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Internationalism, Institutions and Individuals 235
/ Business schools that fail to create a culture of ethics fail to develop business leaders capable of questioning unethical practices in finance and other industries. Creating such leaders is important, as the rapid pace of decision-making in the financial industry and broad impact of those decisions make such decisions particularly complex. This complexity renders the tradition of box-ticking as a means of fulfilling ethical mandates irresponsible if not dangerous. For the investors who invested in Madoff and helped him solicit investment funds, perhaps it should have crossed their minds that reaping these outsized returns might involve some ethical breaches? Then again, who can fault them when ethics has been confined to a box to fill rather than a crucial consideration throughout the investment process?
236 Trust and Ethics in Finance
What kind of business leadership is wanted?
By targeting business schools for change, we can focus our effort on a major pipeline socialising individuals into the finance industry. Furthermore, the current financial crisis provides additional impetus for business schools to do some soul-searching on how their alumni have contributed to the current mess, and how they can ensure that the next generation of business leaders to emerge from their schools can change this system. For too long, business schools have focused on helping their students succeed within the existing corporate system, rather than helping their students shape it.
This debate, at its fundamental level, is about what business leadership should be and could be. Is leadership defined as having alumni who go on to become the Presidents and CEOs of Morgan Stanley, Goldman Sachs, or Blackstone? Or is it about alumni who through their positions in these companies (or outside of corporate circles) help shape business responsibility? It is a fundamental question about position versus impact. Business schools have tilted too much towards the former and they increasingly must address the latter.
Such a revolution in thinking is slowly taking place: in the US, Harvard Business School in its centennial celebration last year, asked itself what impact it wanted its students to have on society. In the Wharton School, newly elected dean Thomas Robertson declares a vision of business as a force for good. Internationally, INSEAD has a long history of promoting the idea of sustainability and corporate responsibility, setting up important centers and programmes in this area.
By changing the philosophy on which business schools are built, schools will be able to provide an environment more conducive to developing ethical leaders. By changing the purpose and approach of business schools, we can provide an environment for nurturing leaders who want to make an impact on the corporate world, instead of students who simply want success – defined as a top position at a top firm. This reInternationalism, Institutions and Individuals 237 quires a thorough change in the culture and purpose of business schools instead of piecemeal programmes that struggle against an entrenched culture.
This change will require bold visionaries to implement. Successful alternatives to the current business school model do not exist. Tried and tested actions are hard to specify, given the diversity of paths in making the change. There are no easy solutions here. Schools will have to make the leap of faith, and some might fail along the way. But the greater threat to creating an ethical financial system is for schools to fail to try.
From top to bottom
The ethical crisis in finance has deep roots at all levels of the industry, from its international nature, to the institutions that define the industry, down to its individual employees. Bringing ethical behavior back into the industry requires us to comprehensively tackle the problem at the different levels at which it exists.
At the international level, ethics have to be effective across the firm, with stronger emphasis on monitoring. Corporate behavior has to be aligned with an evolving external definition of ethics. At the institutional level, professionalisation of the finance profession can aid in defining ethical standards at the industry level, thus preventing the flow of individuals between firms from eroding the effectiveness of company-level ethical codes. At the individual level, we can target the key pipeline into the financial industry – the business school – for reform, in order to nurture leaders who want to use their positions in the financial world to pursue corporate responsibility.
An ethical financial system is essential to the healthy functioning of the entire economy. Making these changes should be an essential part of the rehabilitating the financial system from this age of excesses.
238 Trust and Ethics in Finance References Dunfee, T./ Donaldson, T., 1999. Ties that Bind, Harvard: Harvard Business School Press.
Yip, G., 1989. “Global Strategy… In a World Of Nations?”, Sloan Management Review, fall.
Zaheer, S., 1995. “Overcoming the Liability of Foreignness”, Academy of Management Journal, Vol. 38, No. 2.
“There are two superpowers in the world today in my opinion.
