Reducing Role of Credit Ratings Would Aid Markets

Credit ratings have become embedded in regulations, private contracts

Downgrades can set off destabilizing knock-on effects, spillovers

Ratings reliance should be reduced

The analysis, in the IMF’s Global Financial Stability Report, recommends that regulators reduce their reliance on credit ratings as much as possible and increase their oversight of the agencies that assign the ratings used in regulations.

Credit ratings, which measure the relative risk that an entity such as a government or a company will fail to meet its financial commitments, play a significant role in certifying the quality of investments in fixed-income markets.

Regulators, for example, rely on ratings in setting standards for securities that financial institutions hold. Institutions must hold less capital to buffer against losses on higher-rated assets than on lower-rated ones. Central banks often rely on credit ratings to determine what securities they will accept as collateral on loans to bank or other financial institutions.

Ratings play similar roles in private financial dealings, when securities are posted as collateral and private financial contracts often contain ratings triggers that end credit availability or accelerate a borrower’s credit obligation if a downgrade occurs.

Sovereign debt

In the case of sovereign debt, the IMF said in the report released September 29, the problem does not lie entirely with the ratings themselves, but with overreliance on ratings by market participants, coupled with deleterious selloffs of securities when they are abruptly downgraded— called “cliff effects.” The IMF says, however, that credit rating agencies have to shoulder some of the blame for these cliff effects, because they may pay insufficient attention to sovereign debt composition and contingent liabilities, though in some cases they do not have access to all the information they need.

The IMF report, which is part of the main Global Financial Stability Report to be released October 5, also emphasized that despite these issues, ratings serve a useful purpose. They aggregate information about the credit quality of various types of borrowers and their financial obligations, allowing such borrowers access to global and domestic markets, and enabling them to attract investment funds. The ratings add liquidity to markets that would otherwise be highly illiquid.

Although rating agencies have most recently been scrutinized because of their downgrades of sovereign...