III. Situating Rating Agencies in the Global Financial Structure

III. Situating Rating Agencies in the Global Financial Structure

Notwithstanding their shortcomings, the agencies were casualties of the Asian crisis as much as contributors to its severity. As the crisis expanded, they were less and less able to monitor and understand events. Attempting to catch up with the storm surge, the agencies downgraded Asian countries to reflect what they saw as virtually bottomless risk. The rating agencies thus acted pro-cyclically, in that they added momentum to the downswing rather than looking through it; the downgrades caused panic among investors and exacerbated the crisis. [ See Giovanni Ferri, Li-Gang Liu, Joseph Stiglitz (1999): „The Procyclical Role of Rating Agencies: Evidence from the Asian Crisis", mimeograph, Siena]

Some months later it became apparent that the agencies had misjudged not only the extent of the crisis but its very nature. Despite the enormous swings of capital out of emerging markets and into safe havens such as U.S. Treasury bonds, and the dangerous liquidity and solvency crises in South Korea and other countries in the region, their underlying economies were robust enough to absorb the shocks (though not without huge injections of capital, broad-based economic reform, massive corporate restructuring, and in some cases deep political turmoil).

The vulnerability of developing countries to exogenous shocks is not new, but the phenomenon has continually taken a different shape. The 1980s debt crisis was driven by oil prices, inflation and interest rates. In the 1990s, the source of crisis was the balance of payments account. [ Deficits in the current account of the balance of pay ments are typical of countries in development; they are acceptable if they arise from the import of productive goods or debt service in a sustainable adjustment pro gram. However, such deficits must be balanced by the inflow of funds which is recorded in the capital ac count, and countries must have policies in place which will enable them to absorb unexpected shocks from abroad.] In retrospect, developing regions, global credit providers (including banks) and the international financial institutions failed to establish an equilibrium over the past few decades, resulting in the long-term boom-and-bust pattern of the 1980s debt and 1990s capital flows crises.

Whether these crises were manifestations of the same underlying weaknesses in developing countries or due to external factors – 1970s petrodollar accumulation leading to indiscriminate lending in a rising interest rate environment; the extreme global mobility of capital thanks to high technology and deregulation – is a matter for discussion elsewhere. More relevant for the purposes of this paper is that the shift in developing country financing from multilateral lenders to private investors gave the rating agencies a more critical role than was generally understood. The rating agencies and multilaterals themselves are still coming to terms with this.

Although the rating agencies strongly influence the decisions of global investors, they do not operate in a vacuum. The international financial organizations exert a pervasive influence on the ratings process: IMF structural adjustment programs and pronouncements fulfill an important signaling function as to country trends, while the lending decisions of other institutions condition global investor opinion. But neither the IMF nor the World Bank makes its credit determinations public; it is considered that the confidentiality of information provided by the countries with which they work is essential to maintaining an open and trusting relationship.

The Bretton Woods Institutions, moreover, look at credit through a different set of lenses than the agencies. World Bank credit analysts, for instance, are looking at country credit from the standpoint of a lending institution. Their responsibility is to protect the interests of the Bank’s shareholders, first, then to examine risk-return tradeoffs in credit decisions – the return defined in terms of development gains. World Bank analysts also use sovereign risk analysis to identify the countries most vulnerable to crisis, to take preventive measures or ready contingency plans. [ Based on remarks by Carolyn Jungr, principal economist, Credit Risk Division, World Bank, at the FES conference on the global credit ratings system and developing countries, October 28-29, 1999, New York.]

World Bank credit analysts are also taking a longer-term view than their rating agency counterparts. Given that many professional investors are marking their holdings to market on a daily basis, the agencies in practice look out over a two- to three-year horizon at most. The World Bank by dint of its role is looking at the underlying trends over five to 10 years in fiscal sustainability, debt sustainability, long-run growth potential, and so forth. As a preferred creditor the World Bank is more concerned with inflexible debt, i.e. that which cannot be restructured, such as a country’s debt to IFIs, which cannot by definition be rescheduled, and Paris Club loans provided by developing countries (other than specific debt maturing before the cutoff dates for inclusion in poorest-country debt relief programs).

Consequently, a World Bank decision to lend to a country could be misleading to a private investor considering the purchase of bonds that might be vulnerable to a restructuring. In certain situations, the IFIs might be at cross-purposes to the aims of investors. For example, the IMF and Paris Club have taken the position that private bondholders should share in losses when sovereign debt must be restructured. This demand that private investors be „bailed in" (as opposed to being „bailed out" through the injection of public funds when country finances become strained) has made the IMF’s entry into balance-of-payment crises a less welcome development for investors. The IMF may help stabilize a crisis situation, but for bond investors it is also a preferred creditor with ultra-senior status, and as such is certain to be paid in full before private-sector players.

