Taking a swipe at credit rating agencies (CRAs) has become a popular spectator sport in the past few years, especially among treasurers and banks that may have lost money following the 2008 crash. But all the hot air that has poured forth on discussions of potential reforms has missed the most important point.
Yes, the business models of the big three CRAs in particular are flawed. Yes, the finance sector would benefit from greater transparency about who is selling what information and to whom. But the real problem that needs looking at is the extent to which treasuries and investment firms on both the buy- and sell-side have become dependent on CRAs as the single, authoritative source of data for making critical investment decisions and assessments of counterparty risk in the supply chain or elsewhere. To try to solve the problem the EU is even proposing tighter regulation of CRAs, opening up the possibility of suing them for over creditworthiness errors, an action that is partly driven by anger over the way sovereign debt ratings have been handled during the eurozone crisis.
Many of the problems that the markets and investors are now experiencing can be attributed to the practice of using a triple A rating as a stamp of good housekeeping – instead of conducting the internal research, analysis and due diligence that are the core value proposition of any treasury firm. Indeed, clients shell out management fees and commission for insight and market intelligence, not generic reports from firms who have simply outsourced asset rating and assessment. There is no alpha to be gained from using the same, commoditised data as your competitors; and when everyone acts on the same information – accurate or not – irrational behaviour and unsustainable asset bubbles are the result.
Not much has changed since those bubbles burst in 2008. With the result that too many corporations and investors continue to rely on the same information, without validating it, verifying it or adding any value to it. For counterparty risk assessments it’s the same.
However, the information that CRAs produce has its merits. The agencies have, for a long time, done a great deal of valuable work on fundamental research and analysis. And there is much to be gained by leveraging that work. But a credit agency assessment is only one piece of the puzzle. The full picture will only be gained by going into the detail, drilling down below surface-level information, comparing and contrasting multiple datasets and questioning their sources and assumptions.
When aggregated with data from niche providers, fundamental and historical data, sales and pre-payment information can create consistent, validated intelligence that properly informs decision-making. Combine this with the healthy dose of scepticism that should drive due diligence of all kinds, and this adds the unique investment ingredient to help firms outperform the market.
It is something that hedge funds have long understood. They know that their unique selling proposition is based on two things: specialist and innovative strategies, and unique insights into the market. For the past 20 years, the larger alternative investment funds have been building proprietary data management infrastructures as a strategic imperative. They now have the ability to feed data from a startling array of standard and non-standard sources into their investment decision-making. Treasurers can do the same thing.
More mainstream firms are starting to follow the model. But the interesting conundrum of the investment business of the past 10 years has been that although firms have been narrowing their focus on easily accessible and commoditised data, the amount of information available to them has grown exponentially. Not only are there more data providers than ever before, but internet technology has transformed the distribution models of formal data providers, and opened reams of new information sources to data consumers.
Firms have held back from enriching their investment services with this panoply of data thanks to an unholy combination of a lack of understanding about what can be done and a lack of desire to do it. There have been too many heads buried in the sand, not knowing how to handle the problem but hoping that no one will notice the paucity of the data underpinning investment advice. And there has been an overall reluctance to invest in technology that can consolidate, compare and contrast a multiplicity of disparate data sources; all of which is needed to gain a fully accurate, 3D vision of a market, a sector or even of an individual asset, which is especially useful for counterparty risk and supply chain assessments.
Doing that by hand, or even by spreadsheet, is very costly. This is not a problem that can be overcome simply by adding more people to the process; it is about arming the people you have with the tools that can harness more information more effectively. CRAs should be part of this mix but not exclusively so.
It’s hard to do when there is a lot of pressure on margins. Over the past few years, as passive investments have become a greater focus and customers demand higher redemptions, firms have cut back on the very things that deliver value in the long term. It is research, analysis and due diligence that are the fundamentals that ultimately drive value across the investment business and create unique information that generates alpha. And this means no more standalone reliance on CRAs ‘stamp of approval’. This demands more than one source of data, which in turn demands investment in appropriate infrastructure. Without it, you are going in with limited intelligence; whereas proper infrastructure equips firms with powerful bespoke research and analysis. And that makes it an investment imperative.
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