Credit rating agencies pose stability risks, says IMF paper

Credit rating agencies have information value beyond that already publicly available to the market, and can negatively affect the price of credit default swaps, according to an International Monetary Fund paper published on January 20.

John Kiff, Sylwia Barbara Nowak and Liliana Schumacher, the paper's authors, examine the impact and accuracy of sovereign ratings and how influential they are for financial stability. While ratings produced by the major rating agencies perform reasonably well when it comes to rank ordering default risk among sovereigns, the authors say there is evidence of ratings stability failure during the recent global financial crisis. According to the academic literature, rating agencies add value to markets and exercise their power in three ways: via information provision, certification services and monitoring services.

The authors find credit rating agencies' opinions have an impact in the cost of funding of sovereign issuers, and consequently ratings are a concern for financial stability. The authors say evidence supports reform initiatives to reduce the impact of rating agencies' certification services; more stringent validation requirements for ratings if they are to be used in capital regulations; and more transparency with regard to the quantitative parameters used in the rating process.

Click here to read the paper.