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Risk ratings: Time to shake things up

Americas / 05-07-17 / by

As supply chains become more integrated and new risks threaten business lines, the traditional credit rating model is being challenged. Melodie Michel investigates.

 

The so-called ‘big three’ credit rating agencies – Moody’s, Fitch and Standard & Poor’s – rule the financial world. A ‘negative outlook’ by one of them about a country or company can send markets into a panic and deter previously enthusiastic investors. And the opinion of one is usually followed by consensus from the other two.

There are, however, many questions about why these three agencies, all from the US, bear so much authority in the financial world. It’s not like they never get it wrong – in fact, they’ve been repeatedly blamed for not seeing the global financial crisis coming.

When it comes to sovereign ratings, the big three have been mistaken more than once: their downgrade of the US in 2011 was followed by an acceleration of GDP growth and a reduction of the country’s debt burden between 2012 and 2015, contrary to expectations. The same thing happened with Japan in 2014: shortly after its downgrade, the country’s economy started to grow again as Prime Minister Shinzo Abe’s reforms began to harvest their benefits.

Though they are technically independent, their constant consensus and sometimes controversial sovereign ratings have led critics to suggest that they may act in favour of the US, their homeland. In response, some countries have launched their own credit rating agencies, to various levels of success.

In 2015, Russia created the Analytical Credit Rating Agency (ACRA) after announcing that the government would have more control over the foreign agencies operating in the country – a move which prompted Moody’s and Fitch to exit Russia. The same year, the leaders of the BRICS bloc (Brazil, Russia, India, China and South Africa) declared their intention to set up a rating agency that would fairly represent their interests. The process is now likely to be accelerated after Moody’s recent downgrade of China – the first in 30 years – and the prospect of yet another downgrade in Brazil.

While these efforts are playing an important role in raising awareness about the big three’s arguably unjustified hegemony, it’s unlikely that investors will trust the ratings of agencies created to paint a better credit picture of the countries in which they operate.

 

Conflict of interest

The most disturbing thing about the big three’s monopoly is the fact that they are paid by the companies they rate – a clear conflict of interest. In The Big Short, a 2015 movie about the subprime crisis, this issue is clearly depicted: in one scene, a woman working for one of the agencies explains that if her company doesn’t grant a high rating to its Wall Street bank customer, it will simply go to a competitor to get the rating it wants from them.

Many believe rating agencies gave a false sense of comfort to investors ahead of the crisis, putting their own financial interests first. For that reason, the Dodd-Frank Act drafted as a response to the financial crisis included a number of measures to ensure these agencies’ accountability and transparency – though without changing their remuneration model.

The agencies were forced to disclose information about their performance measurement statistics and the procedures they use to determine debt grades to the Securities and Exchange Commission (SEC). They were also required to come up with an internal control structure to govern the implementation of, and adherence to, policies, procedures and methodologies for determining credit ratings.

Now, the Financial Choice Act introduced by Republicans in the US congress at the end of April could repeal all these control measures, in effect allowing the big three agencies complete opacity about their processes and even protecting them from competition. The bill, which also aims to deregulate Wall Street and defund the Consumer Financial Protection Bureau – a federal agency created in 2011 to protect consumers’ interests in the financial world – has been dubbed the “Wrong Choice Act” by Democrats, who are vehemently fighting it.

Still, the proposal has the support of the Trump administration and could very well be signed into law, allowing the big three to, once again, continue with business as usual.

 

Challenging the status quo

But many investors and corporates are waking up to these agencies’ flawed model, and looking for alternatives. The Reserve Bank of India (RBI) recently came out saying it plans to create a fund – with contributions from banks and the RBI itself – from which payments will be made to agencies for rating of corporate borrowers, in a bid to make agencies more independent.

New York-based RapidRatings International was launched in the US in 2007, and now counts McDonald’s, FedEx and General Electric as clients, as well as a large US bank. The firm offers financial health ratings (FHR) of public and private companies, and works on a subscription basis (clients pay to access the ratings database instead of paying to get rated), eliminating the conflict of interest that plagues the ratings world.

By rating private companies as opposed to public bond issuers only, RapidRatings is creating a sort of financial health database for each sector of the economy, improving transparency and predictability in supply chains.

“Our system is entirely quantitative, whereas traditional ratings are a very qualitative process,” explains James Gellert, the company’s chairman and CEO. “Most private companies are not bond issuers, so they’re not going to pay S&P and Moody’s to rate their instruments, yet there are many companies that interact with, either lending to, investing in, buying from or selling to, private companies.”

Gellert explains further: “Traditional credit ratings, whether they come from the bond ratings portion of firms like Moody’s or even their analytics products, they, generally speaking, are designed to predict default probability. We believe that’s a very limited perspective on a company. The financial health rating system includes an industry-specific risk approach: 24 different industry models that are all integrated to be able to get a financial health rating comparing apples to apples across all industries. We then produce two principal components of the rating: one called the core health score and the other is the financial health rating (FHR). And the combination of these is what gives our ratings much more dynamic usability than traditional credit ratings.”

The firm has already rated “tens of thousands” of private companies around the world this way, and has an 86% success rate in convincing firms to disclose their financials. It is getting requests from large banks to rate the financial health of their correspondent networks, as well as the fintechs they increasingly work with – all with the objective of improving transparency in supply chains.

The advantage of having such an extensive database is that it makes it possible to include a machine learning element to the model. This is something that companies like MarketInvoice, a UK invoice finance firm, truly believes in.

The company’s head of risk, Shaun Alexander, explains to GTR: “We have access to a very large number of invoice transactions across a large number of industries, which means we can develop our model to make even better and more consistent decisions. Our use of artificial intelligence is very much how we differentiate ourselves.”

Alexander joined MarketInvoice from Santander in April this year, with a clear intention to “challenge the status quo of risk management”. “The impression that I have from my time at Santander and Barclays is perhaps an over-reliance on the ratings world. A lot of the banks’ decisions are reliant on a third-party view. For SMEs, the more striking thing that I found was that the minimum criteria [for risk assessment] was only one set of data, not taking into account the direction the company is going in, and the trends analysis behind the rating,” he adds.

 

Benefits for corporates

Gellert admits that the long-term goal of RapidRatings is for the FHR to be “the ubiquitous measure for evaluating corporate risk”. “We’re making a very big stride in creating this universe of transparency for the upstream and downstream relationships that companies and financial institutions have, so the disclosure of financials and the evaluation of financial health can be a very productive part of commercial activities. That’s a great evolution from what credit risk and financial checks used to be not that long ago,” he tells GTR.

In fact, the company recently took another step towards this ideal by launching the FHR Network, an online platform where companies can opt in to be rated for free, with the option of asking RapidRatings to distribute the findings to their potential clients for a fee.

The idea is to use the ratings as a tool for collaboration between buyers and suppliers, not just as a way to decide whether or not to start a commercial relationship. “Companies get value out of communicating their financial health, whether they’re strong or not. The people or companies they want to work with are interested in having transparency for the sake of understanding the potential for their relationship,” Gellert says.

While the big three are likely to maintain their monopoly, the multitude of initiatives looking to improve the credit rating model, and the response these are getting from corporations, are a sign that the industry is ready to shake things up.

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