The Substantial Benefits of the Ratings Revolution for the Banking Industry: In the Financial World a Quiet Revolution Is Taking Place-Ratings Are Becoming a Key Risk Management Tool and Ratings Agencies Are Now a Core Source of Independent Research

Article excerpt

With the increased focus on risk management following the high-profile corporate scandals in recent years financial institutions are increasingly turning to independent sources of research, such as Credit Rating Agencies (CRAs), to assist in managing risk. In response, the CRAs have expanded their services, customer base and research coverage to offer an independent and more precise view of risk and, in some cases, return.

What has changed?

* Technology is improving the tools used by CRAs to measure corporate risk: Technology has opened up opportunities for some CRAs to take a more scientific/statistical approach to rating both corporates and debt securities. Quantitative analysis that focuses purely on financial fundamentals ignores short-term market noise and avoids qualitative bias and a number of other biases that can exist in other research methodologies (refer section 'Bias beware' below). However, not all quantitative methodologies are the same--for example, some employ historical equity share price data as a starting point.

* Ratings measure risk on several levels: Ratings have been traditionally used to measure corporate and sovereign debt risk. However, as the need for independent research rises, the services of CRAs are being used more widely, with users ranging from investors to financial institutions, and from business counterparts to industry regulators.

* Regulation is on the rise: Increased focus by regulators on both CRAs and the financial service industry should improve accountability on several levels. For example, the Sarbanes-Oxley Act 2002 passed in the United States is expected to pave the way for new entrants to enter the industry. Given that a number of the major CRAs have their head office in the United States, the Act has global implications. As part of a Congressional directive under the Act, the US Securities and Exchange Commission (SEC) has been looking into the role and function of CRAs. The SEC is reviewing a number of issues including information flow, potential conflicts of interest, alleged anti-competitive or unfair practices reducing potential regulatory barriers to entry, and ongoing oversight.

* Ratings are being accepted by key industry bodies to measure key bank requirements: The Basel Committee on Banking Supervision recommended the circumstances under which banks could use a CRA's ratings to meet the requirements of the proposed Basel II Capital Accord. Banks have an opportunity under the new Basel Accord to use external ratings from a CRA.

Whilst many banks are improving their own systems, databases and client records in order to prepare internal ratings, others lack the infrastructure to meet the Accord's requirements. Facing high compliance costs, many banks are also concerned that their internal systems may not deliver the required outcomes. One solution is to employ a proxy dataset that resembles a bank's existing or potential database. Many of the ERAs have years of data. Some have a few decades of reliable data that span a range of industries across various sizes of businesses and countries.

* Competition is rising: The lack of competition in the ERA industry' has resulted in the failure by some of the ERAs to improve their methodologies so as to ensure that major default risks are identified before they occur. By challenging traditional business models (where agencies are paid by the companies that are rated), new ERA entrants are increasing the pressure both on the traditional agencies to improve their methodologies and on corporates to improve transparency.

However, challenges exist and ERAs must ensure that they can provide an automated and seamless service and, when required, appropriate datasets that can be used by the banks to rate their own portfolios.

Bias beware

As noted earlier, ratings methodologies can vary significantly and CRAs also need to ensure their methodologies avoid bias. …