 2010 when The Dodd-Frank Act ostensibly removed this ‘regulatory reliance’, there is a potential that Partnoy’s thesis has been disproven. In actual fact, the thesis still stands because, such was the embeddedness of the regulatory reliance, it is almost impossible to remove it with a piece of legislation. However, today’s reports by the ‘Big Two’ and their effect, raise another more important issue.

Today we saw two major rating agencies, who apparently resolve the intermediation issue that is inherent within the capital markets, inform investors that the U.K. is going through a difficult time politically, and that this probably means an uncertain economic future lies ahead. What investor, retail and certainly sophisticated, does not know this already? What investor, retail or sophisticated, is willing to plough all of their resources into the British sovereign debt (and connected entities), in the wake of the triggering of Article 50 and a snap general election that resulted in a minority government being formed, and even another election potentially being called? The answer is no one – investors are not blindly investing their resources. Today’s reports, and the dissemination of them by the media, represents two things: firstly, Partnoy is absolutely right - ratings and rating ‘information’ contain very little informational value above what can be found in the media anyway; secondly, the marketplace is trapped in a trance with regards to the name recognition of these agencies – what can be the reason for the pound taking a hit on the back of reports that contain no new or useful information? It is not enough to make the claim, as is usually the way, that dispersed investors force their investment managers to be constrained by the outputs of these agencies – is it really the case that investment managers must respond to every piece of information emanating from these agencies? Whilst the ratings may serve as tools for dispersed investors i.e. constraining the actions of investment managers, institutional investors have more sophisticated credit research departments than the rating agencies could ever hope to have. So, whilst the paradox that Partnoy describes absolutely exists, the reason for it may not be as Partnoy imagined. Instead of focusing upon the regulators (which is, of course, extremely important), perhaps it is time we turn our attention to the investors. There was absolutely no reason for the market to react negatively to the agencies’ reports today because, quite simply, they did not say anything. Yet, they did respond negatively, and it is important we question why – these agencies must both develop and disseminate useful information, or a concerted campaign should be developed to side-line them permanently; it is incredible to think that this dynamic continues, especially after their hazardous performance in the lead up to the Financial Crisis and beyond. It is time to put the media and investors under the spotlight with regards to credit rating agency regulation.

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