Public Credit Rating Agencies: Increasing Capital Investment and Lending Stability in Volatile Markets 1137365803, 9781137365804

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Public Credit Rating Agencies

Publi c Cred i t Rati ng Age n cie s Increasing Capital Investment and Lending Stability in Volatile Markets

Susan K. Schroeder

PUBLIC CREDIT RATING AGENCIES

Copyright © Susan K. Schroeder, 2015. All rights reserved. First published in 2015 by PALGRAVE MACMILLAN® in the United States—a division of St. Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN: 978–1–137–36580–4 Library of Congress Cataloging-in-Publication Data Schroeder, Susan K. Public credit rating agencies : increasing capital investment and lending stability in volatile markets / Susan K. Schroeder. pages cm Includes bibliographical references and index. ISBN 978–1–137–36580–4 (hardback : alk. paper) 1. Credit bureaus. 2. Capital investments. 3. Business cycles. I. Title. HG3751.5.S37 2015 3329.0415—dc23

2015009602

A catalogue record of the book is available from the British Library. Design by Newgen Knowledge Works (P) Ltd., Chennai, India. First edition: September 2015 10 9 8 7 6 5 4 3 2 1

To the memory of my dad David W. Schroeder Sr.

Contents

List of Figures and Tables

ix

Preface

xi

1

Introduction

1

2

Functions and Malfunctions of the Rating Industry

9

3

Private Credit Risk

25

4

Sovereign Credit Risk

73

5

Regulatory Capture

105

6

Public Credit Rating Agency: Functions and Structure

125

7

Conclusion

161

Notes

173

Bibliography

179

Index

191

Figures and Tables

Figures 2.1 3.1 3.2 3.3

3.4 3A.1 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 6.1 6.2

NRSRO ratings by asset class: 12 months ending December 2013 (Total: 2,437,046) Volatility indicators for selected countries, based upon % change in gross capital formation Volatility indicators for Japan and Korea, based upon % change in gross capital formation Volatility indicators for Australia, New Zealand and United Kingdom, based upon % change in gross capital formation Manufacturing (% of total value added): selected countries Minsky’s graphical determination of investment and finance General government debt/GDP: selected countries Central government debt/GDP: selected countries GDP growth (% change): selected countries Central government expenditure (millions of euro) and share of GDP: selected countries Composition of expenditures by central governments: selected countries Central government net lending (% of GDP): selected countries Current tax receipts by source (millions of euro): selected countries United States: debt/GDP and net lending/GDP Incremental rate for the US economy (1997–2013): OECD vs. NIPA Growth rate of real personal consumption expenditures: United States (1990–2013)

10 57 58

58 59 70 95 95 95 96 97 99 99 101 134 135

x

FIGURES

6.3 6.4 6.5 6.6

6.7 6.8 6.9 6.10

AND

TABLES

IRR vs. interest rate: United States (1976–2013) Smoothed IRR vs. interest rate, 3-year centered moving averages: United States (1977–2012) IRR without property income (personal & government) vs. interest rate: United States (1976–2013) Smoothed IRR (without property income) vs. interest rate, 3-year centered moving averages: United States (1977–2012) Employee compensation and rental income of persons (% of national income): United States (1976–2013) Compensation & rental income vs. corporate profits (% of national income): United States (1976–2013) IRR vs. % change in (real) investment, 3-year centered moving averages: United States (1997–2012) 3-year moving averages of selected industrial IRRs: United States (1998–2012)

135 136 137

137 138 138 139 140

Tables 2.1 2.2 3.1 4.1 4.2 4.3 6.1

Global long-term ratings for major three credit rating agencies Global short-term ratings for major three credit rating agencies Key criteria for corporate ratings Standard and Poor’s sovereign factors and indicators Moody’s sovereign factors and indicators Fitch’s sovereign factors and indicators Rating structure for Export-Import Bank of the United States

14 14 38 82 83 84 145

Preface

The book extends an article that I wrote for the Journal of Economic

Issues, titled “A Template for a Public Credit Rating Agency.” The challenge was not simply to reiterate and provide more detail on the vision in the article but also to discuss such how such an institution could stabilize and promote investment activity, encourage lending and growth. Reviewer feedback from the book proposal also suggested that the book address issues such as the robustness of Ricardian equivalence and the influence of regulatory capture on the rating industry, among other things. This book is the product of those exchanges. This project—a public credit rating agency—was motivated by my desire to come up with something different for stabilizing an economy. There has got to be another way forward on policy and its design than to simply add to the discourse about the relevance and effectiveness of fiscal and monetary policies. For me, new directions ultimately lie in the vision one holds about the inherent nature of investment—is it an activity that helps to stabilize an economy or one that destabilizes an economy? One’s answer to this response highly influences how one thinks about policy. On the one hand, for mainstream economists the vision is that investment activities promote stability. Mainstream economic policies are primarily oriented to support investment’s stabilizing nature by unleashing the power of the markets. On the other hand, for most heterodox (nonmainstream) economists, investment activities are destabilizing. As such, overreliance on the market mechanism ultimately promotes instability. The stance taken here is that investment is inherently destabilizing and what follows will flow from this perspective. This book explores the implications of that distinction for evaluations of creditworthiness, with particular focus on credit rating agencies as the leading, and most publicly accessible, assessors of credit risk. It is important to bear in mind that although the rating agencies are criticized over their ratings of structured finance instruments, they also assess variety of other instruments and issuers that are more

xii

P R E FA C E

closely related to productive investment. If the pace of productive investment is influenced by assessments of credit risk, such as ratings, it is important to address the issues concerning the accuracy of ratings, particularly in this context. Are they as accurate as they could be? The presence of a public credit rating agency could stimulate developments that improve the quality and timeliness of ratings, and assessment of creditworthiness more generally. Benchmarks and instruments can be devised that supplement the use of interest policy to promote the stability of financial systems. Moreover, if a public crediting agency were to be coupled with an industrial policy, it could stabilize not only investment but also everything that investment activities influence, such as profit, income, employment, and economic growth. This does not imply that growth needs to necessarily increase at breakneck speed. Slower growth that is targeted to support civilian industries can be just as powerful, if not more so, for setting the foundations for more stable and just societies in the future. Of late, there has been renewed thinking on industrial policy. However, the basis of the discussion still rests on a vision in which investment promotes the stability of an economic system. As will be discussed in the coming chapters, an implication of this vision is that the success of industrial policy rests on worker productivity. Viewed from the perspective of heterodoxy, productive workers are great. However, productivity is not enough to stabilize investment and keep it profitable. There needs to be an effort to support the absorption of supply of goods and services, especially for activities related to civilian industries. Stable growth and income also means stable tax revenues for governments, which, in turn, will help them reduce their reliance on financing current expenditures with new debt. It would also give them the ability to create plans for debt reduction. The creditworthiness of firms ultimately impacts the creditworthiness of sovereigns; in turn, the performance of these instruments supports the health of banks and other financial institutions and investors. The rating agencies understand the importance of economic performance and structure for the resilience of governments’ fiscal positions. However, the assessments of governments and firms may be overlooking important dynamics associated with investment. An important consideration is whether investment should be considered an inherently destabilizing activity. Revisiting the work of Hyman Minsky and other heterodox economists can provide insights into why that would be the case. What the dominant methods for evaluating creditworthiness may be overlooking is examined here, and how the oversights may explain

P R E FA C E

xiii

the sluggishness and pro-cyclicality in the quality and timeliness of assessment revisions, such as rating changes. Toward these ends, a public credit rating agency could provide the space and support to come up with improvements to default and credit risk assessment, and not just for governments and corporations (nonfinancial and financial), but also for assessments of individuals and small- and medium-sized firms (SMEs) in a variety of industries and regions. At this point, an examination of Ricardian equivalence is especially helpful. Ricardian equivalence requires a very specific context in order to have analytical merit. Once debunked, the tax and debt policy options widen considerably to support a Public Credit Rating Agency (PCRA), the justification for reinvigorating industrial policy and the creation of an insurance scheme to protect the trade credits of SMEs, all of which could contribute to the public’s interest by stabilizing what is an inherently unstable economy. Please note that I tried to cast the discussion as simply as possible in order to facilitate understanding by those who do not possess sophisticated training in economics. Throughout this project I was reminded of my discussions with my dad about my research interests. The quantitative details were always a bit tough going. I tried to minimize them here. I would like to thank the various academics whom I approached to provide feedback on aspects of this project. I also thank the staff at Palgrave Macmillan—Sarah Lawrence, Leila Campbell, and Leighton Lustig—for their patience, professionalism, and encouragement. Last, but not least, I would like to thank my support network—family members and friends—for their patience while listening to me (occasionally) whinge out of fear and frustration. Special thanks to Mrs. Sheila Simpson-Lee for her generous donation of history of thought materials to support this project and others in the works. And, my thanks to anyone who may have been inadvertently overlooked. I hope that you will find this book to be insightful and stimulating. The errors are my own.

1

Intr oduction

In the wake of the Global Financial Crisis (GFC), the rating industry

has undergone renewed criticism of the roles it plays in the economies and financial systems of the global economy. The criticisms have, for the most part, focused on the agencies’ conduct, processes, market structure, and the use of ratings for regulatory purposes. These issues are thought to have a bearing on the quality of ratings, the product of the industry. The quality of ratings influences not only the pace of investment, but also the stability of financial markets. It is in the public’s interest to ensure that evaluations of creditworthiness by the agencies and other assessors are the best they can be. Are they? Concern over the rating quality is not new. In fact, it has been around as long as the agencies themselves (Darbellay 2013; Sinclair 2005). Early methods of credit risk assessment of issuers and their issues relied on expert opinion with the support of checklists and scoring techniques. Inaccuracies were often attributed to human error. Over time, methods changed to reduce the degree of subjectivity of expert opinion. The appeal of more quantitative methods was enhanced by the need to locate efficiencies in the rating processes in order to meet increased demand for ratings and rating structures that promote direct comparability (of issues and issuers). But, still, inaccuracies persisted. Inaccuracies in the assessments of Penn Central and its debt instruments, primarily commercial paper, helped create a situation in which the conglomerate’s default on its commercial paper in 1970 triggered instability in the market for commercial paper. The episode brought to the fore how default by a large entity can lead investors to doubt the creditworthiness of similar issues and compromise their willingness to hold instruments associated with a particular market. The quality of ratings on municipal bonds came under scrutiny in the aftermath of Orange County’s default on a $110 million issue in 1994. Sovereign ratings drew criticism in the aftermath of the Asian crisis and in the

2

P u bl i c Cre di t R at i ng Ag e ncie s

recent episodes in the European Union (EU) and the United States. Even ratings associated with corporates and their issues were demonstrated not to be immune to problems, with the defaults of Enron and Paramalat in the early 2000s. The ratings or opinions concerning collateralized debt obligations in the lead-up to the GFC are now believed to have been too robust or overly optimistic. A credit evaluation that is somehow biased can result in poor financing decisions regarding investment. As a result, a borrower could spend years servicing debt for an underperforming asset, lose market position and status, or default. If an entity is large enough, its default can trigger instability in the financial markets, threatening the viability of financial intermediaries and institutional and financial investors. The key issues that this book explores are what is impeding the improvement in the quality of evaluations of creditworthiness or default risk, such as those of the rating agencies, and how a public credit rating agency (PCRA) could facilitate those improvements and promote stability in the economy and financial markets. To be clear, what is being proposed is not a national agency that would replace the private rating agencies, rating bureaus, reporting agencies, or in-house assessors. Similarly, the objective is not to replace the rating schemes with something new. The objective is to put forth ideas as to how to make assessments better by locating aspects of credit risk that assessors may be overlooking. What is being proposed is a national agency that facilitates discourse and research on the dynamics of default for nonfinancial and financial firms, households, and other entities, no matter how big or small, who, at various points in their lifecycle, come to rely on credit as a source of external financing. Improvements in our understanding of the dynamics of default and in evaluations of creditworthiness support better decisions with respect to investment and its financing. The focus is specifically on rating agencies and their products (ratings) as summary statements or opinions, released into the public realm, about the likelihood of default on an issue or issuer. Their methods are not dissimilar to those of private, in-house assessments conducted by private firms, and they are available for scrutiny to a much greater extent than the evaluations of creditworthiness generated by internal systems. Lenders such as banks and finance companies will often have in-house or internal systems to gauge and rank the creditworthiness of potential borrowers. The results are not as publicly accessible. Moreover, the book restricts its attention to nonfinancial firms and governments for the following reasons. First, the investment activity of

Int r o du c t i o n

3

nonfinancial firms directly supports the productive activities, employment, and output of an economy. Risk assessments, such as ratings, need to support their activities as best they can with accurate assessments. Second, the methods that assess creditworthiness of governments are evaluated. Government debt issues comprise a large portion of what rating agencies rate. These issues provide a valuable source of liquidity. As noted above, rating changes on sovereign debt can have a strong influence on volatility in financial markets. The activities of the rating agencies in this realm deserves attention. And, although a national PCRA should not assess the debt of its sovereign, because of inherent conflict of interest, this should not be taken to imply that it should only be assessed by private rating agencies. It is argued here that an international rating agency could facilitate improvements much like a national agency, but in a global context. The restrictions made here should not render the results overly narrow. The basic methods used by the rating agencies, discussed in what follows, are quite similar to those used by private assessors such as banks and other types of financial institutions (e.g., pension funds, mutual funds, and insurance companies). Moreover, as the scope of rating agencies has widened over the years to include the credit risk of SMEs, and even banking systems and universities, evaluations of creditworthiness by the rating agencies now overlap with assessment activities traditionally conducted by other types of assessors, such as banks, credit reporting agencies, and finance companies. Recent regulatory revisions suggest that improvements in rating quality will facilitate economic and financial stability. This seems reasonable until one recognizes that this simple message is embedded within a particular vision of how a capitalist market economy functions. From this perspective, improvements in rating quality enhance investment activities, which are a key part of how an economic system balances itself. The policy goals are to create ways to facilitate improvements. From a different perspective, the promotion of public interest—stability of economic and financial systems—requires more than simply improving rating accuracy and timeliness. The challenge is to understand why simply addressing these improvements in quality will not necessarily lead to improvements in stability. With that understanding, the sources of instability and default risk, which may have been overlooked by conventional thinking, can be identified and addressed. Our excursion begins by taking stock of the functions that ratings, assessments of default risk, are supposed to perform. We then look at the ways in which the quality of ratings is compromised. In other

4

P u bl i c Cre di t R at i ng Ag e ncie s

words, what are the sources of malfunction? These malfunctions are thought to impede investment, employment, and growth of income and output. The dominant thinking is that the asymmetry of information between lenders and borrowers has not been fully reduced, impacting the perception of likelihood of default. Is this really the crux of the problems in evaluating the risk of default? The answer to this question takes us into the realm of the investment and financial decisions of firms. The structure of the book is as follows. The analysis of the rating industry in chapter 2 yields a list of functions and malfunctions, aspects of which a PCRA may need to support and address in order to promote economic and financial stability. Chapter 3 revisits the thinking as to how investment and financing decisions are effected by firms. How do those decisions influence a firm’s creditworthiness or risk of default? And, moreover, how do those decisions, collectively, influence economic and financial stability? It turns out that there are basically two broad approaches to analyzing this nexus of investment and financing decisions. They can be cast according to the underlying vision of the influence of investment activities on the stability of an economy. From the perspective of investment as a stabilizing activity, evaluations of creditworthiness come to rest on the asymmetry in the distribution of information, which implies the importance of reducing asymmetry for facilitating robust assessments of creditworthiness. The other stance is that a firm’s creditworthiness stems not from uncertainty emanating from asymmetric information per se, but from uncertainty about the performance of its investments. The rate of return on investment is not stable from the perspective of an individual firm. This can be attributed, at least in part, to the collective dynamics of firms’ investment and financing decisions generating cyclical fluctuations in the macroeconomy. The business environment in which firms operate is ever-changing. The instability regarding the rate of return on investment, as impacting its cash inflows, can influence a firm’s creditworthiness. These ideas are explored by extending Minsky’s Financial Instability Hypothesis (FIH) to include the use of the concepts of regulating capital and incremental rate of return. The implications are drawn for methods of evaluating default risk, particularly the approaches of the rating agencies. When viewed from this heterodox or nonorthodox perspective, methods of credit risk assessment appear inadequate in a number of aspects, which helps explain why certain malfunctions occur. Increased sophistication of mathematical techniques simply masks the inadequacies.

Int r o du c t i o n

5

In chapter 4, a similar analysis is performed for sovereign issuers and their issues. It notes the contradictory role that the agencies seem to play in facilitating opportunities for investment, growth, and job creation during some periods, and in constraining opportunities during others. The analysis proceeds to explore the relationship between sovereign creditworthiness and fiscal sustainability, and its associated rules of thumb. The predominant view of fiscal sustainability is related to Ricardian equivalence. For rating agencies, the rules of thumb are starting points for their assessments of sovereign credit risk. The discussion notes other aspects that the agencies take into account when constructing their opinions. Basic approaches to gauge creditworthiness are discussed; the agencies employ these methods to varying degrees. The analysis then proceeds to examine sovereign creditworthiness from the perspective that an economic system is inherently unstable, and with the understanding that investment is an activity that contributes to that instability. In this light, a government’s position cannot be fully captured with approaches designed for firms. It might be possible, however, to create a cash flow technique to assess the health of productive activities of an economy overall, to detect the degree of country risk. With that in hand, changes in productive conditions could portend or signal upcoming pressures on a government’s fiscal position and debt burden. Policies that support the stabilization of investment would go a long way toward stabilizing and strengthening tax revenues. Chapters 3 and 4 provide critical discussions of the methods for assessing creditworthiness; they also offer the basis for an alternative. The following chapter, chapter 5, discusses regulatory capture. This discussion helps to identify ways that an agency, a PCRA, can be structured to thwart or minimize the emergence of bias in the judgment of an agency and its staff to the detriment of the public interest, and to the benefit of the rating industry. It examines recent regulatory changes regarding the rating industry and evaluates publicly available information about the efforts by firms in this industry to influence legislation. Although there appears to be evidence of capture, caution needs to be exercised because without substantive evidence of intent what seems to be capture can also be interpreted as having other motivations. Using recent efforts to reinvigorate the analysis of regulatory capture by Moss and Carpenter (2014), which returns the context of analysis back to the disciplines of law, sociology, and political science, key elements for capture prevention are identified. The open

6

P u bl i c Cre di t R at i ng Ag e ncie s

structure of these disciplines makes their efforts on this topic ideal for interdisciplinary work with heterodox economics. Chapter 6 brings the previous discussions to bear on the functions and structure of a PCRA. The discussions should make clear that if it is in the public interest to promote ways to achieve economic and financial stability, then improvement in rating quality, although helpful, need something more. But how? Improving the accuracy of ratings and other forms of assessment requires an active program of due diligence. Due diligence has been conducted to varying degrees by the agencies. This is an activity that is not directly profit-enhancing, and tends to be more actively pursued when serious issues or events emerge. A PCRA can perform this task continuously. It is in the public interest to do so. Toward this end, it develops sets of benchmarks to monitor the economic conditions of industries and the macroeconomy. Those indicators can be used to assess the timing of rating changes and to validate the performance of ratings. A pilot structure for the benchmarks is provided to illustrate the potential of a cash flow framework by extending Minsky’s FIH. The pilot structure suggests changes in the economy prior to the emergence of symptoms associated with the GFC, such as rating changes on mortgage-backed securities, and the downgrade of the US sovereign rating. It also suggests that the downturn was not due to changes in consumption and that the increased presence of unproductive activities (associated with income from property) has rendered the American economy decidedly more fragile and less resilient to shocks. Once a robust set of benchmarks has been established for economic conditions, benchmarks of default risk can be created in order to assist in-house assessors of lenders and investors to cross-check their systems and to make recommendations on adjustments according to the desirability of managing financing conditions in certain sectors. Benchmarks based on the FIH dovetail quite easily with a similar scale use by the US EXIM bank. The beauty here is that the FIH provides an explanation, and thus guidance, as to what to monitor with respect to changing conditions both internal and external to firms. That said, the intention is not to replace private rating agencies but to find ways to support their efforts. The PCRA also needs to supplement its own effort with the use of traditional validation techniques for substantiating the consistency and historical accuracy of ratings. This function could be partially outsourced by minor rating agencies contracted for this purpose. In this way, the smaller agencies’ abilities to voice their opinions on methods of detecting default risks is enhanced; this also loosens up the

Int r o du c t i o n

7

market structure of the industry. Other functions of a PCRA include the facilitation of meetings and platforms for discussion of the results of validation studies, emerging issues concerning credit conditions (particularly as related to cycles), and developments in credit risk and cash flow models. These functions pertain to the dissemination of information and promotion of transparency. The efforts of a PCRA are not confined to large firms and industries, but also include SMEs and consumers. A discussion is also provided as to how to enhance the efforts of a PCRA to stabilize cash flows. Suggestions are made to introduce an insurance scheme to protect the trade credit of SMEs. The scheme can be financed with a rainy-day fund financed by the users of ratings, both direct and indirect users. Even more support could be attained with the introduction of an industrial policy to provide supply support for civilian industries. By helping to realize the sale of output of goods and services for SMEs and protect their trade credits, their cash inflows are stabilized, which, in turn, stabilizes those who depend on them either for goods and services or for employment and income. This is not a call for broad control by government over the economy. Quite the contrary. Targeted industrial policy can not only bolster industries, those deemed to be of primary importance and those that support them, but does so in ways that protects their creative independence and, at the same time, reinforces communities. The introduction of a PCRA has been downplayed, for instance, by Gavras (2012) because of the potential conflict of interest it may have with evaluating the creditworthiness of its sovereign. Here, the solution is to create a variation of a domestic PCRA at the global level, perhaps located at the United Nations’ Department of Economic and Social Affairs. Both the PCRAs and the IPCRA (International PCRA) can call a moratorium on downgrades with the onset of crisis—similar to the circuit breakers in place on the New York Stock Exchange. This should help reduce feedback effects by lenders and capital markets on the rollover of existing debt during times of instability. Stable growth also means stable tax revenues for governments, which, in turn, will help them avoid financing current expenditures by issuing new debt and also give them the ability to create plans for debt reduction. The creditworthiness of firms ultimately impacts the creditworthiness of sovereigns. The rating agencies understand the importance of economic performance and structure for the resilience of governments’ fiscal positions. But they need support to get better at it. A PCRA could provide that support. The last chapter concludes with an overview of the discussions and directions for future research.

