Chinese Central Bank Chief Identifies Ratings Agencies and Fair Value Accounting as Driving Pro-Cylicality in Crisis

The Governor of the People’s Bank of China has identified two pro-cylical factors that worked to exacerbate the financial crisis: credit rating agencies and fair value accounting. At a meeting of G-20 central bankers, Zhou Xiaochuan said that the problems of fair value accounting have been exposed by the current crisis. Compared with the historical cost approach, he noted, fair value accounting intensifies market fluctuations. While acknowledging that the fair value approach can better reflect the real time value of assets and liabilities, he said that it also magnifies the changes in their values and increases the volatility of returns through the profit and loss account as a consequence.

As a result of the massive collateralized securities they held, financial institutions registered mounting unrealized losses which actually involved no cash flow under the fair value rule. Though these losses were only meaningful in accounting, he said, such astronomical book losses distorted investors' expectations and formed a vicious cycle of tumbling prices and asset write-downs.

GAAP and IFRS define fair value in a similar way, which is a price at which an asset and liability can be traded with a willing counterparty in an orderly manner. Both accounting frameworks also provide measurement approaches at differentiated levels. Level 1: prices can be observed on active market, which are used to measure the value of assets and liabilities, a practice called mark-to-market. Level 2: when there is no active market, prices are assessed by using models with observable parameters as inputs, a process called mark-to-model. The measurement approach used on level 3 is similar to the mark-to-model approach, but it involves unobservable parameters and model assumptions as inputs. Both IFRS and GAAP require disclosure of the adoption of fair value approaches and specific assumptions as well as risk exposures and sensitivities.

In the view of Governor Zhou, the poorly guided adoption of fair value in non-active markets exacerbated market volatility. As defined, the using of fair value approaches must be based on the prerequisite of orderly trading. At times of crisis, as a large number of institutions were forced to liquidate their assets, prices developed under this situation did not meet the prerequisite for fair value measurement. However, due to the lack of specific guidelines on dealing with such circumstances, reporting entities had to conduct fair value measurement on the basis of unreasonable market prices, which magnified book losses and exacerbated the vicious cycle. The governor recommended implementation of circuit-breakers to stem the pro-cyclicality caused by mark-to-market and fair value accounting in specific situations.

The global financial system relies heavily on external credit ratings for investment decisions and risk management, he observed, giving rise to a prominent feature of pro-cyclicality. The rating industry is dominated by a few large players, which provide practically all important rating services. Specific ratings from these players tend to be highly correlated and they are combined to form a strong cyclical force. Many market players adopting ratings from these agencies and using them as the yardstick for operations and internal performance assessments results in a massive "herd behavior" at the institutional level.

Moreover, the central banker emphasized that the rating process is filled with conflicts of interest by virtue of the issuer-paying business model in which issuers also pay for the rating agencies' advisory services on structuring their products, which leads to more problems. He added that the rating models for mortgage-related structured products are fundamentally flawed.

Many financial institutions outsourced the development of their internal control systems and the technical models used by their traders in internal assessment and risk control, including the program trading models that had been widely adopted at an earlier time. Outsourcing of system technologies at such a prevalent scale contributed to high degree of homogeneity in the financial system, he noted, which strongly added to pro-cyclicality. For complex financial products, most institutions used models built by a handful of quantitative analysts that got widely adopted throughout the industry.

The governor urged regulators to require systemically important financial institutions to complement external pricing models with internally developed pricing capabilities. In addition, issuers of complex asset-backed securities should be given incentives to better assess their risks. Regulators should also require them to retain a meaningful share of the underlying assets on their balance sheets in order to alleviate the myriad of problems associated with the originate-to-distribute business model, including moral hazards and fraudulent loan underwritings.

On the users' side of ratings, he continued, there is the long-standing moral hazard issue. Various rules have required investment management decisions and risk management practices to be benchmarked on financial instruments attaining certain ratings from Nationally Recognized Statistical Rating Organizations (NRSRO). According to the central banker, this practice has enabled industry practitioners to piggyback on the external ratings and not to worry about the inherent risks once the instruments have achieved the threshold ratings. Over time, the financial industry has become accustomed to the practice and become complacent of the ratings they rely on so heavily

According to Gov. Zhou, institutional users of credit ratings, such as money managers and financial firms, should be ultimately accountable to their customers and shareholders and should exercise their own judgment of risk, not just outsource risk assessment duties to the rating agencies. To the extent they have to use external expertise, internal and independent judgment has to be deployed as a complement. The problem has become so serious that regulators must encourage financial institutions to enhance internal rating capability to rely less on external ratings. Further, regulators should impose requirements whereby use of external ratings should not exceed 50 percent of business activities for systemically important financial institutions. Internal capabilities should be developed to exercise independent judgment on credit risks at such organizations.