I have read many proposals on how achieve better and more trustworthy credit ratings, as if that is our real problem. No, our problem is the weighting we assign to those credit ratings.

As an example the Minimum Capital Requirements for the Banks issued by the Basel Committee under the Standardized Approach in order to cover for Credit Risk establishes the following in the case of bank lending to corporations.

Rating of..............Required Bank............Allowed
Corporation..........Equity $100 loan.........Leverage

AAA to AA-................$ 1.60....................62.5/1
A+ to A-....................$ 4.00....................25.0/1
BBB+ BB-..................$ 8.00....................12.5/1
Unrated.....................$ 8.00....................12.5/1
Below BB-..................$12.00....................8.33/1

If a loan to a BB- as now had allowed for a 12.5/1 leverage while a loan to an AAA had permitted 15.0/1 then not much would have happened… but the risk weights assigned allowed the leverage to go from 12.5/1 to 62.5/1, based only on the perceptions of a human fallible credit rating agency… truly mindboggling differences.

There is also no weighting in terms of how much in outstanding loans there exists for the different risk categories and so what could appear as a conservative weighting of the loans to risky corporations dos not necessarily compensate for a very permissive weighting of the corporations rated as having a low risk of default.

There is also little consideration given to the fact that markets abhor risks and love security and so that just putting up risk free signs risked a stampede of the herd. I do not have the figures but intuitively I am sure that as a result much more were lost by banks in operations rated as being of low risk than in operations rated as high risks.

The regulators also completely forgot that markets on their own are usually more careful when they know themselves in risky territory than when they feel safe and so, based on this consideration alone, one could make a case for a higher capital requirements when lending to entities rated as having lesser risk.

Finally and on a closely related issue the table above also indicates that the core of our financial system, the commercial banks, pay a de-facto tax based on “default risk” as measured by the credit rating agencies. When bank equity is scarce and expensive this de-facto tax, charged on top of whatever the market commands for assuming higher risks can be extremely and dangerously high.

In conclusion let us not spend so much efforts of getting the credit ratings right before we are really sure of how to use them.

In May 2003, in a workshop on risk management for financial regulators at the World Bank I said “I simply cannot understand how a world that preaches the value of the invisible hand of millions of market agents can then go out and delegate so much regulatory power to a limited number of human and very fallible credit-rating agencies. This sure must be setting us up for the mother of all systemic errors.”

Also in May 2003 the Financial Times published a letter I wrote saying “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic errors, about to be propagated at modern speeds. Friends, as it is, the world is tough enough.”

I believe both of those statements have been completely validated today which why I find it hard sometimes to understand how come we are still discussing this issue.