Investors and credit rating agencies
179. The credit rating agencies are particularly
significant in structured finance markets. This significance is
largely a result of the complexity of many new financial products
as well as the information problems which are a feature of the
'originate and distribute' model discussed in the previous section;
these appear to make reliance on external ratings more important
for investors. This is because, as Professor Buiter explained
to us, that the "information gaps could be closed or at least
reduced by using external rating agencies to provide an assessment
of the creditworthiness of the securitised assets and this has
been used widely in the area of residential mortgage-backed securities
and of asset-backed securities".[246]
However, he added that the use of ratings agencies as a solution
to the information problem "brought with it a slew of new
problems".[247]
180. A large number of witnesses to our inquiry,
including representatives from the credit rating agencies, expressed
concern that some investors in securitised products were over-reliant
on the credit ratings agencies. Such over-reliance could take
one of two forms. First, investors might substitute ratings for
their own credit risk assessment and due diligence procedures.
Second, investors might use ratings to make investment decisions,
rather than using ratings as one factor amongst many when making
investment decisions.
181. Representatives from Standard & Poor's acknowledged
that investors could mistake a group credit rating for a green
light to invest, but added that the credit rating agencies "go
to great lengths in trying to educate investors and others on
how to use ratings".[248]
Representatives from the sector stressed that their ratings did
not address many other factors in the investment decision process,
including liquidity risk, price risk and the potential for price
appreciation or volatility. Ian Bell from Standard and Poor's
said that "no investor should base a decision to invest or
not invest in any debt solely on the rating; this is just one
component of all the risks that investors should take into account".[249]
182. Peter Montagnon, from the Association of British
Insurers, told us that large institutional investors regarded
the credit rating as only one factor in their investment decision;
they did not rely on them.[250]
However, despite the fact that witnesses from the investor community
said investors were not overly-dependent or mis-using credit ratings,[251]
our evidence sessions revealed continuing widespread concern that
credit rating agency scores were used as a 'green light' to invest
by some investors who were overly-reliant on ratings scores when
making investment decisions. Professor Buiter told us that "the
fact that many 'consumers' of credit ratings misunderstood the
narrow scope of these ratings is not the fault of the ratings
agencies, but it does point to a problem that needs to be addressed".[252]
Angela Knight, from the British Bankers' Association, agreed that
there had been too great a reliance on something being called
triple A or triple B that is probably the case.[253]
This point was echoed by Sir Callum McCarthy: "people have
relied too much on the rating agencies rather than doing their
real analysis of whether "this investment is something that
I understand".[254]
Sir John Gieve told us that "people definitely relied on
ratings agencies' ratings in an inappropriate way" and that
many investors believed that "if it is triple A it is all
right, not distinguishing between different sorts of instruments".[255]
The Chancellor of the Exchequer agreed, telling us that "a
lot of institutions give the impression that if the credit ratings
agency says something is triple A, that is fine and they do not
make any further inquiries".[256]
183. The Bank of England, in its October 2007 Financial
Stability report, argued that investor over-reliance on the credit
ratings agencies was increased by information gaps inherent in
the 'originate and distribute' model, which we discussed earlier
in this chapter. The Bank went on to state that investor-over-reliance
was compounded by the complexity of products which meant that
investors "relied heavily on ratings as summary indicators
of asset quality" and this was partly related to concerns
about the loss of information on underlying credit quality, which
might be particularly great when assets were repackaged further,
for example, into CDOs.[257]
184. We are
concerned that many investors were overly-reliant on the ratings
provided by credit rating agencies and that some investors misunderstood
the narrow scope of these ratings. This over-reliance on credit
rating agencies by some investors appears to have been compounded
by the lack of due diligence on the part of some investors in
the products they were purchasing, with many investors taking
a triple A score as a 'green light' to invest. It is incumbent
upon the credit rating agencies to work together with investors
to ensure that investors have adequate information to undertake
their own effective due diligence and a clear understanding of
the meaning of a rating.
185. As part of the debate on reforms to the credit
ratings agencies, the Bank of England, in its October 2007 Financial
Stability Report, put forward a number of suggestions to improve
the information content of ratings.[258]
These suggestions are designed help tackle some of the information
asymmetries identified previously and to reduce investor over-reliance
on credit rating agencies. The Bank's suggestions, which do not
represent the Bank's final position on credit agency reform are:
- Agencies could publish the
expected loss distribution of structured products, to illustrate
the tail risks around them;[259]
- Agencies could provide a summary of the information
provided by originators of structured products;
- Agencies could produce explicit probability ranges
for their scores on probability of default;
- Agencies could adopt the same scoring definitions;[260]
- Agencies could score instruments on dimensions
other than credit risk.[261]
186. We asked witnesses whether they supported the
Bank of England's suggestions for the reform of credit rating
agencies. Mr Sants told us that the that the first four proposals
put forward by the Bank of England "are eminently sensible"
and were "around the point that the principal purpose of
the credit ratings agencies … is to measure credit risk as
opposed to liquidity risk". Mr Sants said that the first
four proposals would help improve the measurement of credit risk,
as well as investor understanding and that therefore the FSA was
supportive of the reform proposals.[262]
He told us that the FSA was very active in encouraging IOSCO to
revisit its code of conduct for ratings agencies to see whether
some of the issues raised the Bank need to be incorporated into
a revised code.[263]
187. Mr Sants was more cautious about the fifth proposal
that agencies could score instruments on dimensions other than
credit risk, telling us that evaluating liquidity as well as credit
risk would be a good idea if it "could be done in a way that
was credible and robust and simple to understand". He thought
that "we have to leave it to the agencies to see whether
that is really something they can deliver … they are commercial
organisations and they have also to decide whether that is a commercially
worthwhile offering to make".[264]
Sir Callum McCarthy added that the fifth proposal needed to be
subjected to a lot more thought before signing up to it:
One of the comments I think made correctly is that
people have relied too much on the rating agencies rather than
doing their real analysis of whether 'This investment is something
that I understand'. It is somewhat ironical that one of the responses
is to try and seek from the rating agencies even more work and
even more assessment not just of credit but of liquidity. [265]
Professor Buiter appeared more supportive of the
fifth suggestion, stating that "the merits of offering (and
requiring) a separate rating for, say, liquidity risk should be
evaluated.[266] Sir
John Gieve, from the Bank of England, acknowledged these concerns
about suggestion five, telling us he agreed with Mr Sants that
"if it is going to confuse people further, then they should
not do it".[267]
188. We also asked Standard & Poor's, Fitch and
Moody's for supplementary written evidence outlining their position
vis-à-vis the Bank of England's reform proposals, which
we have published.[268]
We support the principle
of improving the information content of credit ratings. To this
end we welcome the Bank
of England's proposals to improve the information content of ratings.
We urge progress on measures to improve the information content
of ratings and, to this end, will continue to monitor progress
towards greater transparency of credit ratings. However, increased
information content should not imply to users that they have any
less obligation to pursue due diligence.
189. A
number of witnesses stressed the need to educate investors about
the role of credit rating agencies and the exact service such
agencies offered. Professor Buiter believed that "there has
to be an education campaign to make investors aware of what the
ratings mean and don't mean".[269]
Mr Sants told us that "it is vitally important that people
understand the limitations of the service that a credit rating
agency delivers and do not use it as a shorthand way of avoiding
their obligations to look properly at the structures and the risk
they are taking on".[270]
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