In the FSA’s Turner Review, published today, the regulator says the instability of ratings has produced direct procyclical effects and undermined confidence in the future stability of credit ratings, in turn reinforcing deflation effects.
It says changes in structured credit ratings have been far more volatile over the past two years than the historical record for single name credits and more weighted towards downgrades.
It notes that a bank subject to a downgrade would automatically suffer the withdrawal of deposits but says this was not seen as a major problem in the decades before the current crisis.
But the growing importance of securitised credit has increased the dangers that hard-wired procyclicality would contribute to a self-reinforcing downturn as seen by AIG last September where a threatened rating agency downgrade led to severe liquidity strain.
It says ratings have proven to be less robust predictors of future developments and says the breakdown in their effectiveness reflected they were being extended to a instruments where there was limited historical experience.
It says the breakdown also highlighted a misplaced confidence in the ability of mathematical modelling to define the risks.
It says: “These ratings also play a role within the Basel II framework: the FSA therefore believes there should be a fundamental review of the use of structured finance ratings in that context.”