Are the outside credit agencies headed for extinction? Why structured data drives improved risk analytics.

• Author: Santiago, Dennis

The U.S. Senate Banking Committee, chaired by Richard Shelby (R-AL), held a hearing in February on possible conflicts of interest in the credit rating agency industry. What possible conflict of interest could there be for an industry where the subjects of the analysis are the clients? Plenty.

In the House, Rep. Richard H. Baker (R-LA), chairman of the Financial Services Committee's subcommittee on capital markets, insurance, and government-sponsored enterprises, has expressed impatience with the Securities and Exchange Commission, saying that if the federal agency doesn't take action to reform the rating agency system, he may introduce legislation to address problems he sees within it.

If safeguarding equity analysis independence is a good thing, it would seem to argue that it applies even more so to credit analysts serving a bond market ten times the size. During the Shelby hearings, there was no mention of the question of investors, banks, and companies generating their own internal ratings for measuring default and restatement risk, this rather than rely upon the SEC-imposed monopolies of Moody's, S&P, and Fitch. But that is precisely where the industry is headed: a marketplace where all banks and public companies finally grow up and become rating agencies themselves.

The fact is, under both Basel 11 and Sarbanes-Oxley, risk officers and directors must perform a degree of diligence regarding external threats that obliges them to come up with their own, independent risk ratings for all counterparties, public and private, down to and including retail customers. This means banks and corporations must be able to model these risks in detail and in real-time so that they can maintain internal ratings and produce these ratings for regulators and/or auditors on demand. The era of the rating agency as the definitive source of risk quantification is already ending.

THE END OF AN ERA

Two megatrends are sweeping across the analytical landscape and changing the course of quantitative due diligence. The first is regulations that have deputized banks and auditors as watchdogs, thus raising the bar on their internal risk measurement needs; if nothing else, to defend themselves against error and omission consequences. The second is the technological commoditization of the data needed to support a broader base of high-quality internal analytics by institutions. While neither of these future tides is yet perfected, the die has been cast.

The epicenter for the transformation of risk analytics from a service provided by outsourced vendors to an internal process starts with events such as Long Term Capital Management and the more general expansion of leveraged products in the financial world. The increased use of leverage in the capital markets, along with the collapse of the...