Even where the IMF, World Bank and related institutions play more traditional and benevolent roles (from the standpoint of private investors), caution must be taken in interpreting their signals. For example, the Inter-American Development Bank looks to rating agencies for guidance on the stability of its counterparties in the global swap markets where interest rate and currency risks can be hedged. [ Swap agreements are made between two parties, most often banks or other financial institutions, to trade future exposures to currencies or interest rates. For instance, a development bank issuing bonds in Japanese yen to take advantage of a low interest-rate structure might convert the funds into dollars or euros, but also enter a swap agreement to reacquire Japanese yen by the time its bonds are scheduled to be redeemed. The agreement provides protection against the risk that the yen might rise sharply in value in the interim.] But as the multilateral development bank for the Latin region, the IDB deliberately sets sovereign ratings aside in allocating funding so projects can be examined on the basis of their financial viability and development merits. On the other hand, its sovereign members are collectively responsible for loans: if one country defaults, its obligations must be met by the other members. This arrangement provides a kind of credit safety net for the IDB, allowing it to downplay sovereign ratings.

Despite this interplay, there does not yet exist internationally the kind of close meshing of rating agency and regulatory activity which has existed nationally in the United States for decades. Passage of the ERISA legislation in 1974 brought pension funds and consequently the mutual fund industry under a much higher degree of federal scrutiny as to funds management, among other concerns. As a practical matter, ERISA gave the rating agencies a federal mandate, though without intruding on their business practices proper through direct regulation. The proposals from the Basel Committee on Banking Supervision would confer on the agencies a similar brief where international banks are concerned. The proposals are collectively referred to as Basel II, as the Bank for International Settlements, or BIS, is located in Basel, and the proposals revisit standards set in 1988.

The Basel Committee concluded in 1988 that it was not necessary for banks to set aside capital against bonds issued by member countries of the Organization for Economic Cooperation and Development (Basel I). South Korea subsequently was admitted to the OECD, leading to discomfort among bankers and investors when it became more or less insolvent in 1997-98 and the Korean bonds held by banks were demoted to speculative-grade. The Basel Committee in light of those events reconsidered its earlier decision and suggested in June 1999 that national regulators use the ratings generated by the major rating agencies to decide how much capital banks in their jurisdiction should be obliged to hold against assets.

The Basel II Accord set off a quiet furor, not least because assigning such a role to the agencies amounted to delegating quasi-regulatory powers to the four firms. But the banking industry was mainly dismayed because the proposals, if adopted more or less as written, stood to force banks to restructure balance sheets or increase equity. One probable knock-on effect was that once Basel II was commented on through March 31, 2000, revised and finalized, institutions would reduce holdings of bonds issued by lower-rated developing countries. This would make it harder for such countries to issue bonds, and drive up the interest rates they paid.

Basel II is already the basis for proposed European Union regulations (though these are also subject to revision). So it seems like it is to be here to stay. [ „On November 22nd (1999) the European Commis sion issued proposals to update the regulations gov erning how much capital European financial institutions must set aside as a cushion against the risks they are taking. These are closely based on the recommenda tions of the Basle Committee, which is trying to mod ernize its regulations." (See The Economist, November 27, 1999, p. 75)] Even if the bigger banks are allowed to use their in-house credit ratings, the agencies seem guaranteed to take an enlarged role in global capital allocation. One OECD analyst warns that if Basel II emerges from review more or less intact, the impact of sovereign ratings on emerging market finance will „rise significantly," and the proposals could conceivably „destabilize" lending into the emerging markets.

Some agency officials profess reluctance to take on the responsibilities that the proposal would carry with it, voicing the reservation that this increased influence might lead to government oversight and intrusion, and a loss of independence. Others see Basel II as a positive business development for the rating agencies, as it stands to make their services indispensable to countries issuing bonds.

Either way, Basel II poses a challenge to the agencies at a time when they are in the midst of responding to the setbacks of the late 1990s. To borrow a term from the military, the rating agencies experienced a kind of „mission creep" in the past decade as the sovereign rating task expanded significantly but their historical role remained essentially the same. So the agencies have some urgent consolidation and expansion to carry out if they are to fulfill this substantial mandate.

Basel II could expand rating agency influence in Europe in particular, given that all European banks are considered international whereas the number of banks in the United States that would be affected is much smaller. Moreover, Europeans chafe at the thought of being governed by the judgments of U.S. agencies.

From the developing country perspective, Basel II seems even more ominous, portending the transformation of the rating agencies into supranational entities with the implicit power to dictate macroeconomic policy. Should matters evolve in this direction, the developing countries seem likely to demand more of a voice in such forums as the G22 Working Group on Transparency and Accountability in the aim of establishing global standards for rating agencies, if not licensing.

To avoid such public sector intrusion, agencies seem likely to shift their focus so as to not merely reflect market sentiment or investor concerns, but to also inform and support financial policy makers in developing countries. Multilateral authorities might encourage agency accountability to all stakeholders including rated countries, but in such a way as to maintain the essential independence of the agencies.