2

Func ti o ns and M al f unc ti o ns of the Rating Industry

In order to address the question of how to improve the quality of ratings, we need to have a clear understanding of the objectives and functions served by the industry’s firms and their products. This chapter provides that clarification and, by doing so, isolates the problems or malfunctions that are attributed to the industry. Some problems are recent, others have been around a while but have not yet found adequate resolutions. Further, how are these malfunctions thought to impede the process of capital accumulation? Are there particular circumstances in which the ability of ratings to perform their functions wanes or in which malfunctions are more apt to occur? And, if so, why. The chapter also provides a brief look at how governments have approached regulation and oversight of this industry, leaving a more detailed examination to chapter 5 (regulatory capture). Credit rating agencies are often referred to as the gatekeepers of funding sourced from financial markets for corporations and governments. Their assessments of creditworthiness can widen or restrict access to those markets as a result of the evaluations. Certain forms of external funding that support private and public investment hinges, at least in part, on their opinions. The assessments of rating agencies are just that—informed opinions or interpretations of facts that have been deemed to be relevant for evaluating the ability of borrowers to service their debts in the future. As such, the rating industry consists of firms selling their opinions as products. Their opinions or ratings influence the confidence held by financial investors who consider lending to corporations and governments with new issues or buying existing debt instruments to hold in a portfolio. To obtain an evaluation, an issuer needs to approach a rating agency and purchase an evaluation of its creditworthiness from them, with the hope of widening its sources of external finance. Although there is no guarantee

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P u bl i c Cre di t R at i ng Ag e ncie s

that an agency’s evaluation will widen access with the purchase of an evaluation, what is certain is that assessment will likely influence the firm’s cost of credit. The better the rating, the lower the cost. With respect to industry structure, the most commonly recognized rating agencies are Standard and Poor’s, Moody’s, and Fitch IBCA. Moody’s and Standard and Poor’s are American companies. Standard and Poor’s is a division of McGraw Hill Financial and is based in New York. Moody’s is also based in New York. Fitch is owned jointly by Fimalac (Paris) and the Hearst Corporation; its headquarters are located in New York and London. These three agencies create the lion’s share of ratings for sovereigns and corporations. Figure 2.1 illustrates the proportion of each type of security rated by Nationally Recognized Statistical Ratings Organizations (NRSROs), which include the dominant three agencies. The largest proportion of ratings, 76.65 percent, is for government securities, and the next highest is ratings for issuers of asset-backed securities—10.00 percent. Financial institutions’ debt securities form only 7.88 percent of all ratings; corporate issuers’ share is 4.70 percent, and insurance companies comprise 0.76 percent. Not all agencies rate the full range of asset classes. For instance, the big three rate the full range of asset classes (securities of corporations, financial institutions, governments, insurance companies, and issues of asset-backed securities.)1 Morningstar rates only asset-backed securities, and Egan Jones focuses on corporations, financial institutions, and insurance companies (SEC 2014a). The strong reputation and name recognition of the big three agencies and regulation has at times impeded the entry of new firms and the use of ratings of the smaller agencies for regulatory purposes. 90.00% 80.00%

76.65%

70.00% 60.00% 50.00% 40.00% 30.00% 20.00% 10.00%

10.00%

7.88%

4.70%

0.76%

0.00% Government Securites

Asset-Backed Securities

Financial Institutions

Corporations

Insurance Companies

Figure 2.1 NRSRO ratings by asset class: 12 months ending December 2013 (Total: 2,437,046) Source: SEC (2014a) and author’s calculations

Fu nc t i o ns a nd M a l f u nc t i on s

11

The relatively small size of regional bonds markets also means that the demand for ratings can be somewhat limited in these areas, and this, in turn, has limited the growth of rating industries outside the United States (Van Gestel and Baesens 2009). While smaller rating agencies exist, they tend to play a more peripheral role in the evaluation of debt instruments, accommodating regional, smaller issuers and/or focusing on particular sectors. Regional rating agencies include (not exhaustive): Dominion Bond Rating Service (Canada); Japan Credit Rating Agency, Vital Information Services, Malaysian Rating Corporation Berhad, Seoul Credit Rating and Information, and China Chengxin Credit Rating Group (Asia); Global Credit Rating (Africa); Pacific Credit Rating and HR Ratings de Mexico (Latin America), European Rating Agency, The Economist Intelligence Unit, Bulgarian Credit Rating Agency, Capital Intelligence, Coface, Feri EuroRating Services AG, Euler Hermes Rating GmbH, and URA Unternehmens Ratingagenture AG (Europe). Even in North America there are smaller issuers that focus on particular sectors. A. M. Best, for instance, focuses on ratings of insurance companies. The International Ratings Group was formed in 2006 as an alliance of regional rating agencies to create consistency in assessment of emerging market issues. NRSRO status is conferred through application to the US Securities and Exchange Commission (SEC).2 Once achieved, this status essentially deems the method(s) of a rating agency sufficient to distinguish the quality of instruments that could be used for regulatory purposes, such as “the extent to which a firm could hold assets that fell below investment grade” and ratings on securities used to meet capital requirements (Alcubilla and Del Pozo 2012: 4). At the time of writing, agencies carrying the NRSRO designation include: A. M. Best (withdrew from rating financial institutions in 2011), Dominion Bond Rating Service (DBRS), Egan-Jones Ratings, Fitch, HR Ratings de Mexico, Japan Credit Rating Agency, Kroll Bond Rating Agency, Moody’s Investors Service, Morningstar Credit Ratings, and Standard and Poor’s Ratings Services. The rating process is broadly the same across the three major agencies. There is a team that gathers information from the issuer and combines it with public information such as financial statements and information about the state of development and prospects for its business environment, as defined by the industry and macroeconomy in which it operates. A preliminary rating is brought to a rating committee for discussion; the committee is made up of the team, members of other teams, and select executives of the agency. A key objective is to ensure consistency of the rating with other ratings that the agency

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has issued. The rating that the committee agrees upon is then relayed to the issuer, who is given the opportunity to comment on the result. The rating is then published and surveillance or monitoring of the rating begins. Point-in-time-ratings, which are determined with purely quantitative methods, require more surveillance than through-thecycle ratings (Van Gestel and Baesens 2009: 152). Prior to 1975, when the United States implemented the NRSRO designation, there was little by way of regulation over the rating industry. The agencies were considered to be peripheral to the financial system, except to help distinguish investment from non-investment or speculative grade securities. The US Banking Act of 1933 stipulated that the bonds held by banks need to be designated at least BBB grade by two rating agencies. From that point, concerns over the accuracy and informational content of ratings—particularly as they seemed to lag market developments rather than lead them—meant that the agencies’ reputations were questioned (Darbellay 2013: 22). Increased capital mobility and a bout of financial instability in the early 1970s led to the need for a tool to discriminate the riskiness of securities for regulatory purposes. Even though the ratings had a questionable accuracy, they were something to work with. In 1975 the SEC implemented the NRSRO status in order to enhance the use of ratings for regulatory purposes, designating ratings of selected agencies for this use. The SEC did not have much sway over the industry except to decide which agencies received this designation and which did not. It was not until the Asian financial crisis, the dotcom bubble, and a spate of corporate failures in the early 2000s (such as Enron and Parmalat) that regulation of the rating industry received more serious attention. The International Organization of Securities Commissions (IOSCO) issued a statement in 2003 on the key principles of the rating agencies and, later, a suggested Code of Conduct (in 2004), since revised (IOSCO 2014). The suggestions of the IOSCO are designed to provide flexibility to the agencies—“through a ‘comply or explain’ mechanism”—for determining how the guidelines are satisfied. Within its principles one finds a vision regarding the functions that rating activities serve: reduction of asymmetry of information, provision of evaluations that are objective and independent, promotion of transparency and disclosure, and maintaining issuers’ confidence in the treatment of their private (nonpublic) information. The Code of Conduct suggests that measures be adopted to ensure the integrity of the rating process, avoid conflicts of interest, clarify the responsibilities that rating agencies have with respect to investors and issuers,

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and disclose the measures associated with their compliance with the code of conduct (Langohr and Langohr 2008: 443). These measures are intended to protect the quality of ratings. As compliance with the IOSCO Code of Conduct is voluntary, the rating industry has been largely self-regulating (Darbellay 2013: 64). The recent crisis, however, has stimulated interest in the creation of rules to not only enforce the code, but also to alleviate the problems or malfunctions that have dogged this industry. With this quick overview in hand about the structure of the industry and the process of creating a rating, let’s look more closely at some of functions that ratings and the agencies are supposed to serve, and the nature of the malfunctions that they are accused of generating.

Functions Evaluate creditworthiness. A rating represents an evaluation of the credit risk of a borrower or a debt instrument—specifically, the risk that a borrower will not complete, in a timely way, an interest or principal payment on a debt obligation. Rating agencies specialize in evaluating the (relative) creditworthiness of corporations and governments (at the sovereign or national, state, and municipal levels). There are three basic ways in which creditworthiness is assessed (credit scoring, traditional [statistical] approach, and modern [market-based] approach. Although the methods employed vary between the agencies, there are common methodological features to the approaches. (Methods will be discussed in chapters 3 and 4). Discriminate. Riskiness is not an “either/or” condition, it varies in degree. As such, ratings rank instruments or borrowers of debt instruments according to their relative riskiness. The methods employed either result in relative ranking directly or enable ranking after first gauging absolute credit risk. An important aspect of discrimination is the distinction between investment grade and non-investment grade issues. Investment grade instruments carry less default risk, implying that the stream of returns is steadier and it is more likely that an investor will receive his principal and a rate of return. This distinction is important for institutional investors such as banks, pension funds, mutual funds, and insurance companies, and financial investors more generally, who are required by regulation to hold investment grade securities in their portfolios. A positive change in a rating on a debt instrument to investment grade suggests that it is worth holding (buying), whereas a negative change to below investment grade suggests the instrument is not worth holding (may need to be sold). Tables 2.1 and 2.2 provide the

Table 2.1 Global long-term ratings for major three credit rating agencies Descriptor

Moody’s

S&P

Fitch

Aaa

AAA

AAA

Investment grade Prime (extremely strong) High (very strong)

Aa1, Aa2, Aa3

AA+, AA, AA-

AA+, AA, AA-

Medium—upper (strong)

A1, A2, A3

A+, A, A-

A+, A, A-

BBB+, BBB, BBB-

BBB+, BBB, BBB-

Medium—lower (adequate) Baa1, Baa2, Baa3 Non-investment grade Speculative

Ba1, Ba2, Ba3

BB+, BB, BB-

BB+, BB, BB-

Highly speculative

B1, B2, B3

B+, B, B-

B+, B, B-

Extremely speculative (vulnerable)

Caa1, Caa2, Caa3

CCC+, CCC, CCC-

CCC

Immanent (highly, extremely vulnerable)

Ca

CC, C

CC, C

Default

C

D, R, SC

RD, D

Default

Source: Moody’s (2014a); Fitch (2014a); Standard & Poor’s (2014a); Van Gestel and Baesens (2009: 116)

Table 2.2 Global short-term ratings for major three credit rating agencies Descriptor

Moody’s

S&P

Fitch

P-1

A-1+

F1+

Investment grade Prime High

P-1

A-1+

F1+

Medium—upper

P-1, P-2

A-1,A-2

F1, F2

Medium—lower

P-2, P-3

A-2, A-3

F2, F3

Non-investment grade Speculative

Not prime

B

B

Highly speculative

Not prime

B

B

Extremely speculative Not prime

C

C

Default Immanent

Not prime

C

C

Actual

Not prime

D (and R, SD for issuer)

RD, D

Source: Moody’s (2014a); Standard and Poor’s (2014a); Fitch (2014a)

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range of ratings that establish the relative riskiness for short-term and long-term debt issues and issuers. The scales of ratings published by the three predominant rating agencies (Fitch, Moody’s, and Standard & Poor’s) are based upon an alphabetic/numeric scale where ratings in the A category are the highest (best creditworthiness), those in the B category more risky, and those in the C category carry high risk. There is some variability across the agencies’ scales. Investment grade typically begins somewhere within the B class. Again, a ranking suggests the repayment capacity of a borrower. The stronger an issuer’s capacity to make timely payments on an obligation, the less risk that it will default, and the higher will be its rating (and placement within a rating scale). A lower rating and placement on a scheme represents weak capacity to complete payments. Relative or ordinal risk has traditionally been emphasized over absolute risk per se. Methods that gauge absolute risk are designed with the intention to enhance the timeliness and accuracy of evaluations of creditworthiness. Rebalance asymmetric information. Asymmetric information is an imbalance of information held by parties in a transaction or contract. An imbalance in information creates a situation where one party may not be fully aware of the risks involved with the transaction, and hence may not be adequately compensated for assuming those risks. In such a context, there is potential for unforeseen loss. With respect to new lending, lenders are thought to be disadvantaged regarding the availability of information about potential borrowers. Each borrower possesses full or complete information about his/her situation. The onus is on the lender to glean information from the potential borrower in order to evaluate the borrower’s creditworthiness. Additional information is thought to reduce uncertainty. With additional information, the lender’s judgment about a lending opportunity improves, and, as such, it is better able to judge which investments will yield an adequate return to compensate for risk assumed (and the return of original amount lent). The longer the duration of the loan, the greater the risk assumed because greater uncertainty is associated with a wider time horizon. If the lender miscalculates, it could experience an unforeseen loss that impacts its ability to both grow and compete in the market for lending. Investors who purchase existing debt instruments have even less information. Unlike lenders, they have access to only (public) information contained in annual reports and financial statements. They do not have access to the most recent, or most in-depth, interim information

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about the health of the issuers behind the debt instruments. Financial statements are released at annual and quarterly intervals. For financial investors, whose positions are adjusted in real time, this release of new public information is sluggish. Rating agencies, however, have the ability to access interim information and data about the financial health of solicited issuers (corporations and governments). Although not publicly available, interim information is digested by the agencies, whose compilation of this information is “released” to the public as rating. Any interim changes to the creditworthiness (default risk) of an issuer will call forth a review, and possible revision, to its rating and the ratings on its instruments. Ratings facilitate the flow of information from potential borrowers to investors. Disseminate information. The agencies provide their ratings or opinions of creditworthiness to the public in order to assist issuers to increase the pool of potential investors for their issues. With each rating there is an accompanying explanation or justification as to why it stands as it does. Agencies also provide outlooks that give investors an indication of the direction of change of a rating a year or so out; outlooks can be positive, negative, unchanged, or in process. Important changes in an issuer’s circumstances, such as new information or a sudden event, can trigger a review of an existing rating. A rating is under review or watch for possible change in the near term, which is typically 3–6 months out. Reviews are thought to be “event driven.” A review can result in an upgrade, downgrade, reaffirmation of the existing rating, or be declared uncertain. Used for regulatory purposes. Here, the discrimination function is embedded in financial market regulation to guide the extent to which financial intermediaries and investors may or may not hold speculative grade securities and the use of investment grade securities to meet capital requirements. The use of ratings for regulatory purposes occurs at both the national and international levels. For instance, Basel II and III provide guidance on how to weight securities according to their degree of riskiness. The less default or credit risk that a debt instrument possesses, the lower its weight in the calculation of risk-weighted assets. Enhance liquidity. Ratings are thought to promote the liquidity of financial markets by reducing the asymmetry of information and, thus, bolstering the confidence of investors through the reduction of uncertainty. With their confidence supported, investors are more apt to be induced to lend or take positions in existing debt instruments.

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Improve market efficiency. Market prices of financial instruments are thought to incorporate or reflect all publicly available information. Rating agencies help ensure the accuracy of prices with the public dissemination of the information contained in their opinions or ratings. As such, rating changes influence adjustment of bond prices and interest rates (this is also thought to be a source of malfunction). Rating agencies have access to nonpublic information. After that information is processed by agency analysts, it comes to be reflected the rating. Processing acts as a way to shield the original, private data. Promote the efficient allocation of investment (private and public). The informational content contained in ratings assists investors to allocate their funds to achieve better rates of return. In turn, producers who receive new funding are able to allocate resources more effectively. The information contained in ratings is thought to influence the pace of capital formation and the efficient performance of an economy (Dodd-Frank 2010: 497).) Again, if investors are confident about receiving the stipulated stream of returns on their investments, they will provide funding and invest in marketable debt instruments. Cost of capital. Information helps to clarify risks and assist lenders determine the cost of capital (particularly, the cost of debt finance) for borrowers. The less creditworthy a borrower, the higher his risk premium must be in order to compensate a lender for acquiescing funds for some designated duration. A strong rating will mean lower cost of capital for borrowers. Ratings are used as a method of estimating a firm’s cost of debt when a firm is unable to use the yield-tomaturity approach; the rating method essentially locates comparable debt instruments whose yields can be used as proxies. Benchmark or validate internal systems. Many lenders and investors, particularly the relatively large ones, have an internal system in place to evaluate creditworthiness and monitor changes in conditions that call for adjustments to cost of capital, rationing, or to update compositions of portfolios containing debt instruments. Ratings are used to benchmark internal rating systems and validate their performance. Smaller investors and lenders, who do not have the resources to build internal systems, often outsource evaluations of creditworthiness of corporate and sovereign debt to the rating agencies. Evaluate overall health of a country’s economy. Ratings associated with sovereign debt are an implicit assessment of the overall health of the economy and the quality of its management. Currently, there is no consensus about how to evaluate the health of an economy and its financial system. Ratings on sovereign debt are used as a proxy until

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a better method comes along. Poor economic conditions, attributed to some shock or to weak economic and financial management, are reflected in sluggish growth, inflation, and, for our purposes, poor fiscal positions. Sovereign debt ratings also provide the benchmark against which all other bond instruments are evaluated. This is due the ability of a national government to print currency to satisfy payment commitments, if needed. As such, sovereign is thought to be the safest bond instrument. The debt of corporations carries more risk. All of these functions suggest that ratings and rating agencies are quite useful. But, they also have been accused of generating instability in financial markets, which then spills over into investment decisions, economic growth, and employment. What are some of these issues?

Malfunctions Ratings and the rating agencies provide a host of services to an economy and its financial sector. That said, they are also known to entail issues that can compromise the quality of their assessments of creditworthiness. Conflict of interest. A conflict of interest pertains to a situation where one party to a transaction or decision is swayed to bias the outcome for personal or professional gain. Conflicts of interest in the rating industry are thought to stem from the tensions or dilemmas that rating agency staff encounter at some point during the rating process, which could influence their judgment and the quality of their assessments. In the rating industry, these situations are often attributed to the remuneration structure of rating firms, the use of ratings for regulatory purposes, relationships between issuers and rating staff, and relationships between regulators and rating staff. With regard to payment structure, the source of income for the agencies has changed over the years. Up to the 1970s, payment came from the sales of subscriptions or publications (to investors) that contained the ratings of issuers and their debt instruments. As the demand for ratings increased, the costs associated with their provision also increased. To compensate, the rating agencies began to shift their source of income to the issuers themselves. Neither source of income is unproblematic for the rating agencies. On the one hand, if income comes from subscription sales, the analysts at agencies could come under pressure from investors—the purchasers of their subscriptions—to assign particular rankings that would help justify the purchase of particular debt instruments. On the other hand, income from issuers suggests the possibility of pressure placed upon analysts from issuers for investment

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grade rankings to help place new debt. The designation of NRSRO status and the increased use of ratings for regulatory purposes reinforce the potential for this form of conflict. Rating agencies walk a fine line between investors who prefer high rating standards and issuers who prefer low rating standards (Langohr and Langohr 2008: 187; Darbellay 2013: 127). In essence, the presence of conflict of interest can bias the ratings assigned to issuers and their issues. Biased ratings introduce risks in the economy and financial system as the creditworthiness of borrowers is not accurate. Investors and lenders will make poor decisions about the quality of lending and investment opportunities. Moreover, issuers receive funding for investments that may not be as robust or viable as believed. If ratings are biased, the economy and the financial system will be operating at a greater degree of risk of default than is thought to be the case. Lack of transparency in methods and processes. Transparency pertains to the release of information, into the public realm, by the rating agencies, about their rating methods and processes. Transparency reduces the asymmetry of information, and, hence, uncertainty about evaluations of credit or default risk. A lack of transparency implies that information asymmetry has not been reduced by the agencies as much as they could. As such, this reinforces the perception of market imperfection. Transparency also concerns the handling of issuers’ nonpublic (confidential) information. Rating methods. The experience of the GFC illuminated the difficulty that credit rating agencies had in assessing structured debt instruments (asset-backed securities). The rating methods for traditional debt instruments could not be simply carried over to rating structured instruments. That said, there have been lingering issues with the methods used to evaluate traditional debt instruments and their issuers. If the methods do not fully capture the fundamentals and dynamics of credit risk, the quality of ratings will not be as robust as they could be. Again, biased ratings raise the risk of default in the economy and financial system in general. (This will be analyzed more fully in chapters 3 and 4). Sluggishness and pro-cyclicality. Ratings have been noted to be slow to adjust to changes in economic and financial market conditions (Van Gestel and Baesens 2009: 155), White 2010; Langohr and Langohr 2008: 369; Darbellay 2014: 186–88). The agencies often attribute this phenomenon to the “through-the-cycle” orientation of ratings. Through-the-cycle ratings place less emphasis on changes in shortterm credit quality. As such, changes in ratings will be sluggish if time

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is needed to discern whether economic weakening is cyclical or something more sustained. This raises a question as to whether throughthe-cycle methods fully capture the dynamics associated with the risk of default. Point-in-time methods for ratings are an attempt to avoid this phenomenon, but at the expense of being overly sensitive to the volatility of financial markets. Ironically, rating changes are also thought to be pro-cyclical, even though agencies supposedly rate through-the-cycle. Pro-cyclicality of rating changes promotes instability in both the financial and real sectors. Pro-cyclicality has been attributed to the use of ratings for regulatory purposes, such as Basel II, and the influence of fair value accounting. In the upswing of a cycle, assets perform well, default risk is relatively low, and over time the ratings strengthen, reflecting a lower risk of default. In a downswing, default risk rises and ratings weaken. That weakening can exacerbate financial instability if banks need to write off assets and begin rationing credit. Rating downgrades can also trigger instability in financial markets as investors shift positions. Inconsistency between solicited and unsolicited ratings. Solicited ratings are formed from a combination of public and private information. Unsolicited ratings are formed from only public information. There is evidence that unsolicited ratings may be less favorable (Partnoy 1999; Langohr and Langohr 2008: 423). Moreover, there are instances where rating agencies have been accused of using their market power to force conversion of unsolicited ratings to solicited ratings in order to raise the rating and lower the cost of capital (Van Gestel and Baesens 2009: 155). Weak due diligence. Due diligence is about checking products— here, ratings—against their performance. It has been noted that due diligence by the rating agencies became lax in the lead up to the financial crisis (Coffee 2009; Alcubilla and Del Pozo 2012: 186–87; SEC 2003, 2008). Due diligence is costly, and does not directly contribute to the income of the rating agencies. It is vital, however, for catching persistent inconsistencies between evaluations of credit quality and actual outcomes. Due diligence will catch methods that are underperforming. Weak due diligence does little to reduce the inherent asymmetry of information and, as such, increases the risk of poor investment and financing decisions by firms and investors. Overreliance on ratings. In the previous section, the use of sovereign ratings was listed as a function, because there is no consensus on how to assess the fundamentals of an economic system and, in particular, its vulnerability to a bout of instability. Should ratings

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on sovereign debt be used as a proxy for anticipating economic and financial crises? Rating agencies say no, but since there is no consensus on how to evaluate the health of an economy, including its financial system, ratings on sovereign debt have been used as proxies for evaluation anyway. A downgrade of sovereign debt suggests that economic performance is weakening, either attributed to a shock or to poor policies or mismanagement by the government. (Incidentally, rating agencies are starting to offer assessments of country risk.) There is also concern that embedding ratings within regulation has led to overconfidence in the ability of the agencies to accurately assess the risk of default. To satisfy regulatory requirements, investors need only pay attention to the ratings on issues. As such, there is little incentive for investors to conduct due diligence. In other words, investors may not be conducting research as they should to crosscheck the information they think is contained in the ratings. Market structure and competition. As indicated previously, the rating industry is globally dominated by Standard and Poor’s and Moody’s. This structure has led to the industry’s characterization as being “imperfectly competitive.” This characterization is in line with the mainstream economics’ conception of competition (in which there are many small firms with perfect information and little market power to influence the price of its product [ratings]). The industry naturally gravitates toward large firms because of the economies of scale with the gathering, evaluation, and dissemination of information. This creates large barriers to entry and exit, which is then reinforced by NRSRO status. The lack of competition is thought to make rating agencies complacent about improving the quality of their products and conducting due diligence. Rating triggers. Rating downgrades of issues can trigger investors to shift positions if they are required to hold investment grade securities. A market reaction can occur if a large rating agency downgrades a widely held asset, as investors have tendency to sell en masse. A downgrade can also cause a lender to pressure a firm to repay earlier or increase the interest rate on its debt. Other investors, as a result, could start shunning the firm. Lack of accountability. The rating agencies have been shielded from liability for decades, since the Securities Act of 1933. This is not to suggest that they are not liable, it is just that it is difficult to establish liability when their opinions can be interpreted as free speech. Like the lack of competition, this issue is thought to remove the incentive to both improve quality and implement due diligence of rating methods.

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Summary The functions of the rating industry and the firms that operate within it are envisioned to support the stability of the financial system and the allocation of funds for investment in both nonfinancial firms and financial firms or investors. Ratings are important for both the financial system and for the function of the nonfinancial sectors of an economy, as the information helps reduce uncertainty associated with business environments. Rating agencies glean, process, and publish information about potential issuers and their issues in order to facilitate access to external funding, via financial markets, to finance new investment. The information the agencies provide reduces information asymmetry, which, in turn, enhances the assessment of the likelihood of default associated with issuers and their issues. As such, ratings are envisioned to assist the informational content of prices, promote market efficiency, and more accurately assess the cost of debt on new issues. The agencies benefit financial investors by acting as a supplemental source of information, both providing information that investors are not typically privy to access to, and more timely than the release of firms’ financial statements, and as a means to cross-check or validate internal systems of risk assessment. The facts are digested and presented in a way that does not compromise the integrity of the issuers’ private information. Further, given the size of financial markets and the number of instruments contained within them, the rating agencies have attempted to develop cost-effective methods that can quickly and efficiently handle the workload as markets continue to expand with the increase in demand for external financing and portfolio investments. Rating changes have the ability to roil financial markets through bond prices and interest rates, which, in turn, impacts firms’ cost of capital and their ability to finance new investment. Sluggishness and pro-cyclicality of rating changes have remained stubborn issues over the years. The overreliance on ratings by investors, their use for regulatory purposes to distinguish investment from speculative grade securities, and the use of sovereign ratings as proxies for assessment of economic health seem to suggest that there is something deeper at work. The rating agencies are possibly overlooking something. What could it be? A clue may lie with the orientation of recent regulatory approaches toward this industry. Key issues, such as conflict of interest, lack of transparency, inconsistencies between unsolicited and solicited ratings, and weak due diligence is thought to stem from the industry’s

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structure, the conduct of agencies and the rating processes. The industry is understood to be imperfectly competitive. For instance, the orientation of the (ill-fated) Credit Rating Agency Duopoly Relief Act (2005) of the US Congress took the stance that Moody’s and Standard and Poor’s dominance in the industry was leading to weaker rating performance as the lack of competition was impeding the drive for innovation. The stimulation for EU policy toward the rating industry was, in part, predicated on concern about the imperfectly competitive structure of the industry (dominated by American firms), with a possible breakup on the cards for the duopoly held by Moody’s and Standard and Poor’s. Again, the concern about the structure of the rating industry is that it may impede due diligence and incentives to improve the quality of, and confidence in, the ratings. The industry’s structure largely reflects the exploitation of efficiencies and reduction of costs through the use of systematic processes, both of which reduce the labor intensity of the assessment process and enhance the rating consistency and, hence, the agencies’ reputations. There is a natural tendency for firms that do this well to expand and become large. The industry’s market structure is not attributed to a lack of competition, but, on the contrary, it can be attributed to it. Regulatory agencies have strengthened oversight—such as the Office of Credit Ratings (United States) and the European Securities and Markets Authority (European Union)—to promote improvements in transparency and conduct. (This will be discussed in more depth in chapter 5). This is a shift from the self-regulation orientation prior to the GFC. The voluntary compliance, as recommended by the IOSCO to protect the rating agencies’ independence, is now thought to be insufficient to counterbalance emerging questions pertaining to the quality of ratings. The concerns regarding the quality of ratings have always been present in varying degrees. During the interwar period, concerns pertained to the experiences of private and sovereign debt defaults of the 1930s—, as happened during the Asian crisis—and, today, as is happening with the European and American debt crises. The ratings of commercial paper of Penn Central in 1970, private debt with Enron and Parmalat, and asset-backed securities during the recent financial crisis all suggest that stubborn issues of ratings’ quality persist. Regulation regarding transparency and processes is a good first step; however, the sluggishness and pro-cyclicality that ratings exhibit are not related to industry structure. This suggests that something different is at work. If regulation intends to improve the quality of ratings,

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then a revisit to the current thinking of what drives default risk is warranted. As will be elaborated in the next chapter, there are two broad contexts in which one can cast the dynamics of default risk. One context is that investment plays a stabilizing role, acting to reinject savings or leakages from a system (provided that the financial system is functioning well). The other view is that investment has a natural tendency to destabilize an economy. Depending on which vision one holds, ratings will either facilitate stability or enhance instability. With that distinction in hand, rating methods and regulation can be evaluated for missing elements. It may well turn out that the increased information about assessment methods and rating processes is not enough to compensate for missing elements about the investment and financing decisions of firms. Indeed, if investment is actually destabilizing, the reduction of uncertainty is not about gathering information to reduce its asymmetry per se, but about reducing the uncertainty surrounding the direction of the rate of return or profitability on investment, particularly new or recent investment. It could be that the dynamics surrounding this element, important from the perspective of heterodoxy, are downplayed, or missing, from current methods of creditworthiness.

