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Thursday, 21 June 2018

In Ratings We Trust

Some say that you shouldn't trust anyone, but sometimes you have no choice. The financial system is an example of such.

What does the whole financial system lean on? It is highly dependent on only one thing; trust.
Without trust, there wouldn't be reliable transactions between agents. Without trust, the money and the currencies would have no stable value. As in life also, in financial markets trust is everything. Lose that and bad things will happen.

One source of trust comes from the rating agencies such as Standard&Poor's, Moody's and Fitch Ratings. These institutions give ratings on corporations, securities and even countries and from the information provided by them the financial markets form their products for investors. These companies pretty much give the benchmark for other ratings and determine the interest rates and the quality of certain investments, businesses and economies.

When it comes to auditing, if you have a KPGM or a E&Y stamp from auditing, hardly no one questions on the integrity of their financial statements. But recent history with Arthur Andersen with the Enron-scandal and recently also KPMG with its auditing process on British construction company Carillion which went bankrupt earlier this year, shows that trust can be betrayed easily. And we must not forget the sad story of the Lehman Brothers in 2008 and the nonsense behind their financial statements.

Auditing is all about business and that's why there exists a moral dilemma. How big are the incentives to give good credits from auditing to a big long-term client, which has been a valuable source of revenue? Giving F for financials would in worst case make the client to switch its auditing partner and the auditing firm would lose its valuable client. This is the moral dilemma and several cases of the Big Four have been probed by international regulators worldwide because of this.

Why should we think that rating agencies could be any different? In 2007-2008 already the credit rating agencies (CRA's from now on) were accused of giving triple-A statuses to complex structured financial instruments basically on the basis of business, even though these instruments were evaluated according to some experts to have been backed by bad credit mortgages. These CRA's needed to give the ratings to hold on to their biggest customers and allow them to buy these products to their regulated portfolios that would only allow triple-A securities.

In 2008 the investors trusted these ratings blindly and inflated the popularity and the prices of collateralized debt obligations (CDO's) and we know what happened.

Blind trust can be lethal.

If the biggest and most well-known CRA's (which are American by the way) could make scandalous decisions in terms of business, what about politics? Country's rating influences a lot of the interest rates on which the economy can raise debt and also the attractiveness of the country for investments. In the worst case scenario these ratings could be used (in theory) as a political weapon to downgrade certain countries financial wise.

I'm not saying that something shady would be necessarily going on in the CRAs, since I couldn't possibly know. The thing I know is that many commercial banks and investors rely highly on ratings from these companies and make their investment decisions on the basis of these ratings. If a scandal on the scale of Arthur Andersen or KPMG would be to hit the CRAs again, that would again question the integrity of these institutions and the trust towards our financial system. In 2008, we saw what the lack of trust made happen.

The integrity of the CRAs hasn't been in the news frequently, nor the fact on how dependent the financial markets are from them. Is it because we are too afraid the question these? Or is it just the fact that "in ratings we trust"? They have a bigger influence and power than many people think. If you stopped reading at some point and started to think about the role of CRAs in the middle of this blog, this blog achieved its goal.

Text: SW
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