There’s the United States and there’s Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me, it’s not clear sometimes who’s more powerful.” Thomas Friedman It has been argued that the current global financial turmoil, touted as the worst since the Great Depression, is taking place because regulatory lines of defence failed to hold and prevent the crisis. Sequentially, risk management at firms, then market and official analysts and finally established regulatory bodies each failed to halt the financial meltdown that has pushed most major economies around the world to the brink of recession and caused significant slowdown and failure of some emerging market economies.
The focus of this paper is on the second line of defence in general and Credit Rating Agencies (CRAs) in particular. This is in recognition of the vital and indispensible role that the CRAs play in the global fiTrust and Ethics in Finance nancial system and, as demonstrated by recent events, the great impact of their failure to effectively fulfil their mandates on global financial stability.
With this in mind, this paper is divided into seven sections. (1) An overview of CRAs; (2) The role of CRAs in the current financial crisis;
(3) Key issues to address; (4) Recent regulatory developments; (5) Proposed regulatory options; (6) Options Analysis and; (7) Recommendations.
Overview of CRAs
Origins CRAs trace their roots to more than a century ago when investment in railroad began. 1In the late 1860s Henry Poor published a manual that provided information for investors – a lucrative business that John Moody also established in 1910 by publishing a book analysing railroads and their outstanding securities and assigning ratings to them. By the 1930s, investment policies requiring that bonds be rated were instituted. Today, there are three main international CRAs and a plethora of national and regional CRAs around the world.
Function Henry Poor and John Moody started analysing and rating railroads after realising that investors often lack the information to determine the soundness of their investment. In the same way, today, rating agencies deal with principal-agent problems and asymmetric information.2 Here, the ratings reflect the CRA’s estimate of the probability of default over a given period. CRAs therefore fall under the second line of defence since, like auditors, investment analysts and journalists, they act as gatekeepers Tara Perkins, 2007, Misguided or Misunderstood? Globe & Mail, 7 September 2007.
Richard Portes, 2008, Rating Agency Reform, www.voxeu.com Second Line of Defence 241 of investment-related transactions between market participants. In this way, CRAs play a critical informational, regulatory and transactional role in the global financial system.
Modus operandi A credit rating is defined as an “opinion forecasting the creditworthiness of an entity, a credit commitment, a debt of debt-like security or an issuer of such obligations, expressed using an established and defined rating system”.3 A rating agency derives its rating from both publicly available information and private information provided by firms and analysts. This information then goes through the rating agency’s credit model to produce a rating.4 These ratings signify financial soundness and regularity in interest and principal payments. They range from AAA for the highest quality bond instruments to D for instruments in default.
Role of agencies in the current financial crisis
Although there are several ways to explain the evolution of the current financial crisis, the one that best explains the role of CRAs is the one that sees the current financial crisis, like most financial crises before it, as being triggered by the emergence of innovation. This time, instead of the steam engine or the radio, the crisis emerged from the development of a “new tool of financial engineering” which, as in previous crises, investors were wary of at first before rushing in upon seeing the extraordinary returns, which lead to upward surges in asset prices that eventually burst and petered out.5 Amelie Champsaur. 2005. The regulation of credit rating agencies in the US, and in the EU: Recent initiatives and Proposals.
www.law.harvard.edu/programs/pifs/pdfs/amelie_champasaur.pdf Richard Portes. 2008 Carmen Reinhart, 2008, Reflection on the International Dimensions and Policy Lessons of the US Sub-prime Crisis. www.voxeu.com 242 Trust and Ethics in Finance More specifically, complex financially structured products came into the market when banks started using an “originate and transfer” approach to housing loans. These loans, a large proportion of which were sub-prime, were then securitised by investment companies who shopped around for higher ratings before selling the instruments to investors.
