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IMF Encourages Investors to “Rely On Their Own Due Diligence”

Posted by Larry Doyle on October 7, 2010 9:36 AM |

In the midst of the economic crisis, many business models have been exposed as broken. Other models have been exposed as downright useless. Somewhere in that realm lies the business model of our credit rating agencies. How will these entities, charged with providing meaningful credit ratings analysis, adapt to the changing economic and financial landscape? More importantly from my standpoint in trying to promote ‘sense on cents’, how should investors adapt? Well, my jaw dropped yesterday upon reading a report by none other than the International Monetary Authority on this topic. Let’s navigate.

The IMF recently produced a Global Financial Stability Report. Embedded in that report is an Executive Summary which highlights: 

The credit rating agencies have attempted to produce stable “through-the-cycle” ratings to satisfy clients who find it costly to frequently alter trading decisions that are based on ratings. The chapter shows that a typical smoothing technique used by at least one rating agency is deemed likely to contribute to procyclicality in ratings compared to a method that accurately reflects current information at a “point in time.” This is because a “through-the-cycle” approach waits to detect whether the degradation is more permanent than temporary and larger than one notch. However, this often means that the lagged timing of the downgrade accentuates the already negative movement in credit quality.

Overall the chapter suggests the following policies to lessen some of the adverse side effects that ratings and rating agencies may have on financial stability.

First, regulators should remove references to ratings in their regulation where they are likely to cause cliff effects, encouraging investors to rely more on their own due diligence (LD’s highlight!). Similarly, central banks should also establish their own credit analysis units if they take collateral with embedded credit risks.

Second, to the extent that ratings continue to be used in the standardized approach of Basel II, credit rating agencies should be overseen with the same rigor as banks that use the internal-ratings approach—credit metrics reported, ratings models backtested, and ex post accuracy tests performed.

Third, regulators should restrict “rating shopping” and conflicts of interest arising from the “issuer pay” business model by requiring the provision of more information to investors. A user-pay-based business model is difficult to maintain because of the inability to restrict access to ratings and their public good characteristic of aggregating difficult-to-obtain private information. Hence, mitigating conflicts of interest in the issuer-pay design through disclosure of any preliminary ratings obtained and how the ratings are paid for is preferred.

Not exactly a recommendation of the efficacy and integrity of our rating agencies. In fact, I would categorize this statement as a total vote of no confidence.

Navigate accordingly!!

Larry Doyle

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