3

Private Credit Risk

T

he investment and financing decisions of a firm are integrally related to its creditworthiness. There are two broad contexts in which these decisions need to be considered, however. The context in which those decisions are made will influence one’s understanding of the determinants and dynamics of credit or default risk. The first approach rests on a vision that investment is a stabilizing activity. This view underlies mainstream economic and finance theory. The other approach rests on a vision that investment is destabilizing, and it underlies the heterodox, nonmainstream approach(es). The implications of the two stances are explored in this chapter for how they explain and assess default or credit risk. By doing so, some of the sources of the malfunctions, which were identified (in the previous chapter) as compromising the quality of ratings, can be identified. Sluggishness, pro-cyclicality, and other methodological issues might better be explained if creditworthiness were assessed in the context of investment as an inherently destabilizing activity, rather than from a perspective in which it is a stabilizing activity. As such, the discussion yields new insights for improving methods of assessing creditworthiness. Toward this end, this chapter has the following design. The next section revisits the current thinking on how a firm makes its decisions regarding investment and its financing. This leads us into the realm of how capital investments are assessed and the ways they could be financed. The results of these decisions are recorded in firms’ financial statements. Indicators used to assess creditworthiness are often drawn from these statements, though some methods rely on these more than others (as will be discussed). Tools that guide investment decisions involve assumptions that enable abstract thinking to become tractable or operationalized. Investments can be funded with internal and/or external finance. There is a range of funding types, where certain types of funding are better suited for particular needs of firms. The form of organization of a firm will influence its ability to access external

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finance. Corporations have a broader range of alternatives than SMEs, for instance. With this information, we assess the thinking as to the optimal mix of debt and equity. It turns out that assumptions made to give tractability to tools that support the investment decision reappear in the context of tools that guide the financing decision. The section ends with an explanation as to how investment could be stymied. Next, the methods of gauging creditworthiness are presented and discussed. There are basically three types: scoring methods, traditional statistics, and the modern (market) approaches. Each has its own advantages and disadvantages. The more sophisticated the method, however, the more one sees the assumptions noted in the previous section (to make tools workable) emerge. Although we do not explicitly examine portfolio methods of credit risk, the assumptions are still present—and that’s what is important. If those assumptions undermine the performance of methods, in order to achieve tractability, portfolio methods are just as compromised. With this understanding of investment and financing decisions and approaches to default risk, we clarify how they relate to a particular vision of investment. That vision holds that investment is a stabilizing activity. What if it isn’t? The analysis proceeds to remind us of Minsky’s (heterodox) analysis of investment and financing decisions in which the collective behavior of firms renders investment as destabilizing. The section brings the two approaches of investment to bear on the determinants of credit risk. In this light, the assumptions required to make both mainstream theory and applications workable ultimately undermine their performance by compromising their ability to fully capture the dynamics of production. This analysis relies on recent work by Shaikh (2010) and Soros (1994). The following section draws the implications for the methods used by rating agencies and suggest an alternative way to create benchmarks for creditworthiness of firms. The discussion leads naturally to examination of fiscal sustainability and assessment of a government’s creditworthiness in the next chapter.

Current Thinking on Investment and Its Financing In a capitalist market economy, the activities of nonfinancial firms create goods and services available to sell or “realize” in the market for profit.1 Production involves combining nonlabor resources or inputs with labor. To survive in a competitive environment, firms must grow, and grow faster than their competitors. Whatever its form of legal

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organization—sole proprietorship, partnership, or corporation, each firm must expand. To expand, a firm must produce a positive income or profit. A capitalist system runs on profit. The objective for a firm, then, is to create output in a way that lowers the unit cost through its choice of productive technique(s). Profit is obtained when a firm sells its product at a price greater than the unit cost of production. To maintain profit, a firm must reduce costs faster than prices may fall. By doing so, a firm is able compete on price and survive a price war should one erupt in its market(s). It is possible that weakening profit (per unit) can be offset by increased market share at the expense of its rivals. Competition between firms can also take place through advertising and marketing, influencing consumers’ decisions, and on quality. Though advertising and marketing are activities peripheral to the creation of goods and services, they are necessary in order to facilitate the sale, or realization, of output, and to obtain profit. The financing and investment decisions of a firm, its structure, and growth are documented in its financial statements—balance sheet, income (profit and loss) statement, and the cash flow statement. The balance sheet documents a firm’s assets, liabilities, and owners’ equity at a particular point in time. Assets include current assets (cash, inventories, work in progress, marketable securities, and accounts receivable) and fixed assets (equipment and structures), whereas liabilities are current liabilities (short-term debt and accounts payable) and long-term liabilities (e.g., long-term debt) and equity. Assets that can easily be sold for cash are referred to as liquid assets. An estimate of a firm’s pool of cash is its net working capital (current assets minus current liabilities). The profit and loss statement summarizes the results of operations over a period of time, documenting both the size and structure of a firm’s revenues, costs, and expenses, including taxes, interest, and depreciation. The cash flow statement documents cash flow from operations (net income and changes in net working capital), cash flow associated with investment in fixed assets, and cash flow from financing (debt service, dividends, new borrowing). Changes in investments, financing, and operations will impact a firm’s cash flows. To lower its unit cost of output, a firm must invest in capital equipment to incorporate technological change into its production process Investment in new capital equipment must be financed. Thus, the expansion of capital involves two decisions—a decision about investment and another regarding how to finance that investment. Traditionally, the decision to invest has been approached by estimating the cash inflows from an investment relative to the investment’s

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cost. Cash flows are often discounted to form a sum representing the net present value (NPV) of that investment. An investment is worth making if the NPV is greater than zero. This method and the related calculation of internal rate of return or yield, the rate of return when the NPV is equal to zero, are forms of discounted cash flows (DCFs). From the 1960s, DCFs replaced investment decisions based upon time to payback and accounting return of investment. More recently, the DCFs are being supplemented with applications of options theory in order to fine-tune the treatment of risk for specific investment projects (Bierman and Smidt 2008: 8–9). As discussed below, these calculations contain implicit assumptions that make them tractable, yet impair their empirical performance. There are two basic sources of funding for investment—internal financing and external financing. Internal financing comes from retention of a firm’s income, whereas external financing comes from a lender or investor, who is external to the firm. External financing can be arranged in various durations that align with the duration of the funding objective. “A firm that borrows to undertake an investment programme will try to tailor its debt payments to the expected cash flows from the project. Capital-intensive firms that construct long-term plants and equipment will prefer to issue long-term debt, rather than rolling over short-term debt. Less capital-intensive firms will prefer to borrow short-term. In either case, firms will accommodate changes in their expected cash flows by restructuring their obligations.” (Sobehart and Keenan 2002: 129)

Short-term funding, for instance, supports the realization of output, acquisition of resources, ensuring that obligations are met, and smoothing over mismatches between cash inflows and outflows. Examples of short-term funding include: trade credit, bills of exchange, bank borrowing, commercial paper, and deferred tax payments. Bills of exchange and trade credits are short-term sources of funding that are linked to the sale of goods and services. Trade credit, also known as commercial or industry credit, is a period of grace extended before an account is settled after the delivery of goods or services. Trade credit is usually extended to buyers regardless of credit quality, and its use varies according to industry.2 Industries that produce or distribute goods, especially those that involve inventories, are more apt to use trade credit (Fitzpatrick and Lien 2013). Bills of exchange, or bill finance, and acceptance credits are (postdated) instruments, which are signed by the buyer for the sale price of goods and services received.

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The seller can sell the instrument to a third party at a discount. The third party is typically a bank. Lines of bank credit or overdrafts and promissory notes are stated amounts that a firm can draw upon. This form of financing is limited by a firm’s creditworthiness as proxied, for instance, by its current ratio (current assets to current liabilities); a popular rule of thumb for healthy liquidity is a ratio of approximately 2:1. Corporations are able to raise short-term funding by issuing commercial paper or unsecured notes in financial markets, and reduce their reliance on the banking system. Medium-term funding takes the form of term loans and leases. Due to the tailored nature of these contracts or instruments, the assessment of credit is primarily conducted by banks and distributors who lease goods. Firms that seek these types of finance do so in order to obtain durable goods and equipment for production of their goods and services (Fitzpatrick and Lien 2013). Long-term funding is associated with more substantial investment projects (e.g., expansion of capacity). Long-term loans can involve collateral offered as security. For corporations, long-term financing can be acquired by issuing bonds; SMEs are reliant on bank financing. Bond issuance often entails an agreement or covenant that protects bondholders’ investment by, for instance, placing limits on the issuance of additional bonds, restricting dividend payments on equity (stocks or shares), or keeping financial ratios within certain limits. The agreements become more detailed if the bonds are issued without pledging collateral, that is, where bonds are issued solely on a firm’s creditworthiness. Corporations can also issue stocks or shares. This form of external funding is also the most expensive as anticipated profit must compensate for risk of loss if the firm were to wind up. The cost of external financing via equity is “the cost of capital to the collective body of . . . shareholders” (Merrett and Sykes 1963: 70). The cost of capital is the return, net of tax, on a comparable investment (compensating for any differences in risk). The net of tax rate of return is the rate that balances the present value of dividends with the current market price of stocks. As equity finance is the most expensive form of external finance, the question arises as to whether there is an ideal amount of debt finance where the cost of debt is determined by the interest rate adjusted for risk (and taxes). When firms seek financing, their forms of organization will influence the sources from which they can seek funds. SMEs will primarily be limited to each other and banks, whereas corporations will have access to each other, banks, and the financial markets. Again, smaller firms do not have the size, and, hence, the perceived stability that

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corporations are believed to have, and are limited in how they can externally finance investments. Another dimension to the size of firms is how size limits the use of long-term and short-term debt. A traditional rule of thumb is that medium- to large-sized firms could use long-term debt to finance up to a third of their net assets and short-term debt for up to two-thirds of current assets.3 As such, an acceptable current account ratio (current assets relative to current liabilities) helps determine the limit over the use of short-term debt. Likewise, once a firm designates acceptable net worth and coverage ratios, it works with these to set an upper bound to the use of longterm debt. Short-term debt typically carries lower interest rates than long-term debt due to fewer maturity-related risks. Longer maturities introduce more uncertainty into the stream of repayments. The importance of yield curve behavior enters here as it helps establish the interest rates on the various forms of external financing. The yield curve can shift and invert according to changes in economic conditions. Riskiness with the use of short-term debt can vary. However, so long as firms adhere to an acceptable current ratio it is thought that they should not have issues with the use of short-term debt. Determining the optimal mix of debt and equity has been approached, traditionally, by orthodox economists in the following way. The idea is to maximize the total capital (debt and equity) of a firm, or minimize its cost of capital, by trying to locate the optimal division between interest and equity income. There is an incentive to use debt financing as a way to increase the value of total capital (debt and equity). This idea is captured with the weighted average cost of capital (WACC) or the after-tax cost of capital (the weighted average return on debt and equity). The WACC is expressed as: WACC = D/V * rdebt ( 1- Tc) + E/V * requity where D is debt, E is equity, V = D + E and Tc is the rate of corporate tax (Brealey, Myers, and Marcus 1995: 280).4 The WACC, as an estimate of a firm’s cost of capital, is used to evaluate the return on new assets (provided the new assets have the same riskiness as the existing ones).5 The weighted average cost of capital declines as debt finance, relatively cheaper to equity, increases relative to equity. However, there is a limit. At some point the increased use of debt finance increases the risk that the firm will not be able to meet its obligations when business conditions sour. The firm’s creditworthiness becomes compromised and the value of its debt and equity fall. An implication is that the firm

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must reduce its debt load. There is a natural breaking mechanism to the use of debt. Within limits, the optimal cost of capital is contingent on the firm’s capital structure. Modigliani-Miller (1958) went further and argued that the value of a firm is invariant to capital structure. Changes in capital structure may influence the expected rates of return of debt and equity, but not the firm’s value (the sum of its debt and equity) or operating income. The weighted average cost of capital is not influenced by the use of debt and “is equal to the capitalization rate of a pure equity stream of its risk class” (Merrett and Sykes 1963: 413). Any attempt at an improvement is quickly eroded away as investors adjust their positions. The marginal cost of capital equals the average cost under Modigliani-Miller. This is in contrast to the traditional approach where the marginal cost of capital is different from the average cost.6 It also demonstrates that the WACC is independent of a firm’s capital structure (Brealey, Marcus, and Myers 1995: 386–88). An implication of Modigliani-Miller is that there is no optimal debt-equity ratio that maximizes the value of a firm. However, firms do monitor their capital structures, and debt-toequity ratios are not random across and within industries. One explanation is that as the use of debt increases, a firm will likely face higher interest rates as its risk of default increases. A heavy use of debt will eventually bear upon operating risk (the risk of loss to a firm attributed to changes in market conditions, cost of inputs, and increased use of leverage). Capital structures are also thought to be influenced by taxes, cost of bankruptcy, conflicts of interest, and the pecking order of finance. If interest payments can be deducted on tax returns, the use of debt can reduce the tax burden and the value of the firm; leverage reduces the firm’s WACC. However, as a firm continues to borrow, the risk of financial distress (default) increases. The optimal capital structure, then, tries to strike a balance between the tax shield and the cost of default. There is also the possibility that firms that are highly profitable may avoid the use of debt, preferring to finance investment internally and may not need to resort to external sources of funding (Brealey, Myers, and Marcus 1995: 394, 401). Investment can be stymied by the presence of capital restrictions. Capital can be limited internally by the firm’s management if it were to set a limit to the amount of investment it undertakes or a threshold rate, which is higher than its cost of money (Bierman and Smidt 2008: 141). Capital can also be restricted by the financial sector. This is thought to occur when there is a large difference between the interest rate on borrowing and the interest rate on lending.

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External—or credit—rationing is attributed to market imperfections (such as transaction costs) or merely the perception of market imperfections. The rationales for restricting credit will be examined more closely below. Before we move to the next step, it is important to note that discounted cash flow models, of which NPV is one, involve assumptions about the constancy of the discount rate and either stable or slowchanging required rates of return. Moreover, the required rate of return and rate of discount are one and the same. These assumptions amount to defining these tools, designed for supporting investment and financing decisions, for an equilibrium state or a state of balance. These assumptions are made in order to render the ideas about investment and financing tractable or workable. They seem innocuous in our current context, but in a different context they effectively stunt the incorporation of the strength of a firm’s productive operations into both its investment and financing decisions and the methods that credit risk assessors use to evaluate creditworthiness.

Gauging Default or Credit Risk Now that we have a better understanding of the predominant thinking about investment and financing decisions, we can now evaluate the ways in which creditworthiness or the risk of default have been assessed and gauged. Default risk is the risk of loss due to missed payments or violation of a covenant associated with a debt contract. As such, there is a strong emphasis on the structure of a firm’s balance sheet as it gives an indication of the status of net working capital, a source of funding to honor payment obligations. Investment and financing decisions of a firm will influence its assets, liabilities, and net working capital. A firm hopes that those decisions will be successful and to its advantage within both the market and the industry in which it operates. Changes in the industrial structure and in overall business climate can influence cash flows and net working capital in ways that firms and lenders may not fully anticipate, however. Given these challenges there is a need to ascertain the risk of loss associated with the use of external funds to finance investment. The following approaches attempt to do that by establishing methods that are thought to discern the risk of default. Credit risk assessment can be broken down into three broad types: scoring, traditional statistics, and financial or market-based. The first two align themselves, and are congruent with, the traditional approach of capital budgeting in that they evaluate (relative) risk of default using

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accounting data. The idea is that given the historical accounting data or financial ratios characteristics of firms that experience default, and those that do not, a lender could use the information to compare the financial statements of a potential borrower to see whether it fits the default category or the non-default category. Early rules of thumb evolved into credit scoring techniques that, in the mid-1960s, evolved into more formal statistical techniques. The last type is akin to the modern approach to capital budgeting in that it is uses market data to evaluate creditworthiness. All approaches were developed to assess borrower creditworthiness in a consistent way. As lending expanded over the years, more formal techniques were developed in order to reduce the time and labor used to evaluate default risk as economies grew and demand for credit increased. For all issuers and their debt instruments, the assessment of creditworthiness begins with the issuer. Once the creditworthiness of an issuer has been established, the forms of debt they emit can be evaluated. An issuer’s creditworthiness is an expression of default risk, whereas the evaluation of an instrument is based upon the default risk of the issuer, with an adjustment for some measure of loss, such as loss-given-default, should a default occur.7 This distinction is the source of a methodological issue with the interpretation of a rating as an assessment of default risk. The inclusion of an estimate of loss refocuses the meaning of an evaluation or measure (e.g., rating) away from simply a risk of default. Although the approach to loans and bonds is basically the same, credit risk assessment for bonds is trickier than for loans since loans focus on the borrowers’ creditworthiness whereas bonds focus on the instrument and its auxiliary features (e.g., collateral). Credit scoring techniques, which began with debt products of consumers (e.g., home loans and credit cards), evolved from the use of an expert to evaluate information supplied by a potential borrower. The idea is to discern quality—in this context, creditworthiness— according to criteria that establishes a single value and/or letter representing the risk of loss with respect to a debt contract. The data is typically historical or backward looking. In the context of expertbased systems, one often finds reference to the 5 Cs: character, capital, capacity, collateral, and cyclical conditions (Van Gestel and Baesens 2009; Anderson 2007; Saunders and Allen 2002). A firm’s character consists of its reputation and repayment history; the firm’s age or maturity can be used as a proxy for repayment history. Capital consists of the owner’s equity contribution and is represented, for instance, by the debt-to-equity ratio. Capacity pertains to the ability to pay as

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indicated by its past (and projected) earnings. Collateral is the asset pledged; the higher its market value, the lower the risk of the loan. From here, scorecards emerged as a way to process or weight a potential borrower’s information associated with preselected criteria in order to yield a summary score. The score is compared to a threshold or cut-off value. Firms with scores above the threshold are creditworthy, whereas those below the cut-off are not. An expert is still required to evaluate borderline cases. Rubrics are like scorecards in that they entail a designated set of thresholds, where each threshold represents a different degree of credit default risk. For instance, a rubric could have four levels (“in default,” “high risk,” “medium risk,” and “low risk”). The assessment of designated inputs leads to placement in one of the categories. The expert could then adjust the score according to his/her (subjective) understanding of how factors, other than the inputs, could influence the outcome. In all, there are four steps in scoring: selecting the criteria, collecting information, and processing the information in a way that the result can be placed or mapped into default categories. Features of a robust scoring method include “transparency, power, validation and calibration” (Falkenstein 2002: 174). The scoring technique is understood to be especially helpful in situations where data availability is limited and, as such, would severely compromise more sophisticated techniques. Early researchers working within this tradition (e.g., Beaver 1968, 1966; Tamari 1966) began to notice that certain indicators pertaining to profitability, liquidity, and solvency seemed to change prior to default (in particular, bankruptcy). These indicators included: working capital/total assets (WC/TA), the current ratio, net income to total assets, cash flow/total debt, credit interval, earnings before interest, and taxes/total assets (EBIT/TA), and sales/total assets (S/TA). These have intuitive appeal. For instance, firms with weakening profitability, lower liquidity, and questionable solvency are more apt to default. More recently, Falkenstein (2002: 175) found that indicators associated with volatility, size, growth of leverage or gearing, and inventories have signaling capability. Size, for example, can be a proxy for profitability for smaller firms. Volatility suggests that there is more risk that it will fall below a threshold set by its debt, which implies insolvency. With respect to the leverage ratio, lower leverage implies that the firm is less apt to default. Very high or very low growth rates are associated with greater risk of default. Finally, the larger the inventories that firms carry, the more likely that they will default. Quantitative techniques emerged in order to reduce the human discrepancies, and resulting inconsistencies, involved with the design and

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execution of qualitative assessment practices, such as expert analysis and early credit scoring. The use of data and quantified risk categories in credit scoring opens the door for application of more formal statistical analysis. The application of quantitative techniques is thought to enhance the credibility and objectivity of an assessor. One of the earliest techniques used is discriminant analysis. It places a firm into one of two categories (default or no default) according to how closely the firm’s characteristics match those of either category. Altman (1968) and Deakin (1972) used discriminant analysis to locate empirical evidence that indicators found to have signaling ability according to credit scoring methods also seemed indicative of firm failure. Altman (1968), in particular, was influential by using discriminant analysis to create the Z-score model, a linear model. In 1977, Altman revised his Z-score model to the Z-credit risk model or ZETA, a nonlinear model. The performance of his new model improved with withinsample tests, but worsened with out-of-sample tests (Altman 2002: 160). The static nature of quantitative models, he noted, made it difficult to incorporate the influence of business conditions (the cycle); typically, this is done with the introduction of exogenous variables (e.g., GDP growth). The subsequent appearance of quantitative techniques, such as probit and logit and linear probability, carried a subtle shift in the framing of the problem. Whereas the causal flow in discriminant analysis is from group membership to the characteristics of the groups—that is, the groups are formed prior to selection of the defining characteristics, in more sophisticated techniques the causal flow is the opposite. The emphasis shifted from the classification of an object or event to the estimation of the parameters on explanatory variables (Amemiya 1981: 1508). Models estimate the probably that an event will occur (or not): Prob (event occurs) = P(yi =1) and Prob (otherwise) = P(yi =0), where y is a random variable that takes the value 1 if the event occurs, 0 if the event does not occur. The probability that y occurs is a function of a cumulative probability distribution that depends on x (a vector of factors) and βʹ (a set of unknown parameters), that is P(yi = 1) = F(x, βʹ), where F is a known cumulative probability distribution. F can be defined in the following ways: βʹx (the linear probability model), βx

ɸ(βʹx) = ∫ ϕ (t)dt (the probit model), or Λ(βʹx ) =eβʹx/(1+ eβʹx) −∞ (the logit model).8 The modern approaches to credit or default risk rest on the shoulders of the Black-Scholes model. They are distinguished from the traditional approach by their focus on absolute credit risk and their

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reliance on market data rather than accounting data. The basis of this approach lies in the idea of contingent claims by Merton (1974), who extended the Black-Scholes method of options pricing to default risk. The idea is that a firm will default when the market value of its equity falls below some threshold. Merton’s contribution was extended by Oldrich Vasicek, creator of the Kealhofer, McQuown, and Vasicek (KMV) model (1984), to obtain a credit valuation model that was “consistent with modern financial theory, particularly option pricing theory” (Langohr and Langohr 2008: 274). The market value of a firm’s equity is treated as a call option on the firm’s assets, where the firm’s market value at a future point in time is estimated using “a probability distribution characterized by its expected value and standard deviation (volatility)” (Altman 2002: 162–63).9 The strike price, or “default point,” is the book value of the firm’s liabilities. Using the default point and the firm’s estimated value, the distance to default (DD) is calculated as the difference (measured by the number of standard deviations) between the expected value and its default point. The DD is then matched or mapped to actual, historical default rates. The mapping process yields a cardinal measure—the expected default frequency (EDF)—of default probabilities. As such, the approach estimates absolute risk. It requires much less data and is less labor intensive than the previous approaches to default probability. Moreover, this approach reflects changes in default risk more quickly than traditional approaches based on a firm’s financial fundamentals. The EDF changes as the value of a firm’s equity changes. It is assumed that changes in assets happen in a stochastic or random way, but that the random component can be represented by a normal distribution (summarized by a mean and variance).10 Underlying EDF measures is an assumption that market values and default probabilities are related. More recently, “hybrids” have been created that incorporate both market and accounting data. Again, an advantage of option theoretic or “structural models” of credit risk is that the types of data required were narrowed and easier to obtain. “Reduced-form” models, introduced by Jarrow and Turnbull (1995), use even less data. They are based upon the idea that credit spreads are determined by likelihood of default and recovery expectations of market participants. Reduced-form models supposedly “decompose risky debt prices in order to estimate the random intensity process underlying default” (Allen and Saunders 2002: 48). The reduced form approach estimates stochastic hazard rates. In reduced-form models, default events are treated as “surprises” or unanticipated events. Hence, this approach does not require “the same

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balance-sheet information and the same assumption about frictionless liquidation of the firms’ assets as the CCA approach” (Sobehart and Keenan 2002: 126). Market-implied ratings (or MIRs) are ratings that can be created from structural and reduced-form models. The idea, like the structural and reduced-form models is to create market-based measures of creditworthiness from data on equities, bonds, and credit default swaps (CDSs). MIRs have also been created using regression analysis (traditional statistics) and mapping techniques. There are other approaches used to assess credit risk, such as the Value-at-Risk (VAR), the insurance approach, bond-loan mappings, and so on. These are employed to capture the interdependencies of debt instruments as contained within a portfolio. The point is to give the basic orientations of the broad strands in gauging credit worthiness. It is the methodological underpinnings of the basic orientations that we are interested in. They are similar in many aspects. Credit rating agencies employ these methods to varying degrees. For proprietary reasons, the exact models are not made explicit. The materials provided to the public through their online facilities provides indication of the basic approaches. All the three major agencies (Standard & Poor’s, Fitch, and Moody’s) indicate that their ratings entail a mix of quantitative and qualitative analyses of firms and issuers. The extent of quantitative techniques employed varies with types of issuers and issues. Whatever the exact methods, the agencies all begin by specifying certain factors or criteria that they deem relevant for contributing to default risk. This means that they are interested in evaluating the size and timing of payments on debt obligations relative to the resources at the firm’s disposal to honor those commitments. Cash inflows are recognized as coming primarily from operations (Standard and Poor’s 2014b). Table 3.1 provides a summary of the factors involved in rating corporate debt for these three agencies. (Please note that some factors are presented together to simplify the table). The indicators pertain to business profile, capital structure, operating environments (industry and macroeconomic), management performance, liquidity, and debt burden. But they are not necessarily grouped and analyzed in quite the same way. For instance, capital structure may be part of multiple factor categories, whereas profitability indicators have a designated section with some agencies, but are rolled into assessments of leverage and coverage with others. Basically, elements associated with firm profiles are attempting to establish variability of a firm’s position and its long-term outlook, taking into account the influence of changes in

Table 3.1 Key criteria for corporate ratings Moody’s

Standard & Poor’s

Fitch

Leverage and coverage Debt-payback ratios & See financial profile EBITA/interest expense leverage (below) Debt/EBITDA Funds from operations Free cash flow (FCF)/Net (relative to debt) debt Debt/EBITDA Retained cash flow (RCF)/Net Supplemental debt Cash flow from operations (relative to debt) Free operating cash flow (relative to debt) Discretionary cash flow (relative to debt) (FFO+interest) (relative to debt) EBIT/interest Financial policy History of prior actions Desired capital structure or credit profile Management’s operating performance Management’ ability to balance interests of debtholders and shareholders

Financial risk & policy Accounting positions Cash flow adequacy Governance Strength of cash flows Capital structure Liquidity & short-term factors

Strategy/Governance & group structure Capital structure or credit profile Funding need for new investment Past financing decisions Ownership & organizational structures

Profitability EBITA margins

Profitability ratios EBIT/revenue EBITBA/revenue EBIT/(average capital), a rate of return

Financial Profile Cash flow and earnings Operation expenditure EBITAR Fund flow (operations) FFO Cash flow (operations) CFO Free cash flow FCF Net cash flows Change in net debt Financial flexibility Continued

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Table 3.1 Continued Moody’s

Standard & Poor’s

Fitch

Business profile & scale Firm’s market share Operational diversity Geographic reach Competitive advantages Product differentiation Rivals Technical change Cost position & ability to Control Volatility of past results Scale Size & volatility of revenue base

Business risk Macroeconomic conditions or Country risk Industry conditions Market structure Volatility & competition Firm’s position & growth prospects

Company profile & industry risk and operating environment Position in key markets (product dominance & market power over price) Product diversity Geographical spread of sales Diverse customer base and suppliers Comparative cost position Scale

Sources: Moody’s (2014b, 2014c); Standard & Poor’s (2014b); Fitch (2014b)

industrial developments and macroeconomic conditions. Indicators associated with profit, leverage, and coverage are an attempt to ascertain a firm’s ability, and need, to complete its payment obligations. There is consideration given to external support, such as government support or pledge of assistance from a highly rated guarantor, and to the philosophies of firms’ managements. The criteria and models are monitored for possible revisions by selected staff, at least annually. Models are evaluated in-house with respect to their historical performance. The evaluation process involves rechecking calculations, checking how calculations supported implementation of ratings, and back testing. It is often maintained that models should not and cannot be tested for predictability if ratings are interpreted in a relative manner, that is, if they support the placement of a result within a rating scheme that captures the relative probabilities of default rather than predicting default (Fitch 2014c: 9). That said, there are indicators that are created to predict trends in certain variables, such as cash flows, income, GDP, and interest rates. Implicitly, ratings do carry elements of a predictive nature.

