A new way of rating


The latest attack on ratings agencies in Europe comes from the Bank of France chief, who argues that ratings agencies should downgrade the UK before considering downgrading France! Which reminds me of the proposal from Europe that countries that are about to be downgraded should be advised and removed from being rated. Hmm, how is removal from the ratings not a downgrade? But why do we care about the ratings at all – we know they are imperfect, and were shown to be subject to a number of problems during the GFC. A major reason why ratings are very important is because ratings affect investment decisions and thereby pricing. For example many pension funds are only allowed to invest in AAA rated assets. A real issue seems to me that this leads to highly non-linear decisions. Downgrades can affect pension funds or other investors ability to invest in certain assets, thence affecting interest rates. But what if ratings were on a 100 point scale, rather than the crazy lexicographic scale now used? In that case could not banks be allowed to multiply their sovereign bond holdings by the average quality of those bonds measured on the 100 points scale in determining risk adjusted asset backing? Pension funds might need an average asset mix having a quality of xx, rather than just being allowed to invest in AAA rated bonds. The nature of the current ratings system, and the induced non-linearity in investment decisions seems to me to be both a major problem, and an explanation for the regular lunacy in statements from senior European officials. Does it make sense to move to a new way of rating?

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