Yves here. The impact of the crisis has moved so far into the political realm that we are spending a lot of time there, sometimes to the detriment of addressing fundamental problems in the financial system that remain unresolved. Rating agencies are a prime example, and this first post in a three-post series will help address that lapse.

By Susan Schroeder, a lecturer in the Department of Political Economy, University of Sydney, Australia, and author of Public Credit Rating Agencies: Increasing Capital Investment and Lending Stability in Volatile Markets (Palgrave Macmillan, 2015). Originally published in the July/August 2016 issue of Dollars & Sense magazine; cors posted from Triple Crisis

The role that credit rating agencies played in the global financial crisis is no secret. One memorable scene in The Big Short depicted an employee of Standard & Poor’s (S&P)—one of the “big three” rating agencies, with Moody’s and Fitch—as being blinded by conflict of interest in her evaluation of mortgage-backed securities. In a visual gag, she is depicted as having just come from the eye doctor, wearing literal blinders as she is quizzed by the film’s protagonists about how S&P could give the highest ratings—AAA—for securities based on bundled subprime mortgages. “If we don’t give the ratings, they’ll go to Moody’s, right down the block.”

In the wake of the financial crisis, rating agencies have faced growing public concerns about their ability to evaluate credit risk. Investors who lost large sums on investments involving structured financial products, such as mortgage-backed securities (MBSs), have sued the rating agencies. The agencies had assessed MBSs as having very low levels of risk prior to the crisis. But this is not the first instance when the products of the ratings industry have come under suspicion. In the Penn Central crisis of the 1970s, the financial instrument involved was commercial paper. In the Latin American debt crisis of the 1980s, it was sovereign debt. In the early 2000s, at Enron and Parmalat, it was corporate bonds. In the most recent financial crisis, it was collateralized debt obligations and, in some countries, sovereign debt as well.

The role of credit in an economy is a double-edged sword. During a business-cycle upswing, credit facilitates investment and economic growth. As a cycle matures, credit becomes a burden and debt servicing becomes more problematic. If firms are forced to sell assets en masse to obtain the means to service debts, the economy is exposed to “debt deflation”—a fall in the level of prices, contraction in the profits and net worth of firms, and a reduction in output and employment. Changes in credit ratings over the course of a cycle have a tendency to exacerbate both the upswings and downswings.

How should credit risk be evaluated in the context of an ever-changing macroeconomic environment? One way is to assume a market economy is inherently stable and self-regulating. Credit risk is evaluated in the context of recent experience, with that context occasionally revisited for possible revision. Another way is to assume the economy is inherently unstable and not self-correcting. This is something that economists John Maynard Keynes and Hyman Minsky understood well, but that mainstream economists now treat as heretical. Although assuming instability seems more plausible, assuming stability makes it easier to use quantitative techniques and computing power. When rating agencies are processing information on thousands of credit issuers, speed matters. But it comes at the cost of accuracy and ability to foresee crises.

A public credit rating agency could support the development of better credit risk-assessment by using Minsky’s “Financial Instability Hypothesis” to create more sensitive methods of detecting changes in the overall economy, particularly instability generated by risk-taking behavior of individual firms and investors. By more accurately evaluating changes in the macroeconomic context, such an agency could do a better job of assessing firms’ levels of risk, and thereby reduce the danger they pose to the broader economy.

Why Can’t Private Credit Rating Agencies Solve the Problem?

Credit ratings are a form of credit risk-assessment—an opinion about the ability of a borrower to service its debt. These opinions, however, have the ability to destabilize financial markets and economies like no other. The three largest credit-rating agencies—Moody’s, Standard & Poor’s, and Fitch—dominate the global market for this service. Taken together, their global market share, in terms of the value of all rated securities, is more than 95%. They issue opinions on the liabilities of governments, non-financial corporations, financial firms like insurance companies and banks, and even universities. They are separate from credit reference or consumer reporting agencies, sometimes referred to as “credit bureaus,” which issue assessments about individual consumers.

Credit ratings are supposed to address the imbalance (or, in economic lingo, “asymmetry”) of information that exists between borrowers and lenders. Borrowers are thought to hold the most complete information about changes in their ability to service debt, whereas lenders only become aware of this after a time lag. Ratings may shorten the lag, even if they do not eliminate it. Credit risk-assessments are conducted in a way that borrowers and financial instruments can be compared and ranked according to their relative riskiness. This way, the ratings refine the process by which different firms’ cost of raising capital is established and improve market efficiency and liquidity. At least that’s how it’s supposed to work.

Flaws in the rating methods arise from conflicts of interest, lack of transparency, and changes that coincide with and amplify the business cycle (“pro-cyclicality”). For instance, the agencies’ very business model, in which issuers pay the agencies for assessments of creditworthiness (known as the “issuer-pays” model) generates conflicts of interest. Such conflicts are thought to have contributed to the overly rosy ratings of structured products prior to the financial crisis (e.g., the highest, or “AAA,” ratings for residential mortgage-backed securities), as the agent from S&P in The Big Short made clear. The lack of information about the agencies’ methods and processes made it hard for investors to scrutinize their decisions. The pro-cyclicality of rating changes is striking, as credit risk-assessments are intended to be “through-the-cycle” or impervious to cyclical behavior of the economy. Why is this?

A key flaw with many credit-assessment methods is that the assumptions they make to process data from thousands of borrowers—to make their own quantitative techniques work—are the same assumptions that envision a market economy as inherently stable. For instance, assessment methods often employ traditional statistics that rely on the notion of stable relationships between possible outcomes and their probability of occurrence. That is, the purchase of a security is seen as similar to placing a bet at a roulette table. All the different possible outcomes, and their relative probabilities, are fixed. In real life, the probability distributions describing the riskiness of different securities are not necessarily stable if the broader market economy is inherently unstable. And, given the recent global financial crisis, not many people would be easily convinced that market economies are inherently stable.