Ratings agencies are not the villainous enemies
by Philip Booth
The only thing worse for a government than a downgrading of its debt is not knowing whether it should be downgraded because the main players are banned from offering opinions
When asked to comment, this morning, on the proposal by European Commissioner Michel Barnier to ban ratings agencies from issuing downgrades of government debt in certain circumstances, I stalled – putting it in the "early April fool" file. After completing some other tasks first, I was then staggered to see that the proposal was actually made by the commissioner in a speech. This would be a profound move to prevent freedom of speech.
It is true that ratings agencies have been raised upon a pedestal by the use of their ratings for regulatory purposes - therefore, grossly distorting the market. For example, the use of ratings of bonds to set bank capital gave agencies an incentive to over-rate bonds – the possibility of reducing the regulatory capital of a bank by providing a good rating, perhaps, distorted their incentives. Also, their use in the United States for regulatory purposes, combined with the effective creation by the regulators of an oligopoly, has removed competition from the market. As it happens, Barnier suggested in the same speech that he was going to address some of these problems.
Fundamentally, though, a rating agency simply provides an opinion on the credit worthiness of the issuer of bonds. In the case highlighted by Barnier, the relevant issuers are sovereign governments. We already have the ludicrous situation whereby banks are encouraged to lend to over-stretched sovereign borrowers because the regulatory capital requirements from holding such bonds are less than those from holding similar private sector risks. We are now being told that some of the most important and knowledgeable institutions in the debt markets will not be able to comment, if they believe a particular sovereign issuer has become more risky.
This is a direct attack on freedom of speech. It would make governments less accountable to the people because government could pile up bad debt and informed opinion would be prohibited from commenting, if the government were showing signs of not being able to service the debt. Rating agencies have no vested interests in the matter of sovereign debt at all – unlike the situation that developed in the securitised private debt markets because of the distortions of bank regulation. In the case of a sovereign debt downgrade, a ratings agency simply delivers bad news – or expresses a negative opinion – on an underlying reality.
Barnier's proposal would be a classic case of shooting the messenger. Quite apart from the implications for freedom of speech, this move would also have undesirable consequences for the liquidity of European Union government debt and, ultimately, for the cost of borrowing. It will not help the governments at all. There is only one thing that could be worse than for a government than a downgrading of its debt – that is, the uncertainty of not knowing whether the debt should be downgraded because the main players are banned from offering their opinions on the issue.
Professor Philip Booth is editorial and programme director at the Institute of Economic Affairs think-tank, in the United Kingdom