In this scenario, even the more sophisticated risk-hungry investors did not know how to value these new assets, and so had to rely on and trust the ratings provided by the CRA involved in the securitisation.6 The CRAs, encouraged by their own incentives heeded underwriters’ assurances of the power of pooling to decrease the probability of default and their ability to predict despite a limited track record. As these structured products did not trade, and were sold only over the counter, their price transparency and market liquidity was low.7 Because of this, it is widely believed that the CRAs failure to provide correct ratings on these high risk products and hold the second line of defence played a crucial role in the current financial crisis. This lead the US Congress House Oversight and Government Policy Committee to recently hold a hearing that concluded that the top three CRAs “were aware of serious problems but continued company practices which benefited the bond issuers while disregarding the interests of the investors who relied on S&P, Moody’s and Fitch ratings”.8
Key issues to address
There are several problems associated with the CRAs that prevent them from performing their role more effectively. These are linked to key issues that need to be addressed in order to more fully understand the areas in need of reform.
Guillermo de la dehesa, 2007, How to avoid further Credit and Liquidity Confidence Crises. www.voxeu.com Ibid US Congress, 22 October 2008, Transcript: House Oversight and Government Policy Committee, oversight.house.gov/story.asp?ID=2250 Second Line of Defence 243 No competition Firstly, it has been observed that there are some natural monopoly characteristics in the credit rating industry because of network effects9.
Network effects here refer to how investors want consistency of ratings across issuers. The natural monopoly also stems from the barriers to entry created by regulators who rely on ratings and as such use stringent criterion to determine whether or not an agency holds this regulatory license. CRAs also require highly qualified analysts, as well as high tech and sophisticated rating methodologies that are proprietary.10 In this way, the credit rating industry displays the same quality deficiencies (in terms of accuracy, lack of rigor and innovation) evident in any monopolistic market.
Conflict of Interest Secondly, and this is the most expansive critique of CRAs, there is an apparent conflict of interest in the business models of CRAs, which allow them to first advise on how the construction of a security would affect its rating and then issue a rating that confirms its advice – earning two separate fees in the process (Figure 1, opposite). For example, 44% of Moody’s revenues in 2006 came from its structured finance activities.11 This conflict of interest potentially reduces the objectivity of the ratings provided by CRAs and leads to the problem of perverse incentives in the rating process.
Incentives Thirdly, as is evident from what was alluded to above, there is an apparent incentives compatibility issue with CRAs. In the first instance, CRAs have an incentive to give high ratings in a situation where because the issuer pays for the ratings, he may also shop around for the Richard Portes, 2008.
Amelie Champsaur. 2005.
Richard Portes, 2008.
244 Trust and Ethics in Finance most favorable rating (the best deal). In the second instance, due to the same dual business model, CRAs also have incentives to ensure that securitisation takes place as this generates more business to them by providing more products to rate. To illustrate this, Figure 2 below shows how the revenue of the three big CRAs increased during the time leading up to the current implosion of the global financial system.
Accuracy and Pro-Cyclicality Fourthly, the accuracy of CRAs has been questioned. Agencies are blamed for reacting ex post rather than anticipating defaults. In this way, the ratings are not only lagging indicators12 but also pro-cyclical creating the herding effects, and magnifying instability as they did during the Asian Financial Crisis. In this crisis, as in the current crisis rating agencies, following their pro-cyclical tendencies, overreacted in their effort to distract the investing public from their laxness of the past few years by strict standards going forward13 creating the de-stabilising herding effects mentioned here. Furthermore, critics have highlighted how the agencies’ data and their models are suspect. For example, in rating the securities involving sub-prime mortgages, the agencies are said to have used data from an extended period of rising house prices, during which doubtful mortgages had been validated as householders’ equity grew.14 This led, in part to the inaccuracy of the ratings they provided for these products. With regards to the models’ simulations CRAs used, it was noted that these may not be helpful when markets become so disorderly that they exceed the models’ parameters and tail risk occurs. This is exacerbated by the questionable used of the same metric to evaluate sovereign risk, corporate bond risk, and complex instruments like collateralised debt obligations.15 It is because of these and other accuracy issues that, some literature points to the fact that rating agencies do not add value. This is because the quality of information they provide is believed to be no better than what a good analyst could extract from publicly available data. The questionable accuracy has prompted several detailed studies casting doubt on their ability to assess credit quality better than measures based on market spreads or to predict major changes.16 Ibid Carmen Reinhart, 2008.
Levich et al., 2007. Credit Rating Agencies and the Global Financial System.