We recently spoke to two chief executives of privately owned, for-profit companies that, uniquely, also function as quasi-regulators.

 

Sound odd? Well, for some reason, these two companies are legally sanctioned to provide opinions that significantly impact the entire financial system. This is because they can determine what borrowing costs are at every level of the system; what instruments financial institutions can hold; and how much capital these institutions need to operate. If you hadn't already guessed, the two companies we met are two of the three global credit rating agencies (CRAs).

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On the Sept 15, 2008, we happened to be in Wall Street, right in the eye of a credit rating storm that wreaked mayhem in global financial circles. That mayhem was due mainly to uncertainty about the ability of the United States and its various mega-financial institutions to function globally based on liquidity and their ratings. We were guests at one of the offices of one such institution when the US credit rating was downgraded. Officers from the US Federal Reserve, as well as lenders swarmed the office, demanding to know what liquidity reserves were. This came 24 hours after the credit downgrade. Credit flows immediately stopped and there was an absolute liquidity crunch just due to the downgrade.

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Much hasn't changed since all that chaos, despite a selective closure of some of the biggest financial groups with others were either rescued or even unscathed. But having observed all the havoc, one has surely to wonder whether or not there were serious flaws in the CRAs deliberations and how they actually went about making decisions. How much accountability do they accept for such deliberations?

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In conversation with a G20 finance minister, we were told that they had approached a rating agency and asked: “Tell me the top 10 items that we need to address as a country in order to get our ratings up”. Not surprisingly, the response was very general and not specific at all. We could sense the immense frustration of this finance minister who commented: “We are supposed to be transparent, yet they are not transparent themselves.”

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Fast forward to 2011, then, and while there was nothing new about the US worrying debt situation, we really have to wonder why there was such a rush for CRAs there to judge the US government's measures to chip away at the budget deficit; just days after an agreement was reached that assures that the US will fund its operations through the next election cycle. Additionally, a process had started as to how the US would address its fiscal imbalances. What's more, why did the two other agencies, Moody's and Fitch did not see the need to revise their judgement. Interestingly, one of these two agencies, Moody's actually stated that a credit downgrade would be premature at that point. So why did Standard & Poor's downgrade the US credit rating in a very fragile environment, thereby rocking markets everywhere?

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How often, if at all, does a credit rating agency consider the timing of voicing any of its opinions on the creditworthiness of a country? Would you, as an astute investor, consider that the US is less creditworthy today than it was five weeks ago, especially when its leaders were about to sign a deal which would guarantee the country's ability to honour its financial obligations right through to the next presidential election in 2012? Just take a look at the timing of the credit rating of Iceland when it landed in trouble. In September 2008 the ratings were still investment grade category.

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Observe, too, that the credit rating agencies' opinion as to US creditworthiness gave little, if any, thought to the very special role America plays in the global economy. For one thing, despite choruses to the contrary, the greenback is still the preferred reserve currency worldwide. Also, when investors everywhere look for a safe haven for their assets, they still buy US treasury bonds. In fact, let's not forget that even in the darkest days of the 2008 global financial crisis, the world still valued the US dollar and treasury bonds because, well these were the most trusted reserves.

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Given that confidence in the global financial system is still so fragile, one has to ask why these CRAs have the power to undermine the ability of some institutions to function. Whatever said, these credit ratings can ratchet up uncertainty, which can only too quickly lead to a freefall towards fear. Indeed, that is what we seem to be seeing in financial markets today.

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So wouldn't you like to know why such groups are given so much leeway such that they behave like regulators? Isn't it time that governments did something about such legally sanctioned oligopolies which effectively regulate corporations without any real oversight or consequences to themselves?

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Indeed, when we prodded the two credit agency heads about the far-reaching economic impact from their ratings, the opaqueness of their decision making, and the timing of their releases; the only response we got was a non-committal “well, it is just our opinion.” Surely, if these organisations' ratings can impact the financial system so significantly, this non-committal, almost irresponsible behaviour needs to be immediately addressed.