Outsourcing to rating agencies is not the answer to providing an independent research function; the conflict of interest problem and the accompanying censure will simply move to the rating agencies – and who will regulate them?

Financial services group Nordea’s agreement to outsource its equity research to rating agency Standard & Poor’s (S&P) seems to offer a poor remedy to the credibility gap suffered by the research function in the financial industry and opens the way to similar criticism of the ratings industry. Nordea and S&P tout the agreement, signed last month, as a groundbreaking deal and a bold and imaginative means to transform both the structure and the economics of investment banks’ research operations. From Nordea’s perspective, it clearly provides the answer to the financial group’s requirement that its research be created wholly independently from its investment banking business. But from an industry standpoint, it may not be the solution to improving the integrity of the research process. If investment banks were open to accusations of producing research that supported their own investment banking activities, rather than ensuring independent analysis of the companies in question, then the move by rating agencies to produce equity research for banks – by necessity, often of the same companies for which they calculate ratings in their rating business – could create similar difficulties. True, there is not quite the same potential for financial gain but as rating agencies expand their consultancy services, this situation could change. Allegations of potential conflicts of interest can as easily be levelled at a rating agency as they can at an investment bank and the Scandinavian and Baltic equivalent of Eliot Spitzer will surely be watching this new arrangement carefully. S&P stringently denies that any conflict exists. It highlights the difference between rating the probability of a company defaulting on its debt and making recommendations to buy, sell or hold a particular security. It also stresses the strength of the Chinese walls between its STARS equity service and the confidential information open to the analysts in its ratings business. But if Chinese walls were insufficient to properly separate research from investment banking in banks, will they withstand the pressures that may arise in a ratings agency? The provision of equity research will compound what many describe as an existing potential conflict for all rating agencies: that between taking fees from both the companies being rated and the investors who pay to use ratings services to assess those same companies for investment purposes. And criticism does not end there. In the past few years, rating agencies have come under almost as much scrutiny and censure as have investment banks, if for different reasons. Despite their superior access to the companies and sovereigns they rate, the Mexican crisis of 1994-95 made it clear that ratings agencies, like virtually everyone else, were guilty of reacting to events rather than anticipating them. This perception was reinforced during the Asian crisis and again by corporate failures such as Parmalat in Italy, where the ratings agencies’ judgments could only race to keep up with the drama as it unfolded. In the sovereign sector, the importance of rating agencies in rating emerging market governments has a huge impact on the ability of countries to tap the world’s capital markets. As one academic has put it, since the bond markets are effectively unregulated, credit rating agencies have become the markets’ de facto regulator. Sovereign ceilings also necessarily influence the ability of a country’s companies to access capital markets. When Basel II comes into force, giving rating agencies an explicit role in the determination of risk weights applied to minimum capital charges against different categories of borrower – affecting banks’ loan supply and funding cost – their influence will be even greater. It is about time the industry stopped asking the question, who should regulate the ratings agencies, and found an answer.

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