Thursday, 15 February 2018

Article Preview – ‘Sustainable Finance Ratings as the latest Symptom of “Rating Addiction” – The Journal of Sustainable Finance & Investment

In today’s post, we will be previewing an article produced by this author that was very recently published in the Journal of Sustainable Finance & Investment (available here). The article is concerned with recent developments within the ‘Principles of Responsible Investment’ (PRI) initiative that is being undertaken by the U.N., with the focus being on the proposed incorporation of the leading credit rating agencies (for the most part) and their products. The emphasis of the article is on explaining the view that, based on the historical development of the credit rating industry, inducting them into the potentially systemic-altering movement carries with it great risk, and it is that risk that is analysed within the article.

The article begins by not explaining the developments within the PRI, but by examining a concept known as ‘rating addiction’. Using the literature to provide context for the concept, an assessment is undertaken to examine how the leading rating agencies have been correctly identified as being central to the Financial Crisis (and many other issues) but have not only survived through these socially-challenging periods, but actually prospered – the article advances the claim that the reason for this phenomenon is ‘rating addiction’ which, as one would likely surmise, relates to the notion that the financial system is addicted to the products and therefore the agencies, which has the effect of protecting the agencies against any meaningful punishment for their actions. The article examines the literature that discusses the concept of ‘ratings reliance’, which is similar concept to ‘rating addiction’ in many ways but focuses more on the regulators’ incorporation of the ratings into their procedures for a number of elements, like bank capital requirements, for example; the effect of this reliance has been, according to the literature, a systemic-level of ‘outsourcing’ of regulatory responsibility to third-parties, so much so that the regulators have come to ‘rely’ on the ratings. However, it is arguable, and the article makes this distinction, that ‘reliance’ and ‘addiction’ are two separate phenomena, because ‘addiction’ carries the connotation of the strong inability to remove oneself from the process – much like a drug (or any other commonly witnessed addictions).

Upon declaring that rating addiction does indeed exist, and is fact prevalent, the article goes on to discuss the technical issue of whether ‘reliance’ and ‘addiction’ are indeed separate, describe the same thing, or are different positions within the same linear causal pattern. It is proposed in the article that rating addiction supersedes everything else because, essentially, it predates the regulatory usage of the products of the agencies. Using business history literature, particularly that developed by Professor Marc Flandreau and his doctoral colleagues, the article presents a picture whereby, due to the economic landscape in antebellum America i.e. before the American Civil War, it was the economy that became addicted to the ratings of the agencies, and not a case whereby, as others have suggested, regulators pushed the ratings onto the marketplace – with the ratings being used to deal with the issues being raised by the expansion of the United States, market participants began to realise that ratings were the most cost-effective way of ensuring (to the greatest extent possible) that credit extended to a person or a company would be repaid. Flandreau discusses this at length across a number of fascinating articles, but the conclusion to be drawn from his research is that, quite simply, the regulators in 1933, and in 1975 (to note two key dates in the regulatory induction of ratings; 1933 saw the Office of the Comptroller of the Currency induct the ratings, and 1973 [later promulgated in 1975] saw the SEC formally induce and protect the rating agencies into the modern marketplace) were responding to the marketplace, not influencing the marketplace; understanding this dynamic is absolutely vital to understanding the reason why agencies managed to prosper despite being widely identified as being key actors in the Financial Crisis.

The above hints at the viewpoint that is it actually investors and bond-offering organisations that lay at the cause of rating addiction, which is to some extent true, and on that basis the article then looks at why this may be. One of the key aspects that the article examines is the concept of ‘agency’ and the related theories, which provide a useful tool with which to examine the relationship between an investor, their institutional investor, and the rating agencies. For example, whilst in the 1840s when the first commercialised  rating agency came into being the system involved lenders providing credit to other marketplace actors in a very commercialised manner, the modern system relies on the constant flow of resources; the clearest example to use is an institutional investor, like a pension fund, whereby the ‘lender’ is made of a large number of dispersed investors with relatively small funds, and partake in a system that has investment managers who take the lead on who to lend to, why, and where. The obvious problem with this scenario is that dispersed fund contributors would find it difficult, and more importantly inefficient, to monitor the actions of their ‘agents’ on a daily basis; the solution, within the modern marketplace at least, has been to define parameters within which the ‘agents’ can act, with easily digestible and identifiable ‘ratings’ being a common choice. On the other hand, to protect the system, regulatory (and legislative) bodies have enforced rules that do the same thing but for different reasons, which is why many institutional investors have their investing ability capped by certain rating levels i.e. AAA, or the top ratings prescribed by the relevant rating agency. Yet, as that is the case, the question is then what does that mean when the investing system itself is changed, or at least being proposed to change?

This issue of changing the investing ‘system’ slightly exaggerates the proposals being put forward by the PRI, but the sentiment is close enough. The initiative, which sees a number of large investment practices come together to promote the increased incorporation of sustainable investment practices, whereby key Environmental, Social, and Governance (ESG) concerns are incorporated into investment practices, is essentially the movement being developed by the PRI. In the article the proposals set forth by the PRI are discussed in detail, but the result of that examination is to assess the proposals currently being considered which set out a plan of action for the rating agencies to a. be inducted into the PRI’s movement, and b. have that induction predicated upon the agencies’ incorporation of ESG concerns into their rating processes. Whilst some have championed this idea, there is a problem that is outstanding which forms the crux of the article; whilst the agencies profess to already incorporate ESG into their rating processes, the facts of this are disputable, and for a number of reasons. Firstly, as discussed in the article, the rating agencies are no exactly clear on the levels of ESG incorporation into their analyses, although all say that it forms a part; the majority of responses revolved around the declaration that, for their part, they see financial data as the key driver of their rating analyses, with ESG components playing not much more than a bit part on their deliberations. Whilst the PRI are, as a result of this understanding, aiming to encourage rating agencies to increase their usage of ESG considerations, the responses of the agencies suggest that operationally, and moreover culturally¸ they are not seriously inclined to do so. Yet, the biggest issue of all is that the agencies are notoriously guarded when it comes to disseminating information related to their methodological processes, and this is for a number of reasons – many of the reasons relate to protecting their position, and others relate to protecting themselves when things go wrong or they act in a transgressive manner. Nevertheless, it is on this basis that the article argues that inducting the agencies, in their current form and with their current culture in mind, into the PRI, is a great risk. Whilst that claim may be sensationalised, to an extent (although this author is clear on the view that agencies need to be treated with great care when it comes to incorporation), there is a technical element which describes that risk more accurately. Using the research of Professor Kern Alexander, there is an argument to be had that if the sustainable investment movement continues and regulators place a value on operating in such a manner, then the linking of, say, sustainable finance credit ratings to something like bank capital requirements, could pose a huge risk in relation to the historical conduct of the rating agencies. In doing so, the sustainable finance movement would, in essence, become the latest credit rating-related vehicle with which the systemic safety of the economy could be placed in jeopardy; then, as always here in Financial Regulation Matters, the obvious question is whether the economy, and society moreover, is healthy enough to withstand another shock so soon after the Financial Crisis. Ultimately then, the aim of the article is to present an account of the recent movements of the agencies, and present an account that is determined to highlight the potential risks of incorporating the rating oligopoly into such a progressive and much needed movement; understanding the historical trajectory of the rating agencies provides the rationale for doing so.

Keywords: credit rating agencies, business, finance, investment, law, regulation, @finregmatters.

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