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Quality control measures include training of staff, monitoring for inaccuracies, and addressing those inaccuracies on an “as needed” basis. The frequency of due diligence depends on sudden changes in macroeconomic and industry conditions (SEC 2003, 2008). Due diligence is conducted less frequently in fairly stable environments and more frequently when environments become unstable. Due diligence is costly, and it is understandable that assessors like rating agencies do not want to perform it any more than necessary. Recall that due diligence has been identified as a malfunction in the previous chapter. It is important to note, as discussed in more detail below, that although the criteria used may be stable, the weights applied to the criteria, more often than not, change with variations in macroeconomic and industrial climates. This can explain some of the pro-cyclicality of ratings that are supposed to be oriented toward rating throughthe-cycle. If economic conditions of a cycle are strong and persistent enough, ratings will undoubtedly change as staff is obliged to change the weights. In sum, expert systems and credit scoring are grounded in financial ratios derived from accounting statements, and, as such, are directly linked to a firm’s performance. More quantitative techniques were employed to cross-check the results of the expert system and scoring. The more sophisticated techniques are thought to reduce subjectivity and the influence of human errors in the assessment of default risk, rendering those assessments more accurate and enhancing the comparability of instruments and issuers. In these ways, the techniques are thought to add value. There was still a tendency to apply these methods with financial ratios. Financial ratios are released only at certain times of the year (quarterly and annually). This suggests that there is a lag in the estimation of firm’s creditworthiness unless the assessor has access to nonpublic information. The desire of financial investors to change positions when conditions change has motivated the shift toward modern approaches that rely on financial theory and market data to estimate the probability of default. Changes in creditworthiness can be monitored in real time, or nearly so. Rating agencies provide assessments of credit risk using these approaches, but, more often than not, are more associated with their non-rating activities (e.g., risk management). The KMV model, for instance, is part of Moody’s analytics. It requires three calculations: an estimate of a firm’s asset value (and volatility), estimate of distance to default, and the probability of default. The second calculation uses information from the first and adds a time horizon (selected by an analyst), the expected growth rate of assets, the default threshold and

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future asset distribution. The probability of default is estimated using the distance to default (Langohr and Langohr 2008: 277–78; Altman 2002: 162–63). The modern approaches assume that market prices accurately reflect information about the fundamentals of firms. This assumption may not be as robust as proponents would like. We will reexamine these broad approaches in light of the discussion in the next section about the assumptions that underlie them. This is not to suggest that the methods should not be used, but that they be used only after acknowledging their limitations.

Two Visions of Investment The approaches that we have seen thus far for evaluating credit risk are not without their drawbacks. There are three issues that are of particular concern. The first is the role of investment activity as it underlies the concept of credit risk. The second is the distinction between risk and uncertainty. And the third pertains to the conception of equilibrium. In light of these issues, the stage may be set for an alternative approach. How does the investment process underlie the understanding of credit risk? To grasp this, one needs to recognize that there are two stances pertaining to the impact that investment has on economic activity. One stance is that investment is an activity that helps stabilize the economy, provided it is supported by a financial system that is functioning well. This view underlies mainstream thinking on economics and finance. The other stance is that investment is inherently destabilizing. This view is held by nonmainstream or heterodox economists. The stance that investment is a stabilizing mechanism entails the vision that there exists an equilibrium set of (real) prices that clear the markets for goods and services. These prices, so long as they are flexible, will adjust to balance supplies and demands for both inputs to production and outputs. For a nonmonetary economy, Say’s law ensures that general gluts, and cycles, will not occur. However, for a monetary economy, Say’s law needs support in order ensure that general gluts and cycles will not occur. That is, savings activity could potentially upset the ability of the system to self-adjust toward a position characterized by full employment of resources and markets that have cleared. Fixed investment appears as an injection to counterbalance, through the behavior of the interest rate, leakages due to savings. The interest rate’s flexibility is key to balancing the supply of

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savings with the demand for savings (investment). The activity of the interest rate and investment’s response to it—the classical theory of interest—supports Say’s law and, by doing so, helps ensure that any shock to the system is immediately corrected. The classical theory of interest appears in a modern guise as the supply and demand for loanable funds. Instability and cyclical fluctuations should, according to this vision, not occur. But they do. How were bouts of instability (and cycles) explained? Early monetary cycle theorists focused on the inflexibility or the level of the interest rate and/or changes in the money supply—see, for instance, Fisher (1922), Wicksell (1935: 78), and Hawtrey (1926). Issues that threatened the classical theory of interest and its support of Say’s law would hamper investment’s role as a stabilizer, allowing cycles and recessions to occur. Wicksell (1935,1978) examined how the difference between the natural and market rates of interest could stimulate a cumulative process that impacts investment, and, hence, output, employment, and prices. For instance, if the market rate was set by banks to be less than the natural rate, investment would increase and, in turn, stimulate output and employment. Eventually, prices of consumer and investment goods and inputs increase (that is, inflation erupts). The process stops when banks raise the market interest rate back to the natural rate. Keynes’s cycle theory was innovative in that investment’s volatility was contingent upon a firms’ expectations of demand for their output (business confidence), the marginal efficiency of capital (MEC) (relative to the interest rate), the marginal propensity to consume, and liquidity preference. These factors incorporate strong psychological elements. Changes in investment could be traced to the changing relationship between the MEC and the interest rate. If the MEC is greater than the interest rate, firms are stimulated to invest as the demand price for capital assets (its discounted stream of returns) are greater than the supply price (the cost of producing a comparable capital asset). As investment takes place, and output increases via the multiplier effect (with associated changes in consumption). Over time, modern variations of mainstream theory tried to both contain Keynes’s ideas, by grafting them onto some form of general equilibrium theory, and extend them. Neo-Keynesian cycle theory, for instance, incorporated an accelerator to the multiplier process (Samuelson’s multiplier-accelerator), where changes in output feedback onto investment (Samuelson 1939). The use of general equilibrium microfoundations, however, reintroduced price flexibility (and the importance of market clearing) to the analysis of instability and

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cycles. Increased price flexibility meant that the system was better able to adjust itself back to a full-employment level of output. New classical economists’ work on shock-propagation mechanisms strengthened the role for price flexibility in attenuating cyclical behavior and volatility. One variant of the New classical paradigm places the shock-propagation mechanisms as emanating from the monetary sector (changes in the money supply)—monetary equilibrium business cycles. Here, investment is impacted through lags in information (suggesting signal extraction problems of agents for distinguishing changes in relative prices from inflation and in distinguishing transitory from permanent changes), an accelerator effect and the interest rate. Another variant— the Real Business Cycle (RBC) school—emphasizes the source of shocks via the real sector and their effect on productivity. The New Keynesian paradigm incorporates incomplete markets, imperfections, and transaction costs to explain how reverberations in the aftermath of a shock can have a cyclical form. The idea is that the presence of price rigidities, nominal or real, lead to increased volatility in output and employment. The sources of rigidities can be traced to characteristics of product markets or the labor market. Investment activity is still held to be stabilizing, but the (imperfect) context in which this activity is embedded suggests that it is not able to operate fully. If the imperfections in product markets are alleviated by reducing regulation and promoting greater cost efficiencies, the focus then shifts to making labor markets more flexible both in terms of wage flexibility and the productivity of workers. In other words, in terms of the relationship between the capital and labor, as key elements of an economy’s productive capability (captured by an aggregate production function), if there is nothing wrong with capital (investment), there must be something wrong with labor. (We will come back to this point when we examine approaches to industrial policy in chapter 6). However, mainstream’s orientation is just one of the two visions of the type of role that private investment plays in the economy. The other is that investment is the culprit rendering a capitalist economy inherently unstable. Heterodox economists have approached instability and cycles in various ways. What unites the various strands, such as post-Keynesians and Institutionalists, are the emphases on cumulative causation, the importance of institutions, income distribution, and, of course, investment instability. The idea of cumulative causation perhaps finds its most developed form in Hyman Minsky’s FIH. Minsky (1975) examines the evolution of firms’ liability structures over a business cycle. Starting from a trough of a cycle, the distribution of (nonfinancial) firms suggests that the economy is resilient

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as firms’ cash flow positions are robust (or “hedged”) in the sense that the cash inflows generated by their assets more than cover the stream of payment commitments emitted by their liabilities. At some point, they are stimulated to invest, perhaps by a new innovation that stimulates profit. As firms invest, the growth of output strengthens as do employment and consumption. These, in turn, strengthen cash inflows and stimulate firms to become less risk adverse, and more willing to use debt to finance new investments. They do, and for a while the cumulative process continues. As firms increase their use of debt, their debt service payments increase relative to cash flows. Their liability structures begin to change their configurations as a result. Their cash flows are not enough to complete new investment in its entirety (though they will be able to service debt commitments). Firms that experience this, shift away from a hedged position (where cash flows cover payment commitments) to a speculative position (where cash flows cover only part of payment commitments). At some point, cash flows weaken, though it may take time for firm owners to realize that the rate of return on new investment is falling—and it’s not temporary. There will be firms that are unable to complete debt service payments, let alone make new investments. These are Ponzi firms; they need to borrow to complete payments. Minsky captured this idea by visualizing a distribution or spectrum of hedged, speculative, and Ponzi firms, evolving with the cycle. During the expansion phase of a boom, the distribution shifts from robust end of the spectrum (most firms hedged or speculative) to fragile end (most firms speculative or Ponzi). As the economy nears the peak, the strength of demand for funds leads to a rising interest rate. Minsky identified this rise in the rate of interest as a key element in tipping the economy into a contraction. Both the mainstream and heterodox economists’ view of investment provide roles to the interest rate. It is the heterodox that also maintains a role for the investment’s rate of return. This distinction carries over into their associated theories of credit risk and rationing.

Implications of the Visions for Creditworthiness To understand why, we need to look more closely at how the visions of investment’s impact on stability have an effect on the approaches to credit risk theory and modeling. The predominant approaches rest on a vision of an economy as inherently stable, as tending toward an equilibrium that is characterized as a state of balance. If one looks at

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the investment and financing decisions, for instance, there is a presumption that capital mobility, effected through investment activities in conjunction with flexible prices, equalizes and stabilizes the rates of return. Recall that the present value calculation (PV) is the stream of discounted returns for an asset that yields cash flow for n periods. Its basic structure is: PV (asset) = R1/(1 + r) + R2/(1 + r)2 + R3/(1 + r)3 + . . . + Rn/(1 + r)n, where each Rj is the expected return (cash flow) for the designated period and r is the opportunity cost of capital. The opportunity cost of capital is the foregone expected rate of return on comparable investment (in terms of maturity and risk). The notion of an opportunity cost suggests that there is a required or reference rate of return with which a potential investment needs to be compared. The discount rate is assumed to either slowly change or be constant. Stability of the discount rate suggests a state of balance. The state of balance may change with changes in technology, preferences, and resource availability, but capital flows move to reestablish balance. The removal of impediments to efficiencies that impede balance becomes an objective of government policies. The interest rate channels leakages (savings) back in to the economy as injections (investments). The WACC also relies on the relative stability of the returns on equity and debt. rdebt and requity are the required rates of return sought by lenders and equity investors. The activity of arbitrage helps establish these rates and keeps them stable. Again, under Modigliani-Miller, the weighted average cost of capital “is equal to the capitalization rate of a pure equity stream” according to its risk class (Merrett and Sykes 1963: 414). Any improvement is quickly eroded away as investors adjust their positions. In other words, the activity of arbitrage seeks to maintain balance and stability. With respect to creditworthiness, the mainstream orientation, as represented by New Keynesian economics, reprises early orthodox thinking about the sensitivity and level of the interest rate. So long as the interest rate is flexible, the demand and supply for loanable funds will assist to channel savings into productive investments. Again, loanable funds act as a modern variant of the classical theory of interest. The issues with the interest rate, however, are justified differently from the early monetary theorists. Here, the rationale rests on the presence of transaction costs and asymmetric information at the interface between lenders (financial sector) and borrowers (mainly

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the nonfinancial sectors). With respect to asymmetric information, borrowers are presumed to have more information about the types and profitability of projects they consider. Lenders have limited access to that information, and, as such, their information is incomplete. The implication is that it is the presence of asymmetric information that renders the financial system susceptible to market failures and bouts of instability, and, in turn, influences investment, income, and employment. New Keynesian credit theory begins at the micro level or at the level of individual firms (nonfinancial and financial).11 The idea is that when the financial fundamentals for a firm change, the perceptions of (default) risk, as assessed by lenders, change. Financial fundamentals are defined as elements of a firm’s financial statements, in particular net worth (assets – liabilities, as found on balance sheets), cash flows (as found on cash flow statements) and net income or profit (profit and loss statement). When a firm’s fundamentals change, its lender(s) will take this into consideration when they revise their evaluation of the firm’s credit risk on new credit or rollover funding. If that weakening is severe enough, lenders may restrict or ration credit. The presence of asymmetric information means that there is greater uncertainty in establishing the extent of weakening. Lenders are more apt to somehow restrict credit when uncertainty exists about weakening in a firm’s fundamentals. The more information a lender can obtain, the more accurate is its assessment of fundamentals. Unlike neo-Keynesian mainstream and early monetary theory, which cast interest rate stickiness as a characteristic of disequilibrium, New Keynesians cast issues with the interest rate in the context of equilibrium.12 Even though the interest rate clears the market for loanable funds, the level of the interest rate is not optimum, and it is sticky, due to market imperfections stemming from asymmetric information and transaction costs. The explanation rests on how imbalances in information can, at times, cause lenders to restrict credit. Referring back to the exposition in the first section on investment and financing decisions, we saw there are situations in which a firm may restrict its (internal) finance and others in which lenders restrict a firm’s (external) finance. In effect, New Keynesians provide more depth to the explanation of lenders’ rationing firms’ external finance. Again, like the early explanations of instability and cycles, these phenomena have something to do with the financial sector and the key factors are the presence of asymmetric information and transaction costs. There are two basic strands in New Keynesian credit theory: financial accelerator and credit rationing.13

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The financial accelerator model suggests that firms’ fundamentals influence the cost of intermediation in a way that weakens investment. Cost of financial intermediation include interest rates and the cost of information (such as monitoring costs), collateral costs, and compensating balances (Bernanke and Gertler 1987; Knoop 2010). In the event of an adverse shock, from either the supply or the demand side of the economy, if financial fundamentals of firms weaken appreciably, their risk of default increases, and the rise in costs of financial intermediation will be significant. Lenders restrict credit by increasing the interest rate and tightening lending standards, in effect passing on these costs to the firms. These costs prompt some firms to refrain from seeking external finance, and investment activity slows, which, in turn, slows the growth of income and consumption. The credit rationing variant is more direct. Beginning with Stiglitz and Weiss (1981), weakening fundamentals are thought to cause lenders to restrict the extension of credit.14 The explanation begins as with the financial accelerator model in that in the event of an adverse shock, if financial fundamentals of firms weaken appreciably, firms’ risk of default increases. In an environment characterized by high interest rates, healthy firms with low probability of default are not interested in borrowing as it reduces their profit. Firms that apply for credit in the context of high borrowing costs are viewed to be more risky, that is, less creditworthy. Lenders refrain from raising the interest rates as new borrowers in a climate of high interest rates are more apt to take more risks with the funding (to earn a rate of return that compensates for the high cost of funds) or be more risky generally (desperately in need of new financing). In either case, lenders are more likely to incur a loss by lending in this context. Lenders prefer to keep a lid on interest rates and ration credit instead. In either variant, lenders keep interest rates fairly stable but restrict credit due to their desire to limit their exposure to emerging externalities. In sum, New Keynesian credit theory suggests that restricting or rationing credit occurs in response to a shock to the system that impacts firms’ fundamentals and increases the probability of default. That shock can come from either the demand or supply side of the economy or from the financial sector. Further, restrictions amplify instability in the aftermath of a shock. The impact on the macroeconomy is achieved by analyzing the impact of changes in the demand and supply for credit upon consumption and investment. Credit rationing impacts investment, and also consumption, through weakening employment and income. The financial accelerator works through weakening credit demand as costs of financial intermediation increase.

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Either way, investment, a stabilizing activity, is compromised. Further, it can be improved by reducing the asymmetry of information between lenders and borrowers. This entails a program of gathering information, which is supported by efforts of central banks and national statistics organizations. But, is more data and information likely to facilitate improvement in creditworthiness or lower default risk? The answer to this question may lie in revisiting the tools used to facilitate investment and financing decisions. Thinking in terms of the investment and financing tools at the start, an adverse shock will influence a firm’s investment decisions by lowering the NPV of potential investment projects in two ways. The shock lowers the expected returns on those projects as demand conditions weaken in the economy. It also increases the discount rate (weighted cost of capital) used to evaluate the NPV of investment projects. If there had been no adverse shock, those elements and the economic system would remain unchanged. And lenders would not need to restrict credit; financial intermediation would not be impaired and the interest rates would help direct savings to the productive investment opportunities. If unimpeded, the system is in a state of balance, either static or slowly changing. Episodes of financial instability are only possibilities, not inevitable. DCF models, like the NPV, entail assumptions that include constant discount rate, constant dividend growth, and stable or slowly changing required rates of return (Shaikh 1997, 2008, 2010). Further, the discount rate is equivalent to the required rate of return. The assumptions are tantamount to defining the system as it if were in a longperiod position. Assumptions needed to obtain tools used to support investment, and financing decisions tractable and seemingly innocuous in the context of investment as stabilizing (economy inherently stable), may not be so harmless in the context of investment as inherently destabilizing. For instance, the emphasis on establishing default risk or creditworthiness rests on evaluation of firms’ financial fundamentals (e.g., net worth, net working capital, profit), as reflected in their financial statements. At best, “productive” fundamentals, information on their conditions of production, and position within their markets and industries enter in an indirect way through their impact on financial fundamentals. This is where the other vision of investment might shed light on different aspects of creditworthiness. That is, if investment is understood to be a source of instability rather than stability, how would the analysis of credit risk assessment change? This leads us to consider the second vision of the investment process, one that is inherently

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unstable. In this context, the investment and financing decisions are not only determined differently, but also fit within a framework that can capture the dynamics of production and investment more directly. For this we need to return to Keynes and his interpretation through Hyman Minsky. The irony is that Minsky, too, throws the weight of creditworthiness onto a firm’s financial fundamentals. This can be addressed. From this heterodox perspective, firms’ behavior is cast by their financing and investment decisions in the context of radical or true uncertainty. Whereas the mainstream is content to define uncertainty in a way that it can be modeled with probability distributions, Minsky, following Keynes’s lead, was not. However, this is not to say that Minsky did not have opinions about risk. He was, of course, very much interested in how uncertainty influences the decisions regarding investment and financing of investment. Regardless of the fact that a “precise numerical value” cannot be assigned objectively, “decisions have to be made” (Minsky 1975: 65).15 Firms’ decisions, in this context, are traceable through the evolution of their cash flow and balance sheet statements. The evolution has a pattern over a cycle. Default risk can be expressed through a Minskian cash flow accounting framework beginning with his FIH. The FIH provides rich insights into the dynamics between the nonfinancial (or real) and financial sectors, yet, because of its dialectical nature, the FIH is not amenable to the modeling techniques employed by mainstream economics. Minsky expressed his ideas with cash flow accounting frameworks at the level of the firm and at the level of the macroeconomy. Changes in cash flows give a better picture of the reservoir of (internal) liquidity that can be used to service debt obligations. At the level of the firm, the statement is defined as: Profit + new borrowing = investment + debt service Each firm’s investment and financing decisions are captured in this statement. Minsky argued that these decisions will lead to changes in the relationship of the variables, and will generate cyclical patterns associated with the business cycle. In an upswing, these variables will have three relationships marking three basic states or positions of a firm: hedged, speculative, and Ponzi. A firm whose profit is greater than investment and debt service is hedged: profit > investment and debt service. This firm does not need to borrow to complete debt service. In fact, it can use the difference to reduce outstanding debt; a firm’s debt burden decreases in this state. A firm whose profit is

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greater than debt service, but not quite enough to cover both debt service and investment is speculative: profit > debt service, but investment > (profit – debt service). Here, a firm needs to borrow to help finance investment. A speculative firm’s debt burden is increasing. When a firm’s profit is not enough to honor a debt service payment, that is, profit < debt service, the firm is called Ponzi. Ponzi firms must borrow to complete liability commitments, as successful application for funding is dependent upon the goodwill of financial intermediaries. The intermediaries have confidence that the situation is temporary. The debt burden for Ponzi firms increases. The accounting framework can be brought to the level of the macroeconomy by invoking the representative firm. As a result, equation (1) becomes: Profit (R) plus current account (D) equals investment (I) plus external debt service (V). The economy is called “hedged” when R > I + V; “speculative” when R > V, but R < I + V; and Ponzi when R < V (Foley 2003; Schroeder 2002, 2004, 2009). Please note that the representative firm is invoked on different grounds with respect to the heterodoxy. The mainstream’s emphasis on agent-based analysis means that the representative individual or agent is defined on the basis of the average of the characteristics of all individuals or on some arbitrary set of characteristics. The debate over what the representative agent actually represents has been an ongoing debate for decades (see, for instance, Kirman 1992; Hartley 199716). The heterodox traditions generally work with class-based analyses, not individual-based analyses as with the mainstream economics. In this context, the representative agent represents the key characteristics of the class that it presents, which, in turn, is influenced by the social, historical, and political contexts in which an analysis is conducted. (Foley 2004 and Dumenil and Levy 1990, footnote 3, provide further justification for the use of a representative firm in this context.) Even so, the justification of the representative agent is just a step toward incorporating of the dynamics of production. To enhance the link between Minsky’s framework and the dynamics of production, one needs to first place the framework on a rate basis rather than on levels. The levels of profit, investment, and debt service are not as informative as their rates of change, particularly how they change in relation to each other. Moreover, rather than average rates of change, we will use incremental rates. Incremental rates better reflect short-term fluctuations in demand and financial market conditions. “That is, instead of calculating the average rates of profit and growth of capital stock or the debt service on the stock of debt, we are more interested in determining the rate of profit on an additional

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unit of investment made in the last period (change in capital stock), the rate of growth in investment, and the interest rate charged on new debt” (Schroeder 2009: 294). The use of incremental rates help link a Minskian framework to the dynamics of production. An incremental rate of return or profit (rʹ) is defined as the change in profit (∆R) divided by a change in the capital stock or, equivalently, prior period investment (It-1): rʹ = ∆R/ It-1 (Shaikh 1997, 2008). This rate can be, and has been, interpreted as a rate of return associated with the regulating capital. The regulating capital is a concept through which the equalization of the rates of return between industries is linked to the continual differentiation of rates of return within industries (Botwinick 1993). Each firm has an associated capital composition, reflecting its conditions of production. Although firms may produce a similar product, their structures of production are likely to be dissimilar. Yet, competitive pressures will be such that the price of their products will be equal, or nearly so. This implies that firms’ rates of return and profit margins, within an industry, will naturally differ. Competitive pressures will also prompt capital to flow between industries in its bid for better rates of return (and growth). The regulating capital concept represents the conditions of production that firms monitor when considering to enter an industry. The regulating conditions of production are not the same as the average conditions of production. Rather, the regulating conditions of production involve the best techniques or productive conditions that “can be readily produced and that may allow (firms) to achieve profit rates that are above the average conditions” (Botwinick 1993: 151–52). The average rate of profit cannot be used as a proxy for the regulating rate, at either the levels of the industry or of the macroeconomy, because of the mix of vintages of capital equipment involved in its calculation. Regulating capital regulates the supply of output and acts as the center of gravity around which prices fluctuate, where the centre of gravity shifts (but not randomly) as new technology is incorporated into productive processes. Tendential regulation captures the idea that as capital flows between industries it promotes the equalization of the rates of profit across them. The rates within industries are constantly in flux as producers adapt new technology to their production processes with new fixed capital investments. Tendential regulation supports a vision of a system which is naturally prone to instability rather than a vision of balance or stability (which underlies general equilibrium frameworks of mainstream economics). What evidence is there that there is equalization of the incremental rates between industries? There are a variety of studies that provide

