Wednesday, March 30, 2011

The FDR Framework and Credit Ratings

The search for an alternative to the credit rating services has begun.

In the US, the Dodd-Frank Act requires that regulators figure out how to remove references to the rating agencies from all regulations.

In the UK, the Bank of England recently published a paper discussing how difficult this task will be to accomplish.  According to an article in the Telegraph,
The agencies, which rank the risks attached to lending to an institution or country, have been attacked for failing to fully realise the dangers emerging ahead of the meltdown, particularly around complex financial products. 
... Nonetheless, the agencies are still built into the financial system through the use of their ratings in regulation, investment processes and financial contracts, Bank staff and academics reported. 
"The hardwiring of ratings is now so pervasive that market participants could not ignore them even if they did not consider them reliable," their report warned. 
However, its authors said abolishing the agencies "is not an option. Other gatekeepers would emerge to fill the void with their own ratings-like research and advice." 
To reduce the reliance on ratings, the paper said one option might be a dual approach, with regulators and fund managers considering an internal risk assessment from the borrower in question as well as its agency rating. 
The report also looked at whether rating agencies could return to the model in which investors pay for their information, rather than current set-up which sees borrowers pay to be rated. 
The agencies, who could see their revenues hit by investors "free-riding" and not bothering to pay for the data, argue that moving to an "investor pays" model would create a privileged group with access to crucial information. However, the problems may not be insurmountable, the Bank report said. 
A third option – that a government pays for the credit rating system by creating a single public agency, was dismissed as "fraught with difficulty". This set-up could imply that the state would assume responsibility for any negative consequences of its rating decisions, creating moral hazard, the report said. 
The report fails to consider the FDR Framework solution.  Under the FDR Framework, all the useful, relevant information is made available to market participants in an appropriate, timely manner.  There are not suppose to be any gatekeepers, like rating agencies or regulators, to this information.

What does this mean for the rating agencies?  It is the end of their informational monopoly.

What does this mean for investors?  Under the FDR Framework, investors are responsible for doing their homework as they know that it is buyer beware when making an investment decision.

Under the FDR Framework, investors have the option of dual tracking:  doing their homework plus looking at an independent analysis/rating.

The question is what is the value of a rating if the investor has the same information and can do the analysis for himself?  The answer is the value that the investor assigns to it.

It is a feature, not a bug, of providing all the useful, relevant information that many analytical firms will emerge to offer their own ratings-like research and advice in the hopes of being paid by the investors for this research and advice.  Nobody complains about this model for equities.

At the same time, firms will continue to pay Moody's, S&P and Fitch to produce their ratings for investors who do not want to pay.

Finally, by restricting itself to assuring access to all the useful, relevant information in an appropriate, timely manner, governments avoid any potential moral hazards associated with ratings.

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