Regulation is needed to salvage the credibility of the ratings agencies.

The financial crisis has raised serious questions about the ratings agencies. The agencies are meant to monitor company finances, so why didn’t they identify the problems before the meltdown happened?

Regulators have launched inquiries to find out. One investigation by the US Securities and Exchange Commission (SEC) unveiled “significant problems” with ratings agencies.

The SEC found that the agencies too readily accepted the information they were given by companies, didn’t ask the right questions or probe deep enough, and were too tied in with the products and companies they were rating to provide objective analysis.

The trouble is that a handful of agencies are assigned to rate thousands of listed companies, so corner-cutting is inevitable. They also have difficulty holding on to the best talent because there are better-paid jobs available in banks. All this can make understanding, let alone rating, complex securities a problem.

The most popular grumble is that the providers of ratings are funded by those they seek to pass judgment on. Insurers and banks pay for a rating on a product and, if it doesn’t fly, there’s no money for the ratings agencies. That’s why there’s such a lull in business now; with bank lending frozen solid, there’s nothing for them to rate.

These issues were compounded when it came to assessing the financial strength of the structured credit products that hid so many of the problems associated with subprime mortgages. Analysts should have been making aggressive downgrades against all the bond insurers that were taking on the toxic waste – not least AIG.

Instead of doing that, as the sector began to boom, the agencies, overcome with requests for ratings and eager to get in on the action, helped the banks shift their bundled debt products by giving them a favourable rating. By not turning investors off the products that turned out to be sour, they helped foment distrust in the system. It’s that loss of confidence that has caused so many problems.

But the regulators deserve to bear their share of the blame for the failure of the ratings system. So far, none has come up with a foolproof model for supervision. The consensus, however, is that codes of practice are not good enough and tougher regulation is required. The SEC has been the strictest, but all it has agreed is a set of proposals that have yet to be implemented thoroughly. The French regulator, Autorité des marchés financiers, is in favour of registration and monitoring and is keen to push the European Commission forward with its plans to regulate the agencies. The FSA has been conspicuously absent from the debate, claiming ratings agencies are nothing to do with it.

In an effort to avoid tougher regulation, the ratings industry has agreed a voluntary code of practice to improve transparency and reduce conflicts of interest. It was formulated in July by an agency working group, part of the Securities Industry and Financial Markets Association (SIFMA). While they are wary of more bureaucracy, the agencies do accept that enhanced oversight could help restore market confidence in the ratings they provide. Most market participants agree that more disclosure around how the agencies come to a rating decision is overdue. Stricter rules may also help address some of the conflicts of interest.

Until the rules are agreed and enforced, risk managers and brokers need to be cautious when it comes to relying on the advice of the agencies. Insurers should heed the same advice and weigh up much more seriously whether investments, particularly complex debt structures, are as bombproof as their ratings suggest.

Key Points

• A commercial rating is just one factor that risk managers, brokers or insurers should use to assess financial strength.

• The loss of confidence in the rating system is a key contributing factor to the financial crisis.

• Voluntary codes of practice are no good. Proper regulation is required, but this should not be burdensome.

• Ratings agencies accept that good regulation will help restore confidence in the system.