To avoid any confusion the title refers to two largely unrelated aspects of financial regulation. I have written about these topics before and there has been enough, or depending on your perspective perhaps not enough, going on to merit revisiting them.
As I am sure you recall earlier this year when the banking community was slogging its way out of a crisis the regulators determined that the best way to decide who needed more capital among the nineteen companies that benefited from the Government’s largesse was to run stress tests. This wasn’t anything new. Financial institutions at least in theory had made stress testing a part of their risk management procedures. Unfortunately, the recent crisis proved that stress testing had, to put it kindly, been found lacking.
In fairness the concept is excellent, but the execution can be challenging. Complex questions need to be addressed realistically before such tests can commence. For example, what scenarios will be used, how will the various interrelationships among portfolios, and among clients be addressed, how will changes in correlations among financial instruments be estimated, etc. (An excellent paper was produced on the subject by the Basel Committee on Banking Supervision, “Principles for sound stress testing practices and supervision”, May 2009.) In addition, the results of such tests have to be at the core of risk management procedures, and discussions with senior management and Boards of Directors as well as with regulators.
Stress testing may well have failed in preventing the crisis because the results were not actively incorporated in bank decision making. However it is also likely that the failure is attributable to the construction and assumptions built into the tests. Presumably regulators addressed these issues before basing capital decisions at a very critical time on the results. Moreover, these fixes will likely become part of standard testing procedure. If my assumptions are correct then wouldn’t it be confidence raising for the financial system and the soundness of individual institutions to know how these tests are conducted. Regulators appear to believe that transparency is good for the efficient functioning of markets. A little more transparency on the regulatory side would be helpful as well.
Now let’s consider credit ratings. Two recent news items provide some insight on how rating agencies are being held accountable by the market. One item involves the National Insurance Company Commissioners who are considering hiring a firm (or firms) to assess the risk of insurance company investments with particular emphasis initially on mortgage-backed securities. To put it kindly the Commissioners appear to have no faith in rating agencies, which is understandable. Now if this effort is successful then what other regulatory bodies will begin to look to new sources for credit rating information, and what asset classes will join MBS in the process?
The other news item reflects on the value of ratings from the issuer and investor perspective. What do Highland Capital Management LP, Heineken NV, Gruppo Campari, Credit Suisse Group AG and Dubai have in common? They have all recently successfully issued either bonds or structured complex securities without credit ratings. That’s correct no ratings agencies were involved and no ratings were announced as part of these deals. Investors apparently did their own research or relied on sources other than traditional rating agencies to make credit based decisions.
It may be premature to conclude that the big three rating agencies have lost their lock on this vital market function but unassisted they have managed to reduce the barriers to entry to their business. The market, as it should, is responding.
Ben Wolkowitz, Headstrong November 2, 2009
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