Procyclical Rating

Introduction

The Asian crisis of 1997-1998 and the default wave in 2001 have cast some doubts on the ability of the Agencies to carry out the review of the Ratings.

A series of surveys have shown how high the percentage of market operators who are dissatisfied with the slow progress of the Agencies in adjusting the Ratings. In the interview conducted by Ellis [1998], 70% of investors stated that the Rating should also reflect the most recent changes in creditworthiness.

On the other hand, investors themselves feel the need for a reliable judgment for as long as possible in order to avoid having to adjust the composition of their portfolio too frequently.

S&P conducts its allocation policy primarily in accordance with the latter.

The underlying philosophy of this policy is the belief that the value of its Ratings is higher as they focus on the long-term, without fluctuating for short-term performance.

Therefore, a Rating through the cycle should be issued, i.e. an average Rating for an entire cycle.

It is useless to attribute a high Rating to a company that is facing an extremely positive period but of short duration, or to lower it if it is very likely that the negative phenomenon, which determines its downgrade, disappears shortly.

The procyclicality of Ratings is a topic that has stimulated the interest of many researchers.

The analyses show results from which different evidence can be drawn, depending on the study that is taken into account.

On the one hand, we find scholars like Mora [2004], who maintain that Ratings instead of procyclical ones would be rather insensitive to changes in the economic cycle. On the other hand, however, there is the majority of researchers, who have proved, mostly through empirical investigations, that the ratings are assigned in a procyclical manner: they are overly optimistic in boom periods and penalizing, more than justifiable, in recession periods.

An important contribution to the analysis of the pro-cyclicality of the Rating is provided by the research of Jeffery Amato (Bank for international settlements) and Craig Furfine (Federal Reserve Bank of Chicago), who, using an ordered probit model, examine the universe of US companies evaluated by Standard & Poor’s between 1981 and 2001.

Unsolicited Ratings and Rating Shopping

Among the most felt problems, with regard to the behavior of the Agencies, there is that of unsolicited ratings.

These are the Ratings not requested by the issuer but performed on the initiative of the Agency.

This practice is indispensable, especially in emerging markets, where any information issued about an issuer could be potentially material.

However, as there is no request from the debtor, the integrity of the process leading to a given Rating can be questioned.

Another critical aspect, related to unsolicited Ratings, is the conflict of interest situation in which the Agency may fall.

It can be verified that this is an incentive to issue particularly unfavorable Ratings, in order to induce the issuer to officially make the request and pay the relative commissions, if it wants to obtain a better one.

The unsolicited Rating represents, substantially, a tool through which the Agencies, especially the smaller national ones, aim to acquire market share compared to others that do not provide the same service.

The conflict of interests reoccurs by observing the phenomenon of Rating shopping, which refers to the behavior that pushes issuers to request the assignment of a Rating to more than one Agency, in search of the best one.

Research conducted by Bolton, Freixas, and Shapiro in 2009 showed that Rating shopping would have three effects on the market, which would be completely counterproductive to its efficiency:

? The probability of Rating inflation: the level of the Ratings rises, ceasing to reflect the judgment that issuers actually deserve.

? This probability increases in periods of market euphoria.

? Increased inter-agency competition, counterproductive for less experienced investors.

Conclusion

This article aroused interest in the need that markets have always felt to regulate the activities of rating agencies in an increasingly rigorous manner, in order to avoid as much as possible errors, sometimes catastrophic, for the economies of the countries involved and, at the same time, to protect savers and investors from dangerous risks of default.

Marco Barchetti