Finance is filled with informational asymmetries.  Lenders have more information about their borrowers than outsiders (assuming the lenders have done their due diligence).  Regulators have more information about the banks they oversee than outsiders (including shareholders).  Periodic abuses of those informational asymmetries over the decades has led to a range of regulatory requirements designed to increase transparency and level the playing field among different types of agents that require access to information in order to make good decisions.

Investors lending through bond markets do not have the same ongoing monitoring tools that banks have when they provide loans.  Capital markets thus require independent external verification of credit quality.  Ever since the 1929 stock market crash, capital markets have relied on independent, external assessments of credit quality to address informational asymmetries for lending in bond markets.  Failures at the CRAs as well as risk management failures among investors and banks leading up to the 2008 credit market implosion have created a major public policy shift away from this established operating system.

Today’s issue of The Risk Telescope focuses on the red-hot debate regarding what role credit rating agencies (CRA) can and should play in reducing informational asymmetries among private and public sector users of CRA analysis.  A clearly definable global goal has been articulated by the Group of Twenty (G20) and the Financial Stability Board (FSB) to decrease regulatory and private sector reliance on CRA assessments.  Section I reviews this recent history and suggests some implications for how market behavior could adjust if the G20 reforms are implemented.

However, major divergences are emerging across the North Atlantic regarding implementation of the G20’s policy objectives.  Specifically, the U.S. proposals for amending the Basel II Market Risk Amendment framework and the European Union’s draft directive both address the role of CRAs within the financial system in dramatically different, and potentially irreconcilable, ways.  Section II describes those divergences and their implications.

A focus on heated rhetoric also obscures the fact that policymakers on both sides of the Atlantic have very different views about the role CRAs should play in a market economy.  Both seem to favor more political factors in the credit assessment process, but the European framework suggests only local political views will be acceptable.  Such a perspective may be understandable amidst a crisis (particularly if one believes, as some Europeans do, that the market is unfairly and inappropriately discounting the nature and value of their reform efforts).  But insular views that reject independent, third-party analysis can also feed echo-chambers while rejecting one of the fundamental principles of a market economy:  that private market participants can and should make decisions regarding sovereigns without political interference.