The Evolutionary Memory Palace…

KBRA, a “non-legacy, non-Big 3” rating agency recently published an interesting short note, entitled “Counting on Evolution”. In it, KBRA argues in the context of the banking industry in particular that since the Great Financial Crisis (GFC) there have been sufficient changes as a result of “learning” (in effect, adaptation and evolution) that developed banking systems such as those in the US now represent less rather than more risk than prior to the GFC. Therefore (according to KBRA), the fact that, almost invariably, the ratings applied to the major US banks are currently several notches below those applicable pre-GFC is misguided and overly conservative. Naturally, KBRA “aspires to get to the right rating.”

Such thinking is, on the face of it, not unreasonable. However, it begs or omits a number of questions:

– The ratings, pre-crisis, were appropriate
– Published ratings are easily comparable in terms of assumptions made
– That the Directors and senior executives of said banks (as well as their regulators) have truly learnt (i.e., evolved) as a result of the GFC and have stored the appropriate facts in their individual and institutional memory palaces
– That these “evolved” institutions are no longer vulnerable to market spasms and panics

Let us consider each of these points in turn.

Firstly, given that none of the 3 dominant “legacy” rating agencies forecast the credit consequences of the GFC ex ante, their ratings process demonstrably failed the test of providing any meaningful predictive power of credit quality, particularly in respect of the monoline “doom loop” or systemic failings within the banking system. Of course, hindsight is a wonderful thing, but arguably there was serial “over-rating” going on pre-GFC.

Secondly, in the dim and distant past, ratings scales were relatively simple and essentially unified, with each main agency arguing that a “AAA was a AAA was a AAA”- in other words ratings across different obligor categories were essentially directly comparable. Now there are enough different scales, modifiers and suffixes to make one’s head spin. On the one hand, this indicates that precision about assumptions is critical; but, on the other it, the increased complexity tends to reduce the informational quality of what is published.

Thirdly, while one would expect that rational self-interest would cause bank executives to modify their behaviour (i.e., adapt) in order to avoid the possibility of another GFC, the continuing misalignment of incentives and general lack of accountability make one somewhat skeptical that lessons truly have been learnt. Similarly, post-GFC, regulatory agencies significantly toughened and enhanced requirements for their charges, which should have at least have increased the “survivability” of individual banks and the financial system which depends upon them. Nevertheless, signs of relaxation of these rules have appeared, so one might question how vigilant regulators will actually be if standards within what remains a highly-leveraged, inter-connected system erode.

Finally, all banks within a fractional reserve system are vulnerable to “runs, panics and spasms”; and every time one hears or reads “but this time is different”, one knows that, sooner or later, there will be another financial crisis in which commercial, for-profit institutions will, yet again, try to socialize risk, even if regulators and politicians will, ex ante, be adamant that “this time” major banks will be allowed to fail and that they have the tools necessary to cauterize and confine the risk of contagion.

So, while KBRA may have a point that institutions and systems evolve (as one would hope!), and thus current public ratings are unduly harsh in relative terms, one needs to be cautious that this “evolution” is irreversible.

At Awbury, we believe strongly in analyzing risk based upon an exhaustive fundamental and quantitative analysis. While we respect the service performed by the rating agencies, we prefer to operate without reliance upon the convenient crutch of public ratings, which are simply another piece of information.

The Awbury Team

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