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empirical support for equalization of incremental rates between industries, as rates on regulating capital. Vaona (2012, 2013) and Tescari and Vaona (2014) find evidence in selected OECD countries. Their efforts support both Dumenil and Levy (2002) and Shaikh (1998, 2008) who provide evidence for the United States in particular. Note, Shaikh and Dumenil and Levy differ in their views of the importance of the influence of wage dynamics and capacity utilization in the calculation of the incremental rates. Tescari and Vaona (2014) recently demonstrated that while accounting for capacity utilization and wage dynamics, there remains a tendency toward equalization. The tendency toward equalization in the incremental rates is robust under a variety of circumstances. It is also interesting to note that besides linking a Minksian framework to productive activities, it is possible to also use the concepts of the regulating capital and incremental rate to link the framework to movements in the stock market. Shaikh (1997, 2010) has demonstrated that the activity of turbulent arbitrage equalizes the incremental rate of return on corporate investment to the rate of return on the stock market. The use of the regulating capital concept also helps to incorporate the influence of a falling profit rate. Investment activity between industries tends to equalize profitability among the regulating capitals of the industries in which they are embedded. Investment activity within industries creates turbulence as the investment introduces technological advances (embodied in new capital equipment) into production processes. As such, the composition of capital changes in ways that the unit cost of output is lowered. So long as the unit price of output is stable, profit margin rises. However, competition pushes firms to adapt technology to lower not only the unit cost, but also the unit price. By lowering unit price, firms can undersell their rivals in the markets for their final products, offsetting lower profitability with larger market shares. Collectively, the implication is that there is a natural tendency for the (average) rate of profit to fall, and the center of gravity responds to that dynamic. In these contexts, tendential gravitation or regulation between spheres of capital investment and a falling profit rate render investment activities as inherently unstable. Further, the dynamics of a falling profit rate originate in the activities of the nonfinancial or real sectors, the sectors that produce goods and services. This is a natural result of the investment process, which is overlooked by the dominant economics theory and credit risk models that we’ve seen so far. Regulating capitals act as benchmarks for the productive conditions, setting the pace for their respective industries. Firms with conditions

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of production that are not as strong, in terms of cost structure (and ability to generate profit), are less able to compete in the marketplace and will find their market share eroding unless the conditions are improved. Firms with productive conditions that are stronger than the regulating capital are better able to compete, obtain profit, and expand. The regulating capital can be cast at the level of industry or for the overall economy. Industries that have a relatively large amount of older, less efficient capital will have average profit rates that are less than the regulating rates, whereas industries that have relatively large amount of new, more efficient capital will have average profit rates greater than the regulating rate for their industries (Botwinick 1993: 153; Shaikh 2008). Default risk within the FIH is identified though Minsky’s exposition of lender’s risk and borrower’s risk. The liabilities emitted by a firm entail a strong relationship to the debt service on bonds for corporate debt, or loans for noncorporates. Debt service involves an interest rate with an adjustment for default risk; the maturity and type of instrument determine the manner in which principal payments are remitted. Minsky refers to this as “lender’s risk” (Minsky 1975: 110). The structure of debt contracts explicitly recognize the aspects of lender’s risk as a way to protect lenders. The protection is evident in the way that debt instruments are structured. For instance, lender’s risk is reduced if borrowers are made to face certain, contractual obligations to remit debt service. Borrower’s risk, on the other hand, is the uncertainty that firms face if returns do not come in as expected, in addition to the fall in the capitalization rate as investment in a new asset(s) increases. (See appendix.) Minsky defines default risk with the realm of lender’s risk; there are two types of default: voluntary (a firm chooses not to honor its debt service commitments) and involuntary (due to disappointment of expectations about margin of security) (Minsky 1975: 106). A firm’s margin of security consists of the cash and financial-asset buffers that it holds to protect itself from the vicissitudes of the market (Minsky 1975: 107–8). Involuntary default risk meets with (market) liquidity risk, or the salability of firm’s assets, when a firm’s buffers decrease. Confining default risk to lender’s risk suggests that default risk enters in a rather narrow way in Minsky’s explanation of a firm’s investment and financing decisions. Default risk is the lender’s evaluation of a firm’s margin of security in relation to debt service commitments. There are a couple of implications to draw. First, the management of default risk is primarily the concern of lenders. In the case of voluntary default, lenders need to be mindful of persuading borrowers to honor

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their contractual commitments. With respect to involuntary default, lenders must monitor margins of safety, advising firms how to manage them should they fall too thin. As such, Minsky’s construction is similar to the mainstream’s orientation in that lender’s risk only indirectly captures, or is peripheral to, the performance of a firm’s productive activities. To enable default risk to capture more directly the performance of a firm’s productive activities, the concept of liquidity needs to be broadened to reflect changes in productive activity. In one sense, liquidity can be understood as the ability of an asset to be converted into cash (market liquidity). Liquidity can also be viewed more broadly, in an accounting sense, as a range of assets of various degrees of (market) liquidity supplemented by cash and cash inflows from operations (such as accounts receivable) and inventories; accounts receivable include trade credits. This view is referred to as accounting liquidity and often represented by the current ratio (current assets/current liabilities) or net working capital; if inventories and other less liquid assets are removed from current assets, one has what is known as the quick ratio. Minsky’s FIH is cast using accounting liquidity, as there is recognition of the importance of cash inflows from investments. Again, the lender’s risk pertains to the attainment of cash to service a debt and that assessment is made (by lenders) with respect to the margin of security. There is a bit of whim in the direction of the margin of security, however, as Minsky suggests that a firm’s cash inflows are somewhat unpredictable (“Vary in their assuredness,” Minsky 1975: 70). It is well-understood, however, that cash flows are cyclical and that there is a natural tendency for rates of return on (sustained) productive investment to fall over time. The question is how to capture that influence—enter the regulating capital and the incremental rate of return. To do this, one could consider orienting liquidity risk in terms of anticipated versus actual changes in the margin of safety. Liquidity risk can be defined as the risk that the actual strength and structure of cash inflows (which result from sales, accounts receivable, and income from assets) and new borrowing fall short of anticipated cash inflows, putting pressure on firms to sell assets to make up the difference. The path of the incremental rate can provide signals as to the direction of these flows, particularly the inflows on new investment. As such, liquidity risk can be interpreted as having two parts—an internal component that comes from sale of goods and accounts receivables and an external component that pertains to the acquisition of external funds. Internal liquidity is related to the productive activities, whereas

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external liquidity is related to the activities of financial intermediaries or the financial sector. Default risk, still, rests on an assessment of the liquidity risk (risk of adverse changes in margin of security) in relation to payment commitments, but it now reflects an enhanced integration between the dynamics of both the real and financial sectors, starting at the level of the firm. As it turns out, discussions of ratio theory found in early accounting research on default risk suggest something similar—it is not enough to use ratios built on elements of cash flow statements to assess default risk. Ratios are concrete expressions influenced by the dynamics of cash inflow of operations and payment obligations (see, for instance, Beaver 1966: 79–80). Monitoring for changes in net worth and cash flows, and profit, are a good start, but once persistent changes are detected in these elements, it may be too late to do much to thwart the process. There needs to be a theory or explanation as to what drives changes in the elements of cash flow statements. It is interesting to note that, according to mainstream macroeconomics, if instability emanates from the financial sector, there is a strong focus on conditions that influence external liquidity risk. However, if instability comes from a shock to the real sector, impacting productivity of labor, there is little, if any, analysis of internal liquidity risk. Internal liquidity risk requires an analysis of the conditions of sale of output and the conditions of producing output. If some form of Say’s law is presumed to hold, the conditions of sale are ensured; however, this would imply an inherent contradiction in that Say’s law is presumed to hold during periods of instability. Thus, mainstream approaches to economics and finance do not fully capture the dynamics of internal financing or funding of investment. The orthodoxy emphasizes external liquidity risk to the detriment of internal liquidity risk. Furthermore, interest rates, and, hence, interest rate risk are strongly influenced by central banks. To promote transparency, interest rate risk is signaled by central bank statements. With clear signals about interest rate risk, default risk becomes focused toward the business climate in which firms sell their goods and services. If a firm provides output to markets when demand is strong, its supply will be realized or sold—and cash inflows will be stable and likely to be growing. Default risk is relatively low compared to situations where the business climate is weak, and cash inflows are not as strong. But there is little guidance from the mainstream as to how to anticipate changes in the business climate.17 Minsky saw this long ago. New Keynesian credit theory ultimately rests on a variation of general equilibrium theory in combination with

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rational expectations and recognition of asymmetric information. Using the information at hand, lenders are said to be rational if they make the best assessment and decisions they can (Knoop 2010: 117). It is rational, in other words, for lenders to restrict credit during periods of heightened uncertainty over financial fundamentals. However, it is not rational expectation that is necessary for this theory to be operationalized, but the deterministic treatment of time. The deterministic treatment of time views “the passage of time as the unfolding of a lawful progression of causally connected events” where the future and the past are symmetrical in the sense that there is a definite future and a definite past, implying that the quality of uncertainty about the future is no different from the quality of uncertainty about the past (Foley 2001). In this context, economic processes are reversible. The mainstream’s use of a deterministic treatment of time means that probability can measured. General equilibrium frameworks treat time deterministically in order to use probability distributions as a way to capture or measure uncertainty. (Lawson 1988; Choi 1993; Sent 1998). “What is wrong with rational expectations is not the assumption of expectations on the basis of ‘a theory,’ but the fact that the theory used to form ‘expectations’ is always the Walrasian equilibrium theory” (Minsky, 1984: 455). General equilibrium represents an ideal world characterized by inherent balance. New Keynesian economics is limited to incorporate Minsky’s FIH, as the FIH is cast using a dialectical treatment of time. According to the dialectical view, time progresses in a way such that the past is definite, but the future is indefinite. This is due to qualitatively new phenomenon emerging in response to the contradictions created by existing structures. Since the future comes to be as the present unfolds, the quality of uncertainty about the future is different from the quality of uncertainty about the past, where each regime has its own statistical order. Economic processes are irreversible and path dependent. Both lenders and borrowers face fundamental uncertainty that cannot be modeled by probability distributions. Moreover, viewing investment as a destabilizing mechanism broadens the identification of sources of instability and how they reverberate through the nonfinancial sector. The point is that if investment is a destabilizing activity, the current methods of credit risk assessment are liable to be overlooking important dynamics associated with productive activities. If those dynamics could be captured quantitatively, they could anticipate problems in margins of security. What is the evidence on the volatility of investment?

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Which Vision? To evaluate the volatility of (private) investment, a simple indicator was created using percentage changes in gross capital formation (data sourced from the World Bank, World Development Indicators). An average of annual percentage changes from 1971 to the most recent observation (typically, 2013) was calculated for each of the countries selected. That average was subtracted from each annual observation to obtain a difference, and, finally, that difference was squared. The countries evaluated were: Australia, France, Germany, Japan, Korea (South), New Zealand, the United Kingdom, and the United States. The countries were selected to include representation from small and open economies, economies within the Oceania and Asian regions, the European Union, and North America. They are all considered developed countries (as per the United Nations Human Development Index, 2014). Figures 3.1, 3.2, and 3.3 illustrate the indicators. The average, annual percentage change in gross capital was the lowest for France and Germany. France’s capital formation increased at an annual rate of 1.9 percent, whereas Germany increased a meager 1.3 percent. Korea was the strongest at 9.2 percent; but consideration needs to be given to the influence of investment during its period of transition from developing to developed status. Australia experienced 4.7 percent per annum, and New Zealand was close behind at 3.8 percent. United Kingdom and United States were in the mid 700 600 500 400 300 200 100

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Figure 3.1 Volatility indicators for selected countries, based upon % change in gross capital formation Source: World Development Indicators (World Bank) and author’s calculations

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19 71 19 73 19 75 19 77 19 79 19 81 19 83 19 85 19 87 19 89 19 91 19 93 19 95 19 97 19 99 20 01 20 03 20 05 20 07 20 09 20 11 20 13

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Figure 3.2 Volatility indicators for Japan and Korea, based upon % change in gross capital formation Source: World Development Indicators (World Bank) and author’s calculations 1400 1200 1000 800 600 400 200

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Figure 3.3 Volatility indicators for Australia, New Zealand and United Kingdom, based upon % change in gross capital formation Source: World Development Indicators (World Bank) and author’s calculations

range, United Kingdom experienced a rate of increase of 2.5 percent and it was 3.4 percent for the United States. Japan performed similarly to France and Germany with an annual rate of increase of 1.7 percent. The volatility indicator reveals that the economies with the lowest rate of increase in capital formation were also the most stable. Korea, for instance, had both the greatest averages in the annual increase in capital formation and volatility. The next highest volatility was experienced by New Zealand, which not surprising for a small, open economy. The United Kingdom and the United States had midrange growth rate of capital formation, but had some of the highest volatilities in the group.

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35.0 30.0 25.0 20.0 15.0 10.0 5.0

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How has investment translated into changes in GDP/capita? Average annual percentage changes in GDP/capita were calculated using data from the World Bank (World Development Indicators). All countries, with the exception of Japan, experienced average annual increases in their GDP/capita somewhere between 1.4 and1.9 percent. Japan’s average annual growth was 2.2 percent. However, there were differences in the overall percentage increase between 1990 and 2013. New Zealand had the lowest increase, at 73.1 percent, with France not far behind at 89.6 percent. The best performers were Korea at 1021.2 percent, Japan at 138.9 percent, the United Kingdom at 121.9 percent, Germany at 120 percent, the United States at 112.5 percent, and Australia at 106.0 percent. Of all the developed economies, Germany and Japan were the best at protecting their manufacturing industries (Germany more so than Japan). See Figure 3.4. Even with this simple construction, the instability of investment is evident. If investment is volatile, being influenced by pro-cyclical behavior in profit, it is natural to expect that firms’ margins of security will also change, leading to varying assessments of their risk of over cycles. This is not attributed to the appearance of shocks or market imperfections but rather to the dynamics of capital accumulation. Recent research on profit’s behavior over a cycle suggests its pro-cyclicality. Tapia (2012) analyzes quarterly data on corporate profits for the United States. He finds that growth in profit declines before the onset of recessions, as identified by the National Bureau of Economic Research (NBER). It began to decline, for instance, from the third

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quarter of 2006, well before instability began to emerge in 2007. The result stands regardless of whether taxes are included or not. Sherman and Sherman (2008) provide additional evidence of cyclicality that, moreover, not only validates the work of Mitchell (1951, 1913) but also finds that profit, not savings from personal income, is a key determinant of corporate investment. The pro-cyclical behavior of profit is been noted for quite some time. If investment is volatile, acting as a catalyst to destabilizing economies through firms’ quest for profit, what does this imply for methods of assessing credit risk? In particular, what does this mean for credit ratings and the malfunctions they appear to exhibit?

Implications for Assessing Default Risk and Ratings Again, there are three broad methods of assessing credit or default risk: scoring (derived from expert systems), traditional statistics (approach), and modern (finance) approach. Credit scoring is an empirical method that combines data about a firm’s characteristics, such as size, profitability, liquidity, leverage, and inventories and maps, that result into default probabilities. Credit scoring is thought to be an improvement on the expert system in that the empirical orientation eliminates bias stemming from human judgment. Judgment can be influenced by personal and social experience. By systematizing evaluations, the bias introduced by subjective judgment is reduced. However, it is reduced but not totally eliminated. Scoring is highly dependent on the selections of indicators as identified by an analyst. That selection is subjective, influenced by the analyst’s experience, training, rules of thumb (perhaps set by his/her firm), and supplementary research. Again, there are indicators that seem to consistently signal changes in default risk. These include, again, working capital/total assets (WC/TA), the current ratio, net income to total assets, cash flow/total debt, earnings before interest and taxes/total assets (EBIT/TA), and sales/total assets (S/TA). Each of these components is capturing the (financial) results of operations (sale of produced goods and services) through some aspect of current assets. Recall that current assets consist of cash, inventories, work in progress, marketable securities, and accounts receivable. Information on current assets is released quarterly or annually. Information about changes in cash inflows from operations will be incorporated into assessments of creditworthiness with a lag. None of the indicators

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above directly monitor the conditions of production as reflected in the rate of return on investment. These indicators, and the assessments built upon them, will be sluggish to flag changes in creditworthiness. Changes in the return on new investments, on the other hand, which also reflect short-term imbalances in supply and demand, will signal changes in the strength of cash inflows. Moreover, there is always an issue about reducing complex processes to signal number or letter classification. This reduction is akin to the concerns about index construction. Elements are combined through a series of weights, where the weights try to capture the strength of influence of each of the elements. Given the nature of uncertainty, it is unlikely that trying to reduce complex, dialectical dynamics into a single figure is going to yield robust approximations of a firm’s risk of default. Single figures cannot completely capture complex processes such as investment and its dependence on profit. Moreover, some elements are bound to signal earlier than others, which dilutes the signaling ability of the score or index. In other words, as a firm’s position is constantly changing, scores will always be lagging changes in its position. Finally, the credit scoring implicitly assumes a deterministic treatment of time in the sense that “the future is like the past” (Anderson 2007: 23). As such, they are backward looking and have trouble anticipating strong events. Traditional (statistics) approaches. Something similar can be said for the traditional (statistics) approaches. The use of more quantitative approaches has the advantage that they reduce the subjective elements and render the results more uniform, comparable, and testable. In a sense, applying quantitative techniques to the information and (accounting) data contained in a credit score enables the content of scorecards to be compared. Again, the lagged nature of the release of this data suggests that the quantitative methods will reflect changes in creditworthiness in a sluggish way. Even if analysts have access to private, nonpublic financial data for a firm, that data (accounting data) will not likely reflect changes in productive conditions, which forms the basis for operational results, in a timely way. There needs to be an understanding of the processes influencing the behavior of the figures in accounting statements in order to understand why the figures in those statements change the way they do. The deterministic treatment of time is employed in order to use more quantitative methods such as determinant analysis, logit, and probit; they implicitly assume stable probability distributions. If the past and the future are not the same, that is, if time is dialectical in

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nature and economic processes are, indeed, complex, then methods that implicitly assume stability of economic processes will yield inaccurate results. Modern approaches. Modern approaches to creditworthiness would seem to provide a solution to the sluggishness caused by the use of accounting data, as they rely on market or financial data and theory. Modern approaches seek to indirectly glean information about firms’ financial conditions or “fundamentals” through the information contained in prices of financial assets—that is, from prices of existing assets that are traded in secondary financial markets. An optiontheoretic model suggests that a firm will default when its market value falls below some threshold. The market value of a firm’s equity can be viewed as call option on the firm’s assets, where the firm’s market value at a future point in time is estimated using “a probability distribution characterized by its expected value and standard deviation (volatility)” (Altman 2002: 162–63). An advantage of market data– based credit risk methods are that they are able to circumvent the lack of private information on a firm. Shaikh (2010) and Soros (1994) remind us, however, that the structure of modern finance presumes the independence between the fundamentals, which defines “the gravitational value” associated with a state of balance, with expected and actual outcomes (Shaikh 2010: 4). This independence underlies the notion of equilibrium as a state of balance or rest. Capital mobility and price flexibility are mechanisms to promote equilibrium processes. That is, capital mobility maintains a state of balance. While the Black-Scholes recognizes the importance of turbulence (via profit seeking, arbitrage in the case of securities trading), its concept of equilibrium is static (Langohr and Langohr 2008: 274). The independence of fundamentals from expected and actual outcomes is necessary to support the efficient market hypothesis and the rational expectations. There are two conceptions of equilibrium. One is static and the other is dynamic. One conception is essentially static in the sense that there exists an equilibrium or market-clearing set of prices around which a capitalist market economy gravitates. In this conception, “expected and actual outcomes coincide with, or at least randomly fluctuate around, the equilibrium outcome” (Shaikh 2010: 3). If the data of the system changes, the equilibrium position changes as selfseeking agents shift their positions in response. Competition in this orientation is envisioned as a process that allocates resources to optimal uses (Mueller 1990: 1–3). The dynamic conception of equilibrium is one where the economy fluctuates around a moving center of gravity.

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This concept is what’s known as “equilibration-as-turbulent-regulation.” Here, competition is envisioned as a process that supports the transformation of resources into goods and services, including capital goods that embody new productive techniques. Soros (1994) and Shaikh (2010) have proposed rejecting the assumption that fundamentals are independent of variations in expected and actual outcomes. Soros put forth a theory of reflexivity in which he rejects the idea that fundamentals are independent of changes in outcomes (expected and actual). Shaikh (2010) formalizes Soros’s theses: expectations influence actual prices; actual prices are influenced by fundamentals, and fundamental and actual prices influence expectations. The implication is that prices do not deviate from fundamental values in a random manner. As such, “the future is not a stochastic reflection of the past, so that the overall system is nonergodic . . . . The extended of extended disequilibrium processes invalidates the efficient market hypothesis, and the dependence of fundamentals on actual outcomes invalidates the notion of rational expectations” (Soros 1994: 58, 216–22, as cited in Shaikh 2010: 4).

Expectations induce extended disequilibrium cycles, which imply that gravitational centers are path dependent as fundamentals are influenced by expectations. As such, “Financial markets cannot possibly discount the future correctly because they do not merely discount the future; they help to shape it” (Soros as cited in Shaikh 2010: 7). The assumptions that make modern finance tractable, that is, a constant discount rate, constant dividend growth rate over time, and slow changing required rates of return, compromise the models of empirical performance, in particular the DCF models. Shaikh (1997) goes further by demonstrating that it is the fundamentals of a firm as proxied by the incremental rate of return on new investment—in productive activities—which underlie its stock market rate of return. This contributes to the contention that the vision of a stable economy, in which investment acts a stabilizing activity, is unsupported in the context of true uncertainty and complex processes. The critiques offered by Shaikh and Soros suggest that the empirical performance of market-based ratings is limited. Again, options theory attaches itself to equilibrium conception through the assumption of equalization of rates of return, reflecting the immediate incorporation of information into prices. Without this concept of rational expectations and efficient markets hypothesis, option theory is just as limited as the traditional approach to investment decisions and credit risk. At

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best, options theory can provide indicators that are nearly coincident with changes in economic dynamics. Moreover, the reliance on probability distributions is indicative of deterministic treatment of time. It jettisons the complex processes and the influences attributed to path dependency. Requirements of a stable distribution supports a vision of a system in balance. Its structure relies on the independence of fundamentals as they set a firm’s value of its assets and liabilities and on the independence of the underlying fundamentals from the estimate of the firms’ future market value. Market prices are presumed to fully and accurately incorporate information about a firm. Further, the actual value supposedly moves within the confines of a probability distribution. The presence of interdependences implies that the calculation of the distance to default would not only be inaccurate, but would also explain observations that structural and reduced-form models do not escape the influence of cycles, and that their results reflect cyclical effects on the probability of default (see, for instance, Allen and Saunders 2002). Ratings. In effect, the methods of rating agencies help to fill out the context of empirical estimates of credit or default risk. They place the assessment of (financial) fundamentals of firms relative to the performances of industries in which they operate and the overall health of the economy. A key focus is a firm’s health in terms of product demand as evidenced by sales growth, market position (signal of control over price), perceived quality of products, and associated services (customer support and delivery). This information is best placed with the context of its industry(ies). An industry is examined for its state of development (e.g., new, mature, or declining). The state of the industry will give an indication of the strength of demand for firm’s products (i.e., product saturation) both at present and in the future. The industry’s structure, trends in new products, bottlenecks, and new markets are analyzed to fine-tune the understanding of the industry’s state. The firm’s market position or share within an industry provides insights into the firm’s market penetration. The industry is influenced by imbalances in the economy. Imbalances are thought to be the result of government’s stance and policies to support business development through legal structure, infrastructure development, regulation to support market flexibility (especially labor market flexibility), and a financial system that provides innovative funding structures. Rating agencies also account for financial policies and management of firms, and they provide space to allow for analysis of factors that are unique to particular firms, such as the reliance on international customers and suppliers.

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That said, the above criticisms about empirical, quantitative methods also carry into the empirical, quantitative methods of the rating agencies as they employ the three broad approaches to varying degrees. There are some issues that the activities of rating agencies bring to the fore. For instance, the argument that ratings cannot be tested for their predictability as they are interpreted in a relative manner, not an absolute one (Fitch 2014c: 9). That said, there are indicators that reflect predictions in the trends of certain variables, such as GDP and interest rates. Implicitly, ratings do carry elements of a predictive nature. These criteria could be checked for accuracy as part of due diligence, but, again, the degree of effort varies according to economic conditions. Another issue is that the intensity of due diligence is dependent on sudden changes in macroeconomic and industry conditions. The SEC found that the rating agencies conduct due diligence less frequently in stable economic environments than when the environments are, or become, unstable. It comprises public interest to vary the efforts to check quality. Further, due diligence is conducted internally and there is bound to be some element of conflict of interest if quality control is not supported by external assessments (such as a PCRA). This will be discussed more in chapter 6. An aspect that needs to be addressed is weighting of criteria. Although the criteria may not change, the weights applied to the criteria, more often than not, change with variations in macroeconomic and industrial climates. This can explain some of the pro-cyclicality of ratings that are supposed to be oriented toward rating throughthe-cycle. If economic conditions of a cycle are strong and persistent enough, ratings will undoubtedly change as staff is obliged to change the weights. Furthermore, updates in the criteria, suggest that rating agencies’ benchmarks ratios will vary across industries and over time. A key point that is that the methods do not fully capture and monitor activities of production. They may assess and forecast trends in macroeconomy, industry, and firms’ cash flows, but without a clearer link to the processes of production, which underlie cash inflows, and, in particular, an understanding of the complex relationship between investment and profitability, those forecasts will be off. From an alternative, heterodox perspective, the contradictory behavior of ratings—the sluggishness and pro-cyclicality of rating changes—can be traced to weak monitoring of production processes. They are sluggish because accounting data can only reflect changes in productive conditions, such as the rate of return on new investment, with a lag.

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Moreover, weights used in rating methods are adjusted when changes in economic conditions are persistent enough to do so. The traditional and modern approaches to investment and financing decisions and the evaluation of credit risk rely on assumptions that make them tractable yet, at the same time, weaken their ability to detect dynamics accurately. The broad scope employed by rating agencies to evaluate the contexts in which financial fundamentals evolve suggests that they do so in order to compensate for lack of guidance about the behavior of investment activity, particularly in nonfinancial sectors. If investment activities are destabilizing, then models of assessors are inadequate for anticipating changes in default risk; at best, they are coincident indicators of risk. This holds true for both the rating agencies and for other assessors, such as the in-house assessors of corporations, banks, financial institutions, and other investors.

