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Virtually the whole of the Basel II concept of calculating regulatory capital is built around the concept of a score by the rating agencies. Even internal ratings are cross referenced to external credit assessments. This usage, originally criticized by the same rating agencies, seemed the only way to risk-weigh an asset. But the usage of credit derivatives has introduced a double whammy.
The problem with using external ratings in sub-prime mortgage portfolios is now well known – take a sub-prime mortgage, package it up with a lot of other prime mortgages, sell that package on to a AAA-rated organization, who in turns consolidates it with other similar packages and sells it on to investors. It is now impossible to identify the sub-prime part so the complete final package of securitised mortgages gets the rating of the final packager - investment grade. When sub-prime borrowers start to default, no one can identify which investments are good or bad so the market panics and all fall in value.
However is now appears that the usage of credit risk insurance coupled with external ratings can increase the ineffectiveness of using these ratings as a method of calculating or verifying regulatory capital. Basel rules allowed a asset rated BBB (with 100% risk weighting under Basel II) to be insured and to inherit the external rating of the insurer, say AAA, and therefore to carry a weighting of 20%.
A recent report by the Centre for European Policy Studies (CEPS) shows that AIG, the rescued American insurer, was carrying $300 billion of credit insurance for European banks (see also Sub-prime crisis – so everything is all right now!, Chase Cooper News, 22nd September) and that this was being used for regulatory capital relief rather than risk mitigation.
This puts a different picture of the current rating agency bashing that is going on. The problem is not only with the accuracy of the rating agencies, but with the definitions of the Basel II agreement. The banks discovered that insurance reduces both credit and operational regulatory capital – and the savings were greater than the costs of the insurance. We need the mandarins on the BCBS to bring out a revised version soon – or at least tell us they made a mistake and one is on its way - or the Basel II Accord will be discredited and we will be throwing the baby out with the bathwater.
And we are still here holding our breath regarding the US bail-out!
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