The rating agencies are generally thought to have been tested and found lacking in the recent subprime debacle. Bill Gross was particularly scathing, while the Economist wondered at the rating agencies’ error in tarnishing their very own AAA gold standard.
Trouble is, they can’t stop writing about the potential fall-out – sometimes in a rather strange fashion.
“Round up the usual suspects,” says Moody’s in its latest analysis of systemic risk and the banking industry. The latest episode included hedge funds, a major securities firm, complex financial engineering and a “bail-out” – albeit a non-cooperative and privately put together one.
And, says Moody’s, obviously a tad touchy on this point:
In addition, rating agencies were blamed by some for inadequate ratings. Rating agencies are generally blamed for too high and too low ratings (concealing or exaggerating asset losses), for acting too early and too late, for knowing too much and too little (being too involved in the design of complex structures or being out of their depth), for being too opaque and too transparent (at the price of being arbitraged).
The subprime debacle does not, says Moody’s, raise genuine systemic risk concerns – but there are still “serious reasons to worry.” Instead we are seeing a salutary reappraisal of risk. The core of the system, the financial firms, have the ability to withstand a shock, with a considerably higher pain threshold than even a few years ago.
The incidents of late have exposed a “lingering confusion between default risk assessment – –ratings – that concerns the hold-to-maturity credit world and volatility-liquidity issues that the mark-to-market world is interested in.”
Ratings are not and cannot be predictors of market prices. Ratings are based on the financial metrics of the borrower or the borrowing structure, not on the conditions of the market at the hypothetical time the security may be traded. The prices of securities at any given moment clearly integrate other parameters than default risk, such as a liquidity risk
But the current global financial is marked by “imperfections”, not least what Moody’s calls the “inexorable mushrooming of ‘model risk’.” Their conclusions:
The global financial system has become so large, complex and integrated that the traditional monitoring tools are in need of constant refinement. In fact, it is quite possible that the capacity to have a comprehensive view of the system and its dynamics is increasingly out of reach. This explains the defuse perplexity, if not anxiety, of policy makers and lucid actors.
It follows that the challenge of tracking risk in a refined manner throughout the system or predicting the unfolding of liquidity shocks – – two examples of “known unknowns” – – justifies some degree of healthy scepticism.
In these conditions, the only strategy that policy makers should adopt is: imposing comfortable capital cushions (especially on those institutions that intermediate public saving), setting incentives correctly (and making sure that firms are exposed to the consequences of their inconsiderate financial behaviour) and making crisis-resolution mechanisms operative.