Summary Weakness in the quality of default risk assessments, particularly those by rating agencies, is often attributed to issues associated to rating through-the-cycle (sluggishness), pro-cyclicality, market structure and competition, and lack of transparency (which fails to reduce asymmetric information). Whatever the approach, there is heavy emphasis on assessing a firm’s financial fundamentals, that is, the position of a firm as indicated by strength of its financial statements or proxies of (market data). The investment and financing decisions of firms are explored more deeply to understand whether there are aspects that assessors and their methods overlook. There are two contexts in which to explore these decisions, one in which the economy is inherently stable, where investment is an activity that is envisioned as part of the stabilizing mechanism. This is the orientation of mainstream economics. From this perspective, rising default risk and potential instability emanate from shocks to the economy, which weaken firms’ financial fundamentals. Assessors evaluate the changes in net worth, net working capital, and profit, for instance, through the use of financial ratios. Lenders can use that information on firms’ financial fundamentals to cross-check their own assessments and make decisions as to whether to restrict credit or not. The other context views the economy as inherently stable and investment as an activity that destabilizes it. As per Minsky’s FIH, the investment and financing decisions of firms collectively lead to cycles through their use of debt financing. Firms’ positions evolve endogenously over time, both individually and collectively. The

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instability in the rates of return implies instability in investment and its returns. The evolution of the influence of investment upon economic activity underlies the neat summaries of financial ratios derived from firms’ financial statements and the overall health of the economy. Moreover, firms’ performances, in turn, underlie the performance of assets of financial investors. Lenders restrict credit when they observe persistent (worsening) changes in firms’ financial fundamentals. This is not to say that there are no similarities between the two visions. There are. For instance, they both agree that the choices that each firm makes regarding new investment and how that investment is financed will impact its cash inflows and outflows and, in turn, its ability to honor its payment commitments on the debt that is has emitted. And, that a default occurs when a debt service payment is not received on time or if a firm violates a covenant associated with the debt it emitted. Finally, the business climate of the macroeconomy and the state of development of the industry in which firms function will also have a bearing on firms’ cash flows and their ability to honor payment obligations. The contexts in which these elements are analyzed imply different ways of looking at creditworthiness. Evidence on selected countries was presented, which suggested that investment is an inherently unstable activity. If true, what does this imply for current approaches to evaluating the likelihood of default? The differences suggest that quality could be compromised by viewing investment and financing decisions from the context of an inherently stable economy, where investment is cast as a stabilizing activity. This context ultimately leads to an emphasis on the lenders’ perspective of default risk—evaluation of financial statements and changes to them. Those statements are envisioned to change in random ways according to the vicissitudes of the markets. Moreover, investment projects available to a firm are believed to have rates of return that can be approximated by probability distribution, which the firm knows but its lender does not. A lender may not have an accurate picture of the risk associated with a project for which a firm seeks funding. Adverse selection and moral hazard are thought to influence that riskiness (Wolfson 1996: 445). The credit rating agencies attempt to provide additional information surrounding firms’ performance. Information about performance is processed and released to the public through revisions, warnings, and outlooks. Private investors may also monitor public information in the form of financial statements, profit warnings, and business conditions. Rating agencies may have better access to interim, firm-level

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data on financial fundamentals, but without a systematic analysis of the behavior of productive investments, the results of creditworthiness will not be as accurate as they could be. In other words, additional information on financial fundamentals is great, but it needs to be supplemented with analysis, which yields information on productive fundamentals. What the heterodox vision does is to provide justification for looking more deeply at the dynamics that are reflected in the figures on the financial statements. That is, it enables exploration of how processes of production are influencing the results of those figures. The need for examination of these processes was recognized by early proponents of scoring techniques (see, for instance, ratio theory as envisioned by Beaver 1966, 1968). Minsky, it turns out, provides a framework that can help explain those early observations. However, it needs to be updated to incorporate the influences of regulating capital and the incremental rates of return on new investments. Investment activity generates both a falling (average) profit rate, over the long term, and incremental rates of return that, in the shorter term, tend toward equality between industries but are ever-changing within industries. From a heterodox or nonmainstream perspective, sluggishness of updates of creditworthiness—rating changes, for instance—are due to the use of accounting variables in assessments without fully considering the processes underlying them. Without that, assessment will lag changes in economic conditions as it takes time to update an assessment after new statements are released. The sluggishness is exacerbated if opinions are reduced to a single figure. Pro-cyclicality emanates from the patterns produced by investment activities and their rates of return. Although transparency may be improved by reduction in asymmetric information, if information is incomplete because of an overly narrow focus on financial fundamentals, acquiring more data on financial fundamentals will not be enough. Without a robust theory there is not only an overreliance on data, but also “data has come to define credit quality” (Falkenstein 2002: 172). Overreliance on data then is explained by the lack of a better way to assess health of economies, industries, and firms. Additional data on financial fundamentals will not be able to compensate for information about the status of production conditions for the firm within the context of ever-changing conditions within industries and macroeconomic conditions. The irony is that in evaluating the probability of default along the lines of current thinking, debt dynamics have been rendered external to the assessment of creditworthiness. If the view that investment is destabilizing is correct, then focusing on firms’ financial fundamentals

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when assessing creditworthiness or risk of default, reflecting dynamics of production in an indirect way, will capture changes in productive conditions in a sluggish way. Accounting data from financial statements will be sluggish, reflecting the results of productive activities well after the results of those activities (sale of output and costs of inputs) have occurred. Market approaches to credit worthiness do not fare any better. The use of market data to create (implied) ratings rely on assumptions that permit the use of mathematical probabilities to create measures of absolute default risk. The assumptions reflect a vision of the inherent stability of an economy and the stabilizing influence of investment activities. For, as Shaikh and Soros have made clear, these approaches are modeled in a way that does not capture path dependency created by the feedback between actual values, expected values, and fundamentals. As we draw the implications for the rating industry of the methodological challenges posed above, we need to remind ourselves of the scope of the implications. While this chapter focuses on corporate nonfinancial creditworthiness, the challenges pertain to other issues and issuers as well. The methods employed there are similar although modified to emphasize or downplay criteria found here. The chapter provides the foundation for a new way to detect the health of an economic system and its industries (as developed in chapter 6). The method combines a Minskian accounting framework with the help of concepts of the regulating capital and the incremental rate of return.

Ap p en d i x

Minsky O n the D etermination of Investment and Its Financing

Minsky (1975) provides a graphical exposition of the determination of the level of investment by a representative firm and the mix of external and internal finance used to support it. There are two prices involved. The first is the supply price of investment (PI), which is initially presumed to be stable or constant. The second is the demand price of capital assets (PK), which is also presumed to be stable. The demand price of an asset is equal to the capitalized stream of expected returns (Qi, i = 1, . . . , n), generated by the asset; the associated capitalization factors are Ci (Minsky 1975: 101). For investment to take place, the demand price of the asset must be larger than the supply price of investment. Graphically, this is illustrated in a two-dimensional space in which investment is on the horizontal axis and the demand and supply prices are on the vertical axis; the demand price (PK) lies above the supply price (PI). The analysis begins by allowing these lines to be straight, as in Figure 3A.1. PK,PI PK

Lender’s risk Borrower’s risk PI Q´ internal funds

A I´

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Figure 3A.1 Minsky’s graphical determination of investment and finance

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If a firm were to finance an investment internally from cash inflows, the maximum level of investment possible, in period i, consists of the inflows in that period divided by the price of investment (Iiʹ = Qiʹ/PI). As noted in the figure, this relationship is represented as a hyperbola. What if the firm wants more investment? It can do so, but with a combination of internal and external investment. What’s the optimal split? It depends. Once the possibility of borrowing is introduced, lender’s and borrower’s risks emerge. These risks will influence the demand and supply prices in the following way. Borrower’s risk, the risk that returns may not come as expected, impacts the demand price of capital assets. Recall, this price is the capitalized stream of returns; if the stream weakens for some reason, the price falls. The price will begin to fall from the (maximum) level of investment that can internally be financed (from Iiʹ). Lender’s risk, on the other hand, will pressure the price of investment to increase. Rising leverage leads to higher capital costs as “the ratio of committed cash flow to total prospective cash flows rises” (Minsky 1975: 110), and it is reflected in the price of investment, and also rises after Iiʹ. Moreover, lender’s risk shows up in observable patterns of borrowing rates, “such as those that appear in the ‘ratings’ position of municipal and corporate debt” (ibid). (For ease of illustration, these effects are drawn as linear.) Minsky noted that were would be discontinuities at the points where the influence of these risks became felt. The influences of these risks lead the prices to adjust, as noted by their (respective) lines. The optimal levels of investment, internal and external finance are determined at the intersection of the adjusted PI (lender’s risk) and PK (borrower’s risk). The level of investment is I, where the proportion of internal finance is represented by I to A and the portion of external finance is represented by A to the intersection of the prices. This route to the determination of investment and financing, with the split between external and internal finance, clearly captures the interdependencies between investment and financing decisions and in a much more straightforward way than the orthodox method. As the subjective elements of risk change in response to the difference between actual and expected outcomes, so do the curves and the optimal ratio of external to internal finance. The incorporation of regulating capitals suggests that the curves have the potential to become steeper and exhibit greater volatility with changes in the profitability of new investment.

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Interested readers are referred to Nasica and Raybaut (2005), who provide a formal model that demonstrates the influence of institutional dynamics on Minsky’s FIH. They demonstrate that when fiscal policy is sensitive to changes in private investment, stabilization processes are efficient. If fiscal policy is insensitive, then economic instability is exacerbated.

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redit rating agencies perform an important service to capital markets by collecting and disseminating information about the (relative) credit quality of potential borrowers and risks associated with their debt instruments. They facilitate the creation of liquidity, an important feature of corporate and sovereign bond markets. Recent criticisms of the credit rating agencies have focused on their evaluations of asset-backed securities. The sovereign debt crisis (2008–2012) illustrates how the rating industry can influence financial market stability through changes to ratings on sovereign debt. Iceland was downgraded in 2008; Greece, Ireland, and Portugal in 2009; Spain and Italy in 2010 and 2011, respectively; and, the United States in 2011. In early 2012, Standard & Poor’s further downgraded the sovereign debt of Portugal, Italy, Spain, France, and Greece. Not all of these sovereigns exhibited weak fiscal positions prior to their downgrades, although most carried sizeable debt-to-GDP ratios. The pressure of propping up both flagging economies and/or banking sectors threw fiscal positions, strong or weak, of these governments into unhealthy territories, according to EMU guidelines, the rating agencies, and the IMF. Sovereign downgrades were also present in the Asian Financial crisis of 1997–1998. Before this crisis, the sovereign debt of the Asian countries involved carried strong, investment grade ratings, as they were perceived to have robust fiscal policies prior to the crises. As the crisis unfolded, sovereign ratings were downgraded as governments’ fiscal positions and sustainability of external debt deteriorated with the economic slowdown, currency devaluations, and rising interest rates. In both crisis episodes, the downgrades of ratings on sovereign debt restricted governments’ access to capital markets, rendering them more willing to consider and implement fiscal adjustments as part of their recovery strategies. The agencies, for better or worse,

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help reshape the fiscal positions of governments through the threat (perceived or not) of downgrade of sovereign debt. On the surface, the rating industry appears to play a contradictory role. On the one hand, it facilitates the functioning of capital markets that, in turn, supports corporate and public investment, growth, job creation, and living standards. On the other hand, downgrades of sovereign ratings act as a catalyst for weakening living standards, investment, and growth when governments are forced to trim expenditures and programs. This chapter explores the contradictory role that the rating industry appears to play with respect to sovereign debt. This chapter begins with the concept of sovereign creditworthiness—a government’s ability and willingness to service its debt service obligations—and how it relates to fiscal sustainability according to mainstream thinking. The predominant stance on fiscal sustainability is integrally related to the Ricardian equivalence, the idea that fiscal spending is ineffective when it can be anticipated. The next section provides an overview of the attempts to gauge or rate sovereign creditworthiness. Simple rules of thumb, which stem from the predominant orientation toward fiscal sustainability, are enhanced with more elaborate evaluations by the rating agencies and other assessors. Next, in light of the distinction between the inherent stability (or instability) of a market economy, the methodological underpinnings of Ricardian equivalence and fiscal sustainability are explored from a heterodox perspective. With this understanding, the opportunity arises to reorient fiscal sustainability based upon the inherent volatility of investment. From this perspective, what appears to be a contradiction is a natural outcome of the interaction between the opinions of the rating industry and the inherent instability of a capitalist market economy, an interaction that appears to be eroding social safety nets and standards of living. Moreover, if investment drives the instability of an economy, it appears, from the exposition of methods in the previous section, that the assessors of sovereign risk are not fully capturing the dynamics of productive activities of (nonfinancial) firms. From the perspective of investment as inherently destabilizing, its pro-cyclicality not only has the ability to influence the overall performance of an economy, income, and employment, but can also shape a government’s fiscal position over time. This suggests that fiscal unsustainability is not necessarily the result of poor government policy or shocks, but, rather, of weakening tax revenues caused by endogenous, cyclical dynamics emanating from the investment and financing decisions of firms. In other words, what may be missing from assessments

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of sovereign risk are the dynamics that drive changes in a government’s revenues and expenditures over time. The government’s position cannot be adequately captured with accounting-style financial statements because of its special position. A sovereign can print money (regardless of whether one wants to assume this feature away); it can tax; it is not a profit-seeking enterprise; its assets are difficult to value; and, it will survive after a default event. This being the case, the cash flow framework presented in the previous chapter cannot be applied to government. However, it can be applied, and is in chapter 6, to productive activities of the economy as a whole. By monitoring movements in an economy’s regulating capital and incremental rates of return, the framework can provide a way to detect country risk and signal when the economy is especially susceptible to a bout of instability that, in turn, poses problems for a government’s fiscal position. This suggests that policies that support the stabilization of investment will ultimately stabilize employment, income, and government’s tax revenues and expenditures. As such, there is more scope to examine how tax revenues can be managed to adjust a fiscal position, rather than the present emphasis on managing expenditures. By seeking ways to stabilize investment, a government will ultimately stabilize its own fiscal position and be able to strengthen it over time. The chapter closes by examining the recent behavior of tax revenues for selected countries.

Fiscal Sustainability, Sovereign Creditworthiness, and Ricardian Equivalence An evaluation of sovereign creditworthiness is an evaluation of a government’s ability and willingness to service its debt obligations. Sovereign risk is the risk that a sovereign fails to honor its debt obligations. Until recently, sovereign risk would have been confined to a country’s balance of payments problems—in other words, “the risk that a country cannot generate the earnings to keep up with debt service payments (credit risk) and/or that it does not have enough foreign exchange on hand to transmit earnings to foreign creditors (transfer or foreign exchange risk)” (Schroeder 2008: 504). Credit risk is dependent on the state of health of the economy and the incidence of negative shocks. Monitoring economic health includes key indicators such as GDP growth, inflation, employment, and investment as a share of GDP. Foreign exchange risk is the risk that money supply

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expands in an unexpected way in order to, perhaps, satisfy a budget shortfall or an imbalance in the current account. As such, evaluations of sovereign creditworthiness focus on external debt indicators, balance of payments positions, trade stance, and history of defaults. Willingness to pay emerges as a consideration when a country’s ability to pay becomes questionable. Increased taxes and expropriation are examples of outcomes associated with willingness to pay. The prevalence of flexible exchange rate regimes has somewhat weakened the distinction between foreign currency and local currency denominated debt. When needed, a local currency can be converted to foreign currency in the foreign exchange market. As such, the evaluation of sovereign risk becomes more focused on how a government can acquire funds for remittance, even more so when one considers the need to avoid monetization of the debt in order to protect (the current approaches to) monetary policy. Government’s revenues are mainly denominated in local currency. Tax revenues are the main source of funds for debt repayment. The strength of tax revenues depends on the strength of the economy, and the ability of a government to increase its revenue when needed (often referred to as economic management or effectiveness). Although balance of payment issues are still a consideration, sovereign risk has become increasingly focused on fiscal position, especially in relation to its stock of debt. An opinion about a government’s ability to service its debt is largely an opinion about the sustainability of its fiscal position, and, essentially, that boils down to the health of the economy and government’s ability to manage it. Early theoretical approaches to sovereign risk were, accordingly, related to balance of payments crises. A problem with a country’s balance of payments was thought to emanate from an external imbalance, which, in turn, was attributed to strong domestic absorption as a result of government overspending (Kregel 2004). Sovereign risk was evaluated according to a government’s ability to repay its debt, and the evaluation of that ability was approached from a solvency perspective. For instance, solvency depends upon constraints to tax revenue or upon the difficulty in transferring national assets to foreign lenders (Kharas 1984; Sachs 1984; and Simonsen 1985). Balance of trade identities and/or the fiscal balances were examined for problems that may indicate that a country’s ability to pay could be compromised. Structural weakness (stemming from poor policies or economic management) or an external event were often to blame if an economic slowdown exacerbated balance of payments imbalances. If crisis occurred, it was attributed to erroneous state policies and management. Early analyses

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did not give much of a role to endogenously determined cycles as a balance of payments problem was thought to originate from outside the system (“external factors”) or be the result of misguided policies (Shaikh 1978; Vernengo 2008). The idea that weak fundamentals, such as high budget deficits, are conducive to economic and financial instability, is still prevalent today. Fiscal sustainability is the idea that the servicing of government debt is manageable. That is, the stream of debt service payments can be made without difficulty. Current (mainstream) thinking on fiscal sustainability is conducted with a general equilibrium model with a government sector.1 In this structure, the government faces a budget constraint in the sense that its expenditures, transfer payments, and debt service must equal its revenue (tax receipts) plus new borrowing required to cover any revenue shortfalls. The (nominal) budget constraint has the following form:2 Tax Revenue + New Borrowing + Change in the Stock of Base Money = Government Expenditures + Transfer Payments + Debt Service If bonds have a maturity of one period, then the debt service consists of “the value at maturity of the stock of (nominal) government debt holdings held by the public” during the prior period (Wickens 2011: 93). New borrowing is the discounted value of bonds to be redeemed in the next period. The analysis begins with a question: What are the implications of a permanent increase in government expenditure? The assumption is typically made that there are no changes to the money supply, inflation, or interest rates. If a permanent increase in government expenditure is financed by raising taxes (a lump sum), then consumption, which is dependent on both income and wealth, will be unchanged. This is attributed to the increase in government expenditure being offset by a decline in consumption. Consumption declines because consumers anticipate higher or extra taxes in the future and restrict consumption in order to save to pay them; higher taxes are believed to negatively impact consumers’ wealth. The level of output will also be unchanged. Likewise, if the government were to increase transfer payments, financing this by raising taxes, it would not lead to any change in consumption or output. Would debt or bond financing fare better? Suppose the permanent increase in government expenditure is financed by issuing bonds. Here, not only does the debt have to be repaid but there are interest

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payments as well. As a result, the government’s budget constraint cannot be maintained. To maintain a permanent increase in government expenditure means that new debt has to be issued during each period to support it. As the discounted debt is not zero, it must grow without bound. In other words, it is not sustainable. If that increase in government expenditure is temporary—perhaps, needed to offset a shock—the debt stock will not change. The debt stock will not change because shocks are random. Sometimes shocks have a positive impact on the economy and sometimes they have a negative impact. Over the long term, the impacts of shocks are supposed to cancel out. Given this, there is expectation that at some point in the future, there will be another shock that causes the government to temporarily decrease its expenditure, and offset the temporary increase in expenditure. That is, the average value of the discounted debt is zero. In this context, debt finance is all right to use. By casting the budget constraint so that the variables are expressed relative to output (GDP), it is easier to isolate what is needed to achieve sustainability (from a mainstream perspective). The debt-toGDP ratio is of particular interest. A rising debt-to-GDP ratio suggests that there is something amiss with the fiscal budget, such as poor management or weak tax revenues. If the debt-to-GDP ratio is anticipated to grow without bound, investors will not want to hold the debt as monetization becomes a concern. It is thought that monetizing government’s debt risks a spike in inflation and would erode the value of assets already held by investors. Fiscal sustainability is a key concern for investor confidence when it comes to holding government securities, and if this approach is accurate, the evolution of the debt-to-GDP ratio is a key variable to monitor. The evolution of the debt-to-GDP ratio hinges on the relationship between the nominal rate of interest (i) and the growth rate of nominal output (g), which, in turn, can be decomposed into inflation and the growth rate of real output. A rule of thumb is that as long as the economy’s growth rate of nominal GDP (g) is greater than the nominal interest rate on the stock government debt (i), or g > i, the debt-to-GDP will be stable. It can vary, but if it starts to explode there are concerns of a default (Wickens 2011: 104–5). (See the IMF 2011: Annex III) for a neat overview of the history of thought of this relationship). Again, so long as the debt-to-GDP is finite, the government is fiscally sustainable and is able to maintain creditworthiness.3 After the level and trajectory of this ratio have been established, analysis of sustainability often proceeds to the relationship between the NPV of expected primary balances and the public debt stock (IMF 2013a,

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2011). A government is considered to be solvent if the present value of primary balances is greater than or equal to the public debt stock.4 Fiscal sustainability is related to Ricardian equivalence in the following way. Ricardian equivalence is the idea that the structure of financing is irrelevant for a government. That is, it makes no difference how a government finances expenditures, through debt (borrowing) or taxation, because either route yields the same result—changes to the financing of fiscal policy will not influence aggregate demand and, hence, the real economy.5 The key to the theorem lies in how consumers adjust their spending patterns to accommodate a change in fiscal policy If a representative consumer is infinitely lived, or there is a finite number of infinitely-lived consumers, then the issuance of public debt today will have no impact on the economy as the consumer will save more in order to offset the inevitable rise in tax to pay for debt.6 Evidence is mixed as to whether the Ricardian equivalence is present. Afonso and Rault (2007) and Afonso (2005) seem to find it present in the EU countries; a possible explanation is that the presence of Maastricht Treaty is influencing consumers’ perceptions of their relationship between consumption and the level of government debt. On the other hand, Rahman, Law, and Zaleha (2007), Choi and Holmes (2014), and Evans (1993) do not find evidence of this in Malaysia, the United States, and a host of other countries, including those in the EU. Again, in whatever framework it is cast, the thrust of Ricardian equivalence is that however a government finances new expenditures, the fiscal policy will be unable to influence aggregate demand and, hence, the real economy (Palley 2013). Under what conditions will the Ricardian equivalence theorem not hold? In the context of overlapping generations (OLG), debt will have an impact through the resulting redistribution of income between generations, which “affects intertemporal capital accumulation and consumption” (Tirole 1990: 116). In fact, in the context of OLG, public debt can act like an asset bubble because it is never repaid. Ricardian equivalence also falls apart if the finite number of infinitely lived consumers is heterogeneous, when consumers do not have a bequest motive, if markets are incomplete, and taxes are not lump-sum (Abel 2008, 1987). In these situations, public debt is said to affect the intertemporal path of the economy. Fiscal sustainability can also be violated through political decisions that intentionally worsen fiscal imbalances. For instance, Persson and Svensson (1989) suggest that deficits are attributed to strategic debt accumulation, where conservative policy makers run up the government debt to control spending in the medium or longer term. In a

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setting of limited information, this “new political economy focuses instead on the possibility that strategic interactions can cause the political process to produce outcomes that are known to be inefficient” (Romer 2006: 579–81). There is a growing support to supplement traditional analyses of fiscal sustainability with balance sheet analyses. There is an emphasis on evaluating the assets side of a government’s balance sheet in addition to the liabilities side (where traditional analysis is grounded). Balance sheet analysis supposedly gives researchers and assessors the ability to drill down into the sectors and industries that comprise the economy (see, for instance, IMF 2011, Levy-Yeyati and Sturzenegger 2007). It also provides a way to supplement the analysis of flow variables, as flow variables may change in ways that create imbalances in the stock variables. A change, such as a currency devaluation, can suddenly shift a government’s balance sheet from healthy to unhealthy. This seems to be a promising new way to analyze fiscal sustainability. As we saw in the context of a firm, however, the robustness of this approach depends on which elements of a government’s balance sheet are being evaluated. From this overview of fiscal sustainability, four basic elements emerge regarding the assessment of sovereign risk—fiscal position, health of and outlook for the economy (strength of revenues for the government), debt/GDP and management of the economy. These enter into assessments of sovereign creditworthiness in the following ways.

Assessing or Rating Sovereign Creditworthiness The recent thinking on sovereign default risk suggests an analysis begin with the relationship between interest rate, growth rate, debt stock, and debt-to-GDP ratio. In this section, we examine how the rating agencies analyze these variables in the context of social, political, and external features of an economy. These features provide additional information about how fiscal sustainability and, hence, a government’s creditworthiness change over time. The basic processes, categories of indicators and empirical/quantitative methods are also presented and analyzed. The empirical/quantitative methods are quite similar to those used at the level of a firm; however, the approach to assessing creditworthiness of a government differs from that of a firm because of a government’s unique characteristics and functions.

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The rating processes. The rating process for all agencies involves the gathering of publicly available information, interviewing the sovereign’s representatives for additional information (when the rating has been initiated by a sovereign),7 and pooling the information with the knowledge and expertise of the team of rating analysts. Information pertains to public finances, external position, economic health, and management. Information in these areas is often represented by data series or indicators that are supplemented by description or analyses of experts to deepen one’s understanding of the contexts from which the indicators are drawn. The contexts provide the opportunity to adjust or fine-tune the interpretation of the key indicators associated with fiscal sustainability for nuances associated with a country’s social, political, and institutional features. Sovereign ratings have strong qualitative aspects. Indicators are grouped according to how they align with “factors” that the agencies deem important for assessing sovereign risk. For instance, Standard and Poor’s has five factors: institutional and governance effectiveness and security risk, economic growth and structure, external liquidity and international investment position, fiscal performance and flexibility, and monetary flexibility—see Table 4.1. Moody’s has four: economic strength, institutional strength, fiscal strength, and susceptibility strength—see Table 4.2, and Fitch has four: structural features, public finances (public debt and financing), and external finance (balance of payments imbalances), and macroeconomic performance and prospects—see Table 4.3. The information is combined using an empirical or quantitative technique or combination of techniques, as discussed below. One will find that the indicators are often combined through a system of weights in order to yield a representative or composite indicator for the factors in which they are cast. The factors themselves can be weighted and combined to provide a preliminary ranking or score that represents a sovereign’s creditworthiness (or its sovereign risk). That preliminary ranking is discussed among a committee, typically comprised of the team of analysts who constructed the rating, and senior executives. The outcome is then passed to the issuer who has the right to comment on the result before it is released into the public realm. Indicators. As with firm indicators, the information sets used by the agencies to assess sovereign risk are similar although their analyses differ according to how the information is broken down and grouped (IMF 2010: 99 and Box 3.4). Broadly, the key areas of concern when evaluating sovereign creditworthiness are the state of the economy and

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Table 4.1 Standard and Poor’s sovereign factors and indicators Institutional and Governance Effectiveness and Security Risk

Sustainability of public finances Promotion of balanced economic growth Ability to respond to economic & political shocks Transparency, stability, and reliability of data and institutions, and payment culture Possible geopolitical risks (external security risk)

Economic Growth and Structure

Income levels (e.g., GDP/capita) Growth pattern and prospects (e.g., trend GDP/capita) Economic diversity and volatility Concentration of industry Exposure to natural elements

External Liquidity and International Investment Position

Presence of a sovereign’s currency in international transactions Country’s external liquidity (e.g. current account receipts, office reserves) External indebtedness (e.g., net external debt to current account receipts) Residents’ assets and liabilities relative to ROW

Fiscal Performance and Flexibility

Sustainability of a sovereign’s deficits and its debt burden (e.g. debt/GDP, size of liquid assets, ability to raise revenue or cut expenditure) Fiscal flexibility (debt burden assessment, interest cost) Long-term fiscal trends and vulnerabilities, Debt structure and funding access, and potential risks arising from contingent liabilities.

Monetary Flexibility

Monetary authority’s ability and credibility to implement monetary policy Control of dominant currency used in transactions, monetary base and money supply and domestic liquidity conditions Effectiveness of monetary policy, as evidenced by inflation (e.g., % change in CPI) The breadth and depth of the domestic financial system

Source: Standard & Poor’s (2014c)

economic structure, fiscal position, debt burden, institutional strength, and the effectiveness of government, the development of its financial system, and its external position. Data are sourced from the sovereign, national statistical offices, the International Monetary Fund (IMF), the

Table 4.2 Moody’s sovereign factors and indicators Economic Strength

Growth Average GDP growth, volatility of GDP growth, Competitive index Scale Nominal GDP National income GDP/capita Adjustment factors Diversification, credit boom

Institutional Strength

Institutional effectiveness World Bank indices for law, corruption control, and government effectiveness Policy credibility and effectiveness Inflation’s level and volatility Adjustment Factor Default history

Fiscal Strength

Debt burden Government debt relative to GDP and to revenues Debt affordability Government interest payments relative to GDP and to revenues Adjustment factors Debt trend Other government debt/GDP Foreign currency debt/total debt Public sector financial assets or sovereign wealth funds/GDP

Susceptibility Strength

Political Risk Domestic Geopolitical Government liquidity risk Fundamental metrics Market funding stress Banking Sector Risk Size Strength Funding vulnerabilities External Risk Vulnerability indicator Net international investment position/GDP (Current account balance plus FDI)/GDP

Source: Moody’s (2013)

Table 4.3 Fitch’s sovereign factors and indicators Structural Features and Political Risk

Flexibility in responding to shocks Openness to international capital flows & trade Ability to garner mechanisms (legal & institutional) for reallocating resources Political ability to influence tax receipts and expenditures Human capital development Business environment Governance Legitimacy of the Political Regime Corruption Presence of social and political tensions Voice and accountability Rule of law Strength of the banking sector (e.g., composite governance indicator, GDP/capita, share in world GDP, years since default, money supply)

Public Finances, General Government

Quality of management Level and trend of debt burden (sustainability) Composition of government debt (currency, maturity, and interest rate) Volatility of tax revenue Vulnerability to shocks Assessment of government solvency Debt capacity & degree of development of financial system Net foreign asset position (e.g., general government gross debt, budget balance, interest payments, public foreign current debt)

External Finances

Balance of payments position Foreign liabilities and assets (composition and stock) Ability to generate foreign exchange Trade and financial flows Size and financing of current account deficits Sustainability of external debt burden External balance sheet & its vulnerability to a liquidity shock Ability to borrow in local currency (e.g., reserve currency flexibility, commodity dependence, sovereign net foreign assets, external interest service, current account balance plus net foreign direct investment)

Macroeconomic Performance, Policies, and Prospects

Track record of macroeconomic stability Credibility of the policy framework History of inflation Presence of elements that impede savings and investment Exchange rate regime and monetary policies (e.g., real GDP growth volatility, consumer price inflation, real GDP growth)

Source: Fitch (2014d)

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Organization for Economic and Cooperation Development (OECD), the United Nations (UN), the Bank for International Settlements (BIS), the World Bank, and development banks. Analyses often begin with the elements associated with fiscal sustainability as identified from theory. The indicators include the budget position, borrowing requirements, interest rates, growth of the economy, debt-to-GDP ratio (and its trend), debt stock (size and structure with respect to maturity and currencies), and current fiscal position and its outlook. The analysis is then broadened to incorporate aspects of an economy that are thought to influence those elements and possibly impinge upon a sovereign’s creditworthiness. For instance, a government’s effectiveness in managing an economy will refine the analysis of its budget position and borrowing needs. Geopolitical risk is important for countries facing conflicts and political strife; these influences create volatility in economic growth and a government’s tax revenues and fiscal position. The strength in the rule of law, property rights, and control of corruption provides confidence to investors and the agencies that a country will honor its debt obligations. Strong divisions along the lines of race, religion, region, and income distribution all suggest limitations on a government’s ability to manage effectively. The breadth and depth of a country’s financial system is examined for its ability to encourage domestic savings as an alternative to international financing of investment. These elements are important for assessing fiscal sustainability and sovereign risk, but do not flow easily from a theory based upon a government’s budget constraint. Again, theory is very much a starting point for an assessment of sovereign risk. It is interesting to note that when analyzing economic health, analyses assess the economy’s size in terms of the level of output it produces, the recent growth rate of output, and the structure and development of the economy and identification of potential constraints on growth. Indicators used to assess the state of the economy typically include the level of GDP, rate of change in GDP, estimates of potential output, the output gap, growth patterns of sectors, GDP/capita (as an indicator of economic well-being), and the rates of unemployment and inflation, and so on. Why this is interesting is that one is pressed to find, at least in publicly available documents, analyses and indicators associated with the dynamics of investment and its profitability. As discussed in the previous chapter, these dynamics are integrally related to the macroeconomic performance of an economy. In turn, the strength of a macroeconomy helps determine the strength of government’s revenues, a source of “internal” liquidity, if you will, for a government. Indicators of government liquidity, more often than not,

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refer to “external” liquidity, the access to a pool of funds controlled by investors (domestic or international). Here, too, the dynamics of accumulation seem to be overlooked. Rating methods and quantitative techniques. The agencies employ mixed methods for rating sovereign debt. A mixed method typically combines a quantitative technique or set of techniques, which processes data in order to establish the basis of an opinion regarding creditworthiness, with a qualitative analysis. Qualitative analysis adds depth in understanding about the context from which the data were drawn; it can have empirical elements. One will find similarity between methods used for firms and those used for sovereigns. Scoring techniques (or scorecards) are used, as well as traditional (statistics) approaches and modern approaches based upon finance theory. Here, too, one finds a distinction between rating through-the-cycle and point-in-time rating. The differences between firm ratings and sovereign ratings lie in the scope of the assessment, the factors thought to influence risk and range of indicators. Scoring or scorecards begin by identifying the indicators thought to influence the risk of a sovereign default. As seen above, the rating agencies group the indicators into classes or factors, and often subfactors, in order to focus on certain aspects of sovereign default risk. The indicators are combined using designated weights, resulting in a score for the factor within which they are grouped. The factors themselves are combined with the use of weights and/or multidimensional grids, where each axis of a grid represents a range of strengths (low to high). For instance, Standard and Poor’s range of strength runs from 1 (strong) to 6 (weak). The combination of factors yields a preliminary ranking or rating of sovereign creditworthiness, which is then adjusted if need be. For instance, an upward adjustment (“uplift”) might be warranted for local currency sovereign debt, strengthening a sovereign rating by 0 to 2 notches, for instance in the case of Standard and Poor’s. Limited capital mobility might weaken the rating, a consideration for Moody’s, as is vulnerability to a shock. At times, one will find partial combinations of the factors in order to create profiles that represent areas of broad interest. For instance, Standard and Poor’s creates two profiles. The first profile is based upon the areas of institutional and governance effectiveness and the economy. The second one is based upon the monetary and external sectors and the fiscal position. The “institutional and governance effectiveness and economic” profile reflects economic performance according to income levels, the outlook for future growth, and whether growth has been balanced and has promoted diversity. It captures how well

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the sovereign government’s institutions and policies have promoted growth, bolstered sustainability of fiscal position, and responded to economic and financial shocks. The “flexibility and performance“ profile summarizes external aspects (such as external debt, use of currency in foreign exchange transactions, and liquidity), fiscal aspects (sustainability of the budget deficit and debt), and monetary aspects (whether the central bank has achieved its mandate, typically low inflation) (Standard and Poor’s 2014c). Standard and Poor’s and Moody’s employ scoring. Although Fitch weights its categories of indicators, it employs regression analysis. Through-the-cycle ratings are ratings with a long-term orientation, ignoring the short-term volatility that can occur and temporarily impact sovereign creditworthiness. The ratings change when something occurs that is expected to impact the performance of the sovereign and economy in the medium to long term. Changes to through-the-cycle ratings are expected to be slow as dynamics associated with trends are slowly evolving. This characteristic has appeal for investors such as pension funds, mutual funds, banks, insurance companies, and so on, who hold sovereign debt for the stability of guaranteed interest payments. Investors who are interested in short-term, capital gains are more interested in point-in-time ratings, ratings with an immediate or near-term focus. Using market data, point-in-time ratings allow for short-term volatility to immediately influence the evaluation of creditworthiness, enabling investors to change positions quickly. Quantitative methods comprise econometric and other statistical techniques that attempt to estimate, directly or indirectly, the probability that a country will experience a debt problem given some set of explanatory variables. These techniques are thought to be the least subjective and most systematic for assessing creditworthiness. As noted in chapter 3, these methods evolved from scoring techniques, which identified indicators that might have significance or power in explaining the likelihood of a sovereign default. Here, too, one often finds the use of discriminant analysis, linear probability analysis, logit, probit, principal components analysis, and ordinary least squares regression. (For brevity, the discussion in chapter 3 will not be repeated here). Fitch, for instance, employs a multiple regression model called Sovereign Rating Model or “SRM.” An ordinary least squares regression is performed with the following variables (Fitch 2014d Appendix 1)8: Macroeconomic performance: CPI, real GDP growth, real GDP growth volatility

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P u bl i c Cre di t R at i ng Ag e ncie s Public finances (general government): budget balance, gross debt, interest payments, public foreign currency debt External finances: commodity dependence, current account balance plus net FDI, gross sovereign debt, external interest service, official international reserves. Structural features: money supply, GDP per capita, composite governance indicator, reserve currency status, years since default.

Each factor or pillar is given a weight: macroeconomic performance (10.3%), structural features (47.4%), public finances (25.4%) and external finances (16.9%). “These weights are fully determined by the coefficients of the regression model, and there is no subjective judgment involved” (Fitch 2014d: 7); the weights are periodically reviewed for revision. The result of the model’s application is a score that is calibrated or mapped into its scale for long-term ratings. The rating can be adjusted by the sovereign rating committee. Fitch emphasizes that the model is just one tool in a toolkit containing qualitative and quantitative elements. It explicitly recognizes that influences on sovereign risk cannot be captured completely with a quantitative model. With respect to market-based approaches, common approaches include bond spreads and credit default swap (CDS) spreads as proxies for sovereign default risk. The market-based approaches seek to reflect the collective opinion of market participants. Bond spreads are the difference between bond yields and interest rate swaps. Sovereign risk is thought to rise when the difference increases. A CDS spread is the premium paid by the protection buyer (who buys a contract of insurance) to the seller of protection; the premium is quoted in basis points. (Note, the CDS is different from traditional insurance in that purchasers of CDSs do not need to own the underlying debt instrument). If the probability of default by a sovereign increases, the premium increases (i.e., the spread widens). These are market-based approaches that have been growing in use, and, until the GFC, their applications had focused on sovereigns in emerging economies. Since the crisis, their applications have increased to include sovereigns of advanced economies; the IMF attributes this to the increased “need to hedge counterparty risk” (IMF 2013: 60). The IMF also notes that “rating agencies have started to use SCDS (sovereign credit default swaps) spreads when they determine their own ratings, introducing reverse causality from SCDS spreads to ratings” (IMF 2013b: 63, footnote 16). The agencies have since extended the market-based approach by modifying the spreads to account for market noise or volatility associated

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with systemic risk (global and regional). For instance, Moody’s “CDS Implied Expected Default Frequency (EDF)” model incorporates systemic risk associated with holding a portfolio of sovereign debt instruments (Patel, Russell, and Sesum 2011). Fitch introduced its variation called CDS-implied rating (or CDS-IR), and also has created Sovereign CDS indices (Bubak and Garcia 2012). Fitch’s CDS-IR has two steps to construct: smoothing the CDS market spreads (to isolate the longterm component) and then mapping the spread level to credit rating. The variation by Standard and Poor’s is its S&P Capital IQ Sovereign, which employs a 5-year cumulative probability of default in combination with its proprietary credit data, the industry standard model, and recovery assumption; it, too, provides sovereign indices (S&P/ISDA CDS sovereign indices),9 (Standard and Poor’s 2014c). The idea of all three is basically the same. In a perfect world, the traditional credit rating and rating implied with a credit default swap would be the same. As the world is not perfect, particularly with respect to the symmetry of information, market-based and traditional ratings will not be the same. The differences in information can lead to differences in opinion. The market-based version of ratings (via CDS) is thought to have the ability to lead the ratings because it incorporates new information and market opinion much more quickly. Balance sheet approaches are being developed as a way to identify imbalances in stock variables as complementary to an analysis of flow variables (Traa and Carare 2007). The rationale is that stock variables reflect the buildup of imbalances as a result of behavior in the flow variables. Imbalances in stock variables, captured in a public sector balance sheet (i.e., government’s net worth), could be just as important as imbalances in the flow variables, as captured by the fiscal position. For instance, a sudden change in foreign exchange rates or loss in investor confidence can upset the debt service payment of foreign-currency denominated bonds and the debt burden. Potential vulnerabilities that threaten the strength of the public sector balance sheet include the performance of state-owned enterprises and assets, resource depletion, and environmental degradation. Toward this end, Traa and Carare suggest the universal implementation of public sector balance sheets, where the components are valued mainly at book value. Moreover, they recommend a shift toward a stochastic balance sheet, in which values contain some random component, hence endowing them with a dynamic element. Public balance sheets could also be integrated with other sectoral balance sheets—the integrated system would represent the economy and ease monitoring of spillover effects. The authors note Standard and Poor’s use of intertemporal

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accounting to assess fiscal sustainability. Information from sovereign balance sheets, where available, is being employed with the three broad methods of sovereign risk assessment. In particular, sovereign balance sheet information is being incorporated into the contingent claims or structural approach in order to permit the influence of the capital structure into the estimates of default (Gapen, Gray, Lim, and Xiao 2008). Not surprising, the agencies show a keen interest in the sustainability of the public debt burden for the evaluation of public finances. They acknowledge that what constitutes a sustainable debt burden will vary between countries and over time. The relationship between sovereign creditworthiness is not linearly dependent, for instance, on the debt-to-GDP ratio or debt service relative to government revenue. However, there will be a tendency for a sovereign to receive weak rating if it carries a large debt burden.

A Heterodox Critique of Ricardian Equivalence and Its Implications for Sustainability As was discussed in the last chapter, the differences in the vision of the inherent volatility of a market economy and the role that investment plays for stabilization carry strong implications for the explanatory power of both theory and methods of assessing creditworthiness (of firms). Can one say the same of sovereign creditworthiness? Again, the starting point of sovereign risk assessment is fiscal sustainability. An assessment of fiscal sustainability, according to orthodox thinking, is couched in terms of the relationship between the growth rate of an economy’s output of goods and services and the rate of interest. If the growth rate is greater than the interest rate, the debt-to-GDP ratio will be stable and fiscal sustainability is possible. As noted above, this result is related to Ricardian equivalence. The theorem of Ricardian equivalence is attributed to Buchanan (1958), who sought to reprise Ricardo’s comments on war finance. When considering how to finance public expenditure, Ricardo did not believe that there would be a difference between financing, say, a war, with debt or with increased taxes; however, the populace would likely prefer debt finance. This preference represents a form of fiscal illusion as the debt would have to be repaid eventually (Konzelmann 2014: 701). The theorem was recast by the Barro (1974) within the New classical paradigm of macroeconomics, demonstrating the ineffectiveness of fiscal policy on aggregate demand with the help of rational

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expectations. Recall, rational expectations is a form of expectations hypothesis in which agents form expectations or subjective valuations about a variable’s future value given publicly available information. That is, “expectations are formed ‘rationally’ in line with utility-maximizing behavior on the part of individual economic agents” (Snowden and Vane 2005: 226). A stronger version, which is what’s used in the New classical paradigm, is that the agent’s expectations of future values of variables coincide “with the true or objective mathematical conditional expectations of those variables” (ibid). Although the concept of rational expectations does not suggest that agents have perfect foresight, it does suggest that agents’ expectations are, on average, correct. That is, agents do not make systematic errors, as is the case with a hypothesis of adaptive expectations. The presence of systematic errors suggests that agents’ expectations adjust sluggishly to change; without systematic errors, expectations are not only immediately corrected, but their errors are also random. Errors in the formation of expectations are possible, as public information is not complete. Under rational expectation, errors will not be systematically wrong as agents learn from their errors and adjust fully. As such, the forecasting errors associated with rationally formed expectations will be random (with mean zero) without systematic bias, and will possess the lowest variability of other forms of forecasting (Snowden and Vane 2005: 227). Errors are not related to information set and will not affect the underlying fundamentals of the system. What this means is that when agents receive information that the government will finance new expenditures with tax or debt, they adjust in ways to generate savings to offset the expectation of increased taxes in the future. That behavior renders fiscal policy ineffective. Moreover, if government expenditure increases, it reduces private expenditure. Consumption falls as agents save to pay future taxes. Further, investment falls as interest rate rises when government and businesses compete for funding (Konzelmann 2014: 722). Rational expectations appear to be key to the demonstration. There have been a number of efforts to demonstrate why rational expectation do not hold, and, hence, permit fiscal policy to be effective.10 Broadly, rational expectations hypothesis does not hold in three circumstances: (1) when agents hold different understandings of how an economy works, (2) when information is costly and causes agents not to hold all available information, and (3) true uncertainty. PostKeynesians emphasize the latter. While rational expectations appear to be key to the demonstration, however, it needs to be recalled that it rests on a general equilibrium framework. This framework is cast,

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by design, to demonstrate that a capitalist market economy is inherently stable. Apparatus, such as budget constraints, are part of the theoretical structure that intends to demonstrate the existence of a balance or balanced growth path. In other words, the ideal world is the world of Arrow-Debreu in which equilibrium is cast as a state of rest. Irregularities that occur are quickly eliminated through the price mechanism, and changes to technology, preference, and resources (the data of this approach) stimulate changes to the allocation of resources and distribution of output in such a way that the welfare of society remains maximized. In this ideal world, investment is envisioned as an equilibrating mechanism. What if it isn’t? If equilibrating processes are both tendential and turbulent, as per the heterodox orientation, the capitalist system is inherently destabilizing. Competition leads to continual disparity between individuals’ rates of return on investment within industries, as firms invest to improve efficiencies in production and lower unit costs of output. Further, there is a tendency toward equalization of rates of return on investment between industries as capital shifts across spheres of investment. The continual movement capital between and within industries creates “a perpetual oscillation of market rate of profit around one another, i.e., the notion of a turbulent tendency for rates of profit to equalize across spheres of capital investment” (Shaikh 1997: 389). An implication is that a general equilibrium concept can only, at best, demonstrate the tendency toward balance. It can only model the dynamics associated with continual disparity as external to the system’s quest for balance. Firms’ desire for bigness and market power—seen as “imperfections” according to mainstream theory—are actually their attempts to stabilize their flows in what is an inherently unstable business environment. Market power is sought in order to stabilize prices and sales of output and factor inputs. Advertising and marketing are tools for stabilizing prices and sales. The firm’s need to expand, at the expense of its rivals, is a way to gain that market power, and, hence, stability of profit flows, the internal funds for investment, and margins of security. Rather than a market system seeking a point or path of balance for stability, the relatively stable periods for firms, in the context of inherent instability, are the upswings of business cycles for the possibility to sell or realize products is strong. The center of gravity and its path change with fundamentals, which, in turn, are endogenously changing in response to differences between actual and expected values of variables. If a firm, for instance, finds that the actual price of its output is greater than the price it

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expected (and, so, the actual rate of return on investment is higher than anticipated), the firm will likely increase capacity utilization and, if persistent enough, invest in new capacity. The collective finance and investment decisions of firms will change the fundamentals of the system in response to the market’s feedback to firms about differences between actual and expected values of variables, such as prices. Because fundamentals are always changing, there will always be discrepancies between actual and expected variables, except by fluke. This basis is a dramatically different setting than the one in which Ricardian equivalence is cast. The ability of the centre of gravity to be influenced by expected and actual values, which continually differ, invalidates the concept of rational expectations (Soros 1994; Shaikh 2010). Without rational expectations, Ricardian equivalence, and the fiscal sustainability rules that have been derived while relying upon it, are rendered suspect. If an economy is truly inherently unstable, then the general equilibrium foundation of Ricardian equivalence is not capturing destabilizing dynamics associated with competition between firms. What does this imply for the methods of assessing sovereign risk? One aspect is that the importance of investment and its profitability are being overlooked, as is the case with firms. Investment activity is a key driver of growth and tax revenues. Although volatile, their paths are not without trend. The list of indicators associated with the rating agencies suggest that this aspect of economic activity is not given enough emphasis. Indicators of economic performance often rely on GDP, its trend, and volatility. Attention paid to the nonfinancial sector, its profitability, and its diversity is overshadowed by analyses of GDP. This is a key sector that drives trends in income, employment, and investment. Using a cash flow framework, a method is piloted in chapter 6 that suggests a way to gauge the strength of investment, as it portends changes in overall economic, and financial, health. Another aspect is that credit scoring, traditional statistics and market-based approaches are all based upon assumption of probability distributions that are stable or nearly so. That is, they presume that the future is like the past. As discussed in the previous chapter, time is treated deterministically. This assumption might be suitable for situations in which systems tend toward a balance as a state of rest, but not systems in which tendencies toward balance are continuously thwarted through the collective activity of market participants. Credit scoring, for instance, makes the assumption that the future will be like the past, and results in a situation analogous to “driving a car by looking through the rear view mirror” (Anderson 2007: 16). Likewise for traditional statistical methods.

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With respect to market-based approaches, if Soros and Shaikh are correct, the interplay between actual, expected, and equilibrium values (as defined by fundamentals) implies that market-based approaches are likely to yield inaccurate results. Shaikh (2010) formalizes Soros’s analysis that (1) actual prices are influenced by expectations, (2) fundamentals are affected by market prices, and (3) expectations are influenced by actual prices and fundamentals. As such, “expectations can induce extended periods of disequilibrium” ( Shaikh 2010, reference to Soros (2009: 50–75, 105–106). This nullifies the efficient markets hypothesis. The attempts to incorporate balance sheet data into structural models and defining indicators as stochastic are suggesting that the methods, in and of themselves are not fully capturing key dynamics. This reflects persistent issues with accuracy and timeliness of ratings and other methods of assessing credit risk. The problem is not rational expectations per se, but the use of general equilibrium apparatus that requires expectations to be formed in this way to protect the demonstration that unimpeded free markets are inherently stabilizing. What this means for fiscal sustainability is that the implications derived from a government budget constraint are not as robust as they appear to be. Increasing taxes can finance increases in public expenditure, temporary and permanent. Debt can be used to finance persistent increases in public expenditure, not just for temporary increases or financing capital expenditures. Fiscal positions do not have to be sustainable at each and every moment in time. Moreover, the focus on financing government expenditures could be shifted toward how to stabilize and strengthen tax revenues.

Recent Behavior of Tax Revenues In this section, the recent experiences with fiscal positions, government expenditures, and revenues are analyzed. How congruent are they with the rules of thumb drawn under the influence of Ricardian equivalence? What is the evidence in the wake of austerity measures? The scope of analysis is restricted to the following EU countries that experienced sovereign downgrades in the period 2009–2011: Portugal, Ireland, Greece, Italy, and Spain. Their experiences are compared with that of the United States. The time period 2000–2013 is selected in order to establish the data prior to the GFC and after it. Figures 4.1 and 4.2 illustrate the progress of general government debt-to-GDP and central government debt-to-GDP ratios for the selected countries.11 Prior to 2008, both general government and central government debt ratios are stable. Portugal’s rises slightly,

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200.0 180.0 160.0 140.0 120.0 100.0 80.0 60.0 40.0 20.0 0.0 2000

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Figure 4.1

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Greece

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General government debt/GDP: selected countries

Sources: Based on OECD and Eurostat data 160 140 120 100 80 60 40 20 0 2000

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Figure 4.2

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Greece

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Central government debt/GDP: selected countries

Sources: Based on OECD and Eurostat data 12.0 10.0 8.0 6.0 4.0 2.0 0.0 –2.0 –4.0 –6.0 –8.0

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Figure 4.3

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GDP growth (% change): selected countries

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whereas Spain’s improves. From 2008 there are marked changes in the ratios, with the exception of Italy. As Figure 4.3 makes clear, all countries experienced weakened GDP growth in 2008; Ireland, Greece, and Portugal contracted outright. In 2009 they all contracted and

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have struggled since. This explains part of the reason why the debt/ GDP ratios have been problematic to contain. The other part is how government expenditure and revenue, or net lending, have changed. Figure 4.4 illustrates how the expenditures by central or national governments, in terms of volume and relative to GDP, have changed over 2000–2013. Since the crisis, expenditures have stagnated around their 2009 levels after first rising to soften the economic and social blows. However, with the contraction in GDP, government expenditure-toGDP ratios appear to have risen. However, the increase in these ratios is attributed to GDP either slowing or contracting during a recession. Corresponding figures for general government tell a similar story. We will concentrate on the debt and deficits of national (sovereign) governments in order to focus more clearly on what they confront directly. When the expenditures are decomposed (Figure 4.5) into areas such as health, education, defense, social protection, and so on, the 500,000 450,000 400,000 350,000 300,000 250,000 200,000 150,000 100,000 50,000 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 Ireland

Greece

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Figure 4.4 Central government expenditure (millions of euro) and share of GDP: selected countries Sources: Eurostat data

Ireland

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Figure 4.5

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Composition of expenditures by central governments: selected countries

Sources: Eurostat data

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120.0 100.0 80.0 60.0 40.0 20.0 0.0 2000

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Figure 4.5

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Continued

shares are quite stable. (Please note that Eurostat does not have the 2013 observation at the time of writing). This suggests that given the weakness in fiscal positions, represented by net lending/GDP (Figure 4.6), there is a story with respect to government revenues. Figure 4.7 contains a decomposition of current tax receipts of the national governments of Ireland, Greece, Italy, and Portugal (unfortunately, data is incomplete for Spain.) The data suggests that tax revenues have softened. Moreover, the burden of government revenues has shifted away from corporations and toward the workers, including those who are self-employed. This is supported by KPMG data on tax rates. Greece’s corporate tax rate dropped from 29 percent in 2006 to 26 percent in 2013. Ireland has maintained its corporate tax rate at 12.5 percent, and, likewise, France has kept its tax rate

10.0 5.0 0.0 2000

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–10.0 –15.0 –20.0 –25.0 –30.0 –35.0 Ireland

Figure 4.6

Greece

Spain

Italy

Portugal

Central government net lending (% of GDP): selected countries

Sources: Eurostat data

Ireland

30,000.0 25,000.0 20,000.0 15,000.0 10,000.0 5,000.0 0.0 2004

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Taxes on production and imports

Taxes on corporate income

Other

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30,000 25,000 20,000 15,000 10,000 5,000 0 2004

Figure 4.7

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Taxes on production and imports

Taxes on corporate income

Other

2012

Current tax receipts by source (millions of euro): selected countries

Sources: Eurostat data

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180,000 160,000 140,000 120,000 100,000 80,000 60,000 40,000 20,000 0 2004

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Taxes on production and imports

Taxes on corporate income

Other

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0.0 2004

Figure 4.7

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Personal current taxes

Taxes on production and imports

Taxes on corporate income

Other

2012

Continued

stable at 33.3 percent. Portugal has decreased its rate from 27.5 percent to 23 percent, and Spain decreased it from 35 percent in 2006 to 30 percent in 2008 (KPMG 2014a). Personal income taxes rates have, however, increased. Greece’s income tax rate was increased from 40 percent to 45 percent in 2010, but declined to 42 percent in 2012. Ireland’s personal income tax rate increased from 42 percent in 2006 to 48 percent by 2011. Italy has held its income tax rate steady at 43 percent, whereas Portugal’s increased from 42 percent to 48 percent in 2012, and Spain’s increased to 52 percent in 2012 from 43 percent in 2010 (KPMG 2014b).

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120.0 100.0 80.0 60.0 40.0 20.0 0.0 2000

2001

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2013

–20.0 Debt/GDP

Figure 4.8

Net Lending/GDP

United States: debt/GDP and net lending/GDP

Source: The White House website.

How does this compare with the experiences in the United States? Figure 4.8 pertains to the United States and demonstrates that the effects found in the EU countries presented here also occur in the United States. The figure uses quarterly data from the Bureau of Economic Analysis, as this data provides a clear picture of the timing of changes. Expenditure is stable, yet tax revenue reflects increasingly less reliance on corporate tax and more on personal income tax. The United States’ fiscal position and debt/GDP ratios were influenced by the need to bolster the economy at the same time that the financial system needed support. It has maintained the corporate tax rate steady at 40 percent, but increased the income tax rate from 35 percent to 39.6 percent in 2012. A key impact of the recent austerity measures is that a higher proportion of social spending is being financed out of personal income tax receipts. That is, workers are being shouldered with more of the burden to come up with funds to support themselves when times are rough. It suggests that as wages stagnate and income distribution widens that tax revenues from workers are likely to have limited growth. With debt service payments anticipated to increase in the coming years, fiscal strife looks set to continue.

Summary Credit rating agencies appear to play a contradictory role in the promotion of economic growth and improvements to standards of living. During periods of strong growth, ratings facilitate sovereign’s access to credit markets, but in times of weak growth, and crisis periods, especially, the ratings restrict access, often leading to austerity

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programs to generate the funds to service debt. From a mainstream perspective, this dichotomy results from shocks. From a heterodox perspective, however, there is no dichotomy. The evaluation of creditworthiness will naturally vary over a cycle for both firms, as income and profit fluctuate, and sovereigns, as tax revenues and expenditures change over a cycle. The activities of the rating industry naturally exacerbate periods of growth and instability. While improving the quality of ratings is a step in the right direction, the quality alone may not be enough to help achieve economic and financial stability. If the validity of the Ricardian equivalence and the rules of thumb for fiscal sustainability, however, are placed in doubt, what are the possibilities for managing the fiscal positions of sovereigns? Minsky, in the tradition of Keynes, discusses the role of Big Government and the active use of fiscal policy to stem the ill effects of a contraction. Government expenditure, for instance, could be used to absorb output of firms to support the profitability of investment, giving firms an incentive to continue to invest, and thus, support employment, income, and consumption. The activity of a Big Government complements the role of a Big Bank to ensure the availability of liquidity. Unfortunately, Minsky did not leave much guidance. But, there is some help from like-minded post-Keynesian economists. Arestis and De Antoni (2008), for instance, note that Minsky’s work suggests that the goals of economic policy need to be rethought. He explores this idea by applying the logic of Minsky’s FIH to the experience of the EU with respect to fiscal policy over the past 15 years. Again, the implication of the FIH is that a Big Government (fiscal policy) and a Big Bank (monetary policy), when employed well, can attenuate instability and the ill effects of a recession. However, a Minskian perspective suggests that monetary policy is better focused on tempering financial instability rather than inflation. Fiscal policy should be used to support employment (as an employer of last resort), strengthening the performance (profitability) of the sectors by compensating for investment shortfalls during recessions, and providing liquidity to the financial system with the provision of bonds (assets for investors) that are convertible into money. Their analysis reveals that at every key juncture of the recent crisis, policy makers did exactly opposite to what Minsky would have proposed. For instance, Minsky would have recommended promoting a speedy economic recovery over maintaining sound public finance that involved austerity packages. Whereas Minsky would have recommended raising taxes on the rich in order to satisfy criteria for sound public finance, the analysis in the previous section

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suggests that austerity programs apparently did not increase the tax flows from corporations. In fact, this component of governments’ revenue was reduced. In addition to changing the goals, Sawyer (2009) recommends creating a Fiscal Policy Committee analogous to Monetary Policy Committees of central banks (Sawyer 2008: 90). He also (2008) refutes the crowding out effect that fiscal expenditure has on private investment by suggesting that the crowding out effect is only relevant when ex ante savings and investment are in balance at full employment (level of output). Konzelmann (2014) also notes the possible relevance of Ricardian equivalence at near or full employment. What the analysis of this chapter suggests is that Ricardian equivalence may not be relevant at any time, because it is an idea cast on a framework constructed to demonstrate the inherent tendency of a market system to push itself toward, and achieve, balance. Wray (2006) cautions that Minsky’s categorization of firms cannot be extended to governments directly because of the government’s ability to monetize their deficits and debts, if need be. This may be the case, but from the previous chapter we see that there is the potential to use a cash flow framework to evaluate country risk. Country risk is broader than sovereign risk in that sovereign risk pertains to the elements involved with default on an instrument, whereas country risk pertains to an event that impacts the operations of the financial systems and/or production of goods and services. A Minskian style framework that detects the development or degree of financial fragility could alert government as to changes in economic conditions that could pressurize its fiscal position, that is, increase sovereign risk. A pilot is presented in chapter 6. As this chapter comes to a close, perhaps a revisit to the work of Richard Musgrave is in order. Richard Musgrave, Buchanan’s contemporary, was an advocate of strong government. During his debate with Buchanan, he observed the following with respect to orthodox economic theory: “Relating the well-being of others only in the context of mutually profitable exchange seems amoral at best. It surely does not meet the essential tradition of Western civilization”(Musgrave 1999: 226). Rather, he argued that the market only captures part of an individuals’ range of social relationships. He proceeded to propose a moral community, rather than a moral order, where individuals consider others as extensions of themselves, making the inclusive community the relevant moral unit. This permits inclusion, as opposed to expulsion, of the much wider range of social relations and experiences. Moreover, with the development of a capitalist economy, the need to

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support it (such as enhancements to infrastructure) naturally lead to an increased share of government spending relative to the economy’s total product. Decisions with respect to fiscal economics are then made in the context of a social structure, not simply based upon an analysis on self-interested individuals in the marketplace (Musgrave 1999: 32). Consideration of the size of a budget relative to GDP would shift from its reduction toward improving the effectiveness of the government’s expenditure. The government, in this way, complements the market system, rather than compete with it.

5

Regul at ory C apture

A

s new regulatory guidelines are implemented to thwart the next episode of financial instability, the phenomenon known as regulatory capture has reemerged as a topic of discussion. Whereas regulation has often been justified to correct some form of market failure, regulatory capture is typically cast as a form of regulatory failure that permits the firms in a particular industry to exert control over the government agency or the office charged with overseeing it. This chapter analyzes regulatory capture in relation to the credit rating industry. There are a number of questions to ponder. How has the rating industry come to require regulation? How has the thinking about regulatory capture been advanced recently? Is there evidence that firms within the rating industry have tried to influence recent regulatory changes? In light of the discussion regarding the differences in the vision of investment, are recent regulatory efforts overlooking anything with respect to venues for capture? If a PCRA is to liaise with this industry, we need to explore the thinking about the potential ways in which it could be captured. The answers to these questions will help strategize how such an agency could be protected from capture. These issues are approached in the following way. The next section discusses the issues that have justified regulation of the rating industry, and the orientations of these approaches both prior to and since the GFC. Theoretical approaches to regulatory capture are then examined in order to identify the motives and routes by which regulatory capture occurs. In the wake of the financial crisis, this concept has been refined and extended to encompass broader scenarios. The efforts of academics and researchers from the fields of political science, sociology, and law have maintained the concept’s relevance and its applicability to modern-day contexts. Moreover, the open structure of their methods suggests that they have better congruence with the traditions within heterodox economics than with mainstream economics. Using a scheme provided by Carpenter and Moss (2014),

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we assess publicly available information for the types of and degree to which regulatory capture may have occurred in the rating industry. In light of the recent advances in capture theory, the new regulatory initiatives in this industry are discussed for what they do well and how could they be better. In particular, a heterodox economics perspective, in which investment is inherently destabilizing, can offer insights that have been overlooked and identify gaps that need to be addressed. The final section concludes and sets the stage for clarification and discussion of the functions and governance of a PCRA in the following chapter.

Early Regulation of the Rating Industry and Recent “Market Failures” Until recently, the rating industry has had relatively little regulation. Early regulation over the industry pertained to governments’ desire to distinguish between investment grade and speculative securities. An investment grade issue has lower credit risk than a speculative grade issue. In the United States, for instance, the Office of the Comptroller for the Currency ruled (in 1931) that banks could hold securities (bonds) at their face value provided the securities were classed as investment grade. An investment grade security was defined as a 4-star security as designated by at least one of the four statistical organizations that existed at that time—Standard Statistics, Poor’s, Fitch, and Moody’s. The ruling helped to thwart further collapse of the banking system if securities had been priced at their going market value (mark-to-market method) (Flandreau and Slawatyniec 2013). The ruling was followed by the US Bank Act of 1933, which tipped ratings as a tool to help monitor and supervise banks, and, as such, assisted the American government to shore up and rebuild its banking system during the experience of the Great Depression. In that same year, the Securities Act of 1933 (section 11) helped shield the rating agencies from liability (SEC 1933; Darbellay 2013: 78), and the Foreign Bondholders Protective Council was created to monitor the quality of foreign bonds (SEC 1933, Galliard 2012: 4). From this point, the rating agencies were granted the ability to certify the quality, or the strength of creditworthiness, of issuers and their issues.1 This distinction is important for it bolsters the confidence of those who were/are required to hold investment grade securities, such as banks and other bond investors (e.g., insurance companies). As noted in chapter 2, the rating industry waned from the 1950s through the 1960s. However, ratings came to be used in the American

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states’ regulations of insurance companies, and later in federal regulation of pension plans (White 2010: 101). The demand for ratings also rose as international capital flows and lending increased. The instability of the early 1970s and the need to account for varying degrees of riskiness of assets used to satisfy capital levels prompted additional regulation. The designation of NRSROs granted by the US SEC began in 1975. The designation was introduced to support regulatory requirements that relied on the distinction of quality of issues. Quality was established with reference to the opinions of rating agencies given the NRSRO status. The designation ultimately entrenched the three main agencies with superior market position as the criteria effectively precluded agencies without national recognition from participating in regulatory schemes. Beyond this, in the United States, the SEC took a “hands-off” approach (i.e., self-regulation) toward the rating industry. It was thought that the operation of a free market for rating assessments would guide improvements to their quality and timely dissemination and, hence, promote capital accumulation and financial stability (GAO 2012, White 2013). In effect, market discipline was thought to be sufficient to prompt firms with poor performance (opinions) to either improve or exit the industry. In the aftermath of the Asian crisis, and especially after Enron and Parmalat, the rating agencies experienced criticism by policy makers, regulators, and academics for what seemed to be inaccurate assessments of creditworthiness, both of sovereigns and of firms. With respect to the Asian crisis, the combination of a shift of industry policy from state managed to a market-oriented approach and liberalization of financial systems in the context of implicit government guarantees, quickly changed the size and structure of capital flows (Chang 2000). Capital flows became more short term and less guaranteed, prompting firms and banks to over rely on private, foreign currency denominated debt (Schroeder 2004). These elements raised the riskiness of sovereign debt, which the agencies had not fully accounted for. Just months prior to the floatation of the Thai baht, all three agencies had assessed Thailand’s debt as investment grade. With respect to Enron and Parmalat, a few years later, the agencies were criticized for not anticipating the collapse of large corporations in a timely manner. In the United States, the SEC was tasked by the Sarbanes-Oxley Act (2002) to report on the history of the NRSRO designation and issues associated with market structure (barriers to entry), conflict of interest, timeliness of information, and the use of ratings for regulatory purposes. The information provided by the SEC reports (2003) stimulated the Rating Agency Reform Act (2006), which amends

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the Securities Exchange Act of 1934 (see, for instance, SEC 2003). The regulation sought to promote accountability, transparency, and competition. Improvements in these three areas, it was hoped, would enhance the quality (accuracy) and timeliness of ratings and the regulation attempted to identify potential conflicts of interest by, for instance, requesting firms identify the largest issuers they rate. The rating agencies could not rate instruments that they had helped design. The Reform Act also “forbade the SEC from influencing the ratings or the business models of the NRSROs” (White 2010: 222). To increase competition in the industry, an effort was made to boost membership to NRSRO status. For instance, in 2003 and 2005 the SEC granted NRSRO status to Dominion Bond rating (based in Canada) and the A. M. Best (insurance company specialist), respectively. There were three new NRSROs in 2007—Japan Credit Rating Agency; Rating and Information, Inc (Japan); and Egan-Jones—and two new NRSROs in 2008, Lace Financial and Realpoint. The Act also defined “NRSRO” and provided criteria for use when evaluating a firm for the NRSRO designation. The SEC voted to implement the provisions of the Reform Act on May 23, 2007—just as the GFC hit. The EU, like the United States, maintained a hands-off approach to regulation of the rating industry. European states have used ratings for regulatory uses much like the United States, but to a lesser extent and in a less codified way (Langohr and Langohr 2008: 431). In response to Enron and Parmalat, the European Commission requested advice from the Committee of European Securities Regulators (CESR) in 2004 on four issues: conflicts of interest, transparency of methods, how rating agencies treat inside information, and the market structure of the rating industry (CESR 2006). CESR’s key recommendation was “not to regulate the credit rating industry at an EU level for the time being, and instead propose that a pragmatic approach should be adapted to keep under review how credit rating agencies would implement the standards set out in the IOSCO Code of Conduct” (CESR 2006: 2). In effect, the rating industry remained unregulated, with recognition that ratings could be useful, and used, for regulatory purposes as per EU directives (Rousseau 2012: 4). The EU, instead, deferred to the suggestions provided by the International Organization of Securities Commissions’ Code of Conduct (IOSCO). The IOSCO Code was first implemented in 2004. The code rests on four principles that suggest that the rating agencies voluntarily take measures to maintain their independence of opinion (avoid conflict of interest and other pressures), actively improve the quality of their ratings (reduce information asymmetry), protect issuers’ confidential information, and be transparent and disclose opinions

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in a timely manner. If agencies decide not to comply with the code and its principles, they need to explain why. The CESR maintains a record of whether the agencies have complied, or not. Failures specific to the GFC episode. In light of the GFC, the rating agencies came under renewed criticism. A number of problems were identified, including: accuracy and timeliness of the ratings, rating processes lacking robustness, the role of the NRSROs in securities markets, supervision (weaknesses in) by the SEC, conflicts of interest, market structure (lack of competition), disclosure, and transparency. Some of these are recurring issues, such as accuracy, timeliness, lack of robust processes, conflicts of interest, market structure, transparency, and disclosure. Other issues are specific to the GFC: the role of ratings in securities markets (specifically for structured finance products), their use for regulatory purposes, and weakness in supervision. For the most part, examinations of the industry zeroed in on three issues that needed to be addressed in order to improve the performance of ratings—the process of ratings, conflict of interest, and transparency, particularly over rating methods, assumptions, and criteria (SEC 2008; IOSCO 2008). The focus of regulatory modifications has been to improve the conduct or behavior of the agencies and supervision over their processes. With respect to conduct, the regulatory authorities have revised rules for the agencies’ internal governance in order to promote transparency and disclosure, and reduce conflicts of interest. At the international level, the IOSCO revised its code to require that rating agencies disclose the following: issuers that make up 10 percent of their revenues, the attributes and limitations of their opinions, the method(s) used to determine ratings, sensitivity of their opinions to the assumptions made, and their internal code of conduct. The “comply or explain” facility remains in place. In 2014, the IOSCO proposed revisions to its code in order to increase the robustness of the rating processes, manage conflicts of interest, promote transparency and protect proprietary information, and improve training and management (IOSCO 2014). The national regulatory approaches have gone a bit deeper, in particular by attempting to address liability (accountability) of the agencies and the reduced reliance of ratings for regulatory purposes. In the United States, for instance, Dodd-Frank (2010) attempts to build on prior regulatory efforts to boost transparency, reduce conflict of interest, encourage disclosure, and enhance oversight (supervision). To achieve these ends, the Office of Credit Ratings (OCR) was created within the SEC. The OCR conducts annual examinations of each NRSRO, monitors their activities, provides the annual reports to the public, conducts research on the industry, manages the NRSRO

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registration process, and so on. To boost transparency, Dodd-Frank (2010) requires that NRSROs have an internal structure that documents their rating methods and compliance with procedures, and submits an annual report (to the SEC) that indicates the status of their internal controls. Dodd-Frank, for instance, addressed conflict of interest by weakening the “regulatory license” conferred to rating agencies that hold the NRSRO designation. Regulatory license is a term used to denote the ability of NRSROs to discern the strength of creditworthiness through their ratings. The regulatory license weakens as regulatory agencies adjust their wording in the legislation to remove the use of NRSRO ratings as a tool to indicate credit quality. However, the process has slowed as realization sets in that there is nothing to replace the ease of deferring to the rating agencies for identifying investment grade securities. Conflict of interest is thought to emanate from the regulatory license that rating agencies hold (Partnoy 2006; Flandraeau and Slawatyniec 2013). Weakening the license is thought to weaken the basis of conflict of interest. Conflict of interest is also addressed by keeping records of staff conduct and changes in employment. DoddFrank also makes the agencies accountable by making them liable for the quality of their ratings (Partnoy 2011). Making rating agencies liable for inaccurate opinions is an attempt to provide investors with recourse to recoup capital losses. The regulatory changes made by the IOSCO and the United States have influenced regulatory reforms elsewhere. Regulatory reforms in the EU have been similar in many ways to those in the United States. Again, there is a strong focus on conflict of interest and transparency (White 2010). The EU introduced the European Securities Market Agency (ESMA) to oversee the registration of rating agencies, as well as for their supervision. The EU has gone further with respect to method and requires the agencies to disclose their methods for examination by ESMA; in the United States, the methods need to be approved by a rating agency’s board of directors. It has also introduced more stringent rules to make the rating agencies liable and accountable. Countries within the EU have also taken stances on liability for the rating agencies, where liability is shaped by the structure of the legal systems and the nature of the relationship between the rating agencies and the market participant who incurred a loss (Darbellay 2013: 79–83). Mexico, Japan, Italy, Canada, and Australia have implemented registration requirements for rating agencies; registration involves the provision of information on registration forms, which provides regulators with details regarding aspects of conflict of interest and

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statements of adherence to transparency and disclosure (IOSCO 2008; Darbellay 2013). In Australia, the credit rating agencies are overseen by the Australian Securities and Investment Commission (ASIC). Until July 1, 2009, the rating agencies could operate without a license. General licensee obligations for CRAs include addressing conflicts of interest, making certain their credit analysts are trained to construct ratings, and ensuring that there are adequate resources to conduct business and the supporting services associated with these products are performed efficiently and fairly. Managing conflict of interest entails avoiding it, controlling when it occurs, and disclosing it (ASIC RG 181). Australia stands out for finding Standard and Poor’s accountable (liable) for ratings on structured debt instruments (ABN AMRO Bank NV vs. Bathurst Regional Council [2014] FCAFC 65). The Full Federal Court of Australia understands a CRA as owing investors a duty of care when rating financial products. Rating agencies must exercise “reasonable care and skill in the issue of the credit rating” (Clarke and Freehills 2014). A number of local councils purchased structured financial products (constant proportion debt obligations) that Standard and Poor’s rated. After the purchase, the instruments fell in value as a result of the effects of the GFC. This piece of litigation is important as it is “the only common law example of a rating agency being found liable to investors as a result of ratings which were found to have under-estimated the default risk of products which performed poorly during the financial crisis” (Clarke and Freehills 2014). That said, in February 2015, Standard and Poor’s Financial Services and its parent company, McGraw Hill, announced they would settle a US Department of Justice lawsuit for US$1.38 billion over ratings and subsequent surveillance on mortgage-backed securities and CDOs (McGraw Hill 2015). For all these regulatory changes, recent efforts to either repeal or slow their implementation may not be conducive to the public interest but, rather, are more conducive to the agencies’ self-interest. As such, we now address the issue of regulatory capture.

Regulatory Capture and the Rating Industry Regulatory capture is the result or process by which regulation, in law or application, is consistently or repeatedly directed away from the public interest and toward the interests of the regulated industry, by the intent and action of the industry itself. Carpenter and Moss (2014: 13)2

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Astute readers will have noticed that this concept of regulatory capture is cast in a way that is different from the traditional definition at the start of this chapter. Recent research into the phenomenon has led to a broader definition that allows for degrees of capture, not simply examining whether capture exists or not. Further, it makes a clear distinction between public interest and industry or special interest. To analyze the degree of regulatory capture, the regulated industry or interest must both hold the intention and (knowingly) engage to shift regulation in its favor, away from the public interest. In our context, the public interest is a stable economy and financial system and addressing rating quality is thought to promote that result. Degrees of capture vary from weak to strong to corrosive. Weak regulatory capture is influence exerted by the regulated industry or a special interest in a way that does not jeopardize “healthy regulatory functioning.” Strong regulatory capture interferes with regulatory functioning to the extent that the public interest would be better served by scrapping the regulation and replacing the regulating agency and public policy toward it. For instance, strong capture would be defined as restrictions that block entry of new firms into the industry (Carpenter and Moss 2014: 11) The difference between strong and corrosive capture is that strong capture contains the intention to seek rents by shaping regulation in industry interests, whereas corrosive capture drives deregulation or thwarts an increase in regulation (as a way to reduce the costs of adhering to regulation and protect, if not increase, profit).3 Another form of capture is cultural capture. Cultural capture is a non-materialist form of capture that allows for the recognition that nonrational influence can occur during the execution of administrative process. That influence can run counter to policy positions that a regulator holds. Cultural capture pertains to the ways that the regulator and the regulated industry become cooperative in order to further public interest through cognitive biases (deviations in judgment) that can be attributed to group identification, status, and relationship networks. It is cultural in the sense that “it operates through a set of shared but not explicitly stated understanding about the world” (Kwak 2014: 79). This form of capture is indirect. An example of culture capture is the phenomenon known as “revolving doors.” In this scenario, employees of regulated firms and the regulator migrate between the public and private sectors. This migration and the social contacts that are established, along with the potential employment opportunities, bias the regulator’s ability and/or willingness to enforce regulations, permitting capture.

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These recent advances on regulatory capture criticize analyses of regulatory capture conducted through the lens of mainstream economics for a variety of reasons. Mainstream economics, for instance, casts the concept too narrowly. The object of analysis with economic models is often cast as rent-seeking behavior through the erection of barriers to entry or bribes. Posner (2014) traces the emergence of this literature to Stigler’s “positive economic theory of regulation” in which the economics of regulation was cast in the supply and demand tradition. Regulatory capture was the idea that competing segments of industries or industries themselves could capture regulation in a way similar to a market transaction. Regulation could be bought and sold. This is a form of interest group theory of regulatory capture. Interest group theories demonstrate how agents within industries are motivated to capture regulators as a way to obtain rent (supernormal profits). The interest group strand has two sub-strands—the Chicago School (for instance, Stigler, Becker, and Posner) and the Virginia School (Tullock and Buchanan) (Boehm 2007). A common attribute is that the regulator (public agent) is passive. In contrast, tollbooth theories are also about rent seeking, but it is the regulator who is active in that he seeks rent. Here, regulation is erected as a barrier in order to extract rent from firms (ibid). Principal-agent theories employ asymmetric information. The presence of asymmetric information, as a barrier, implies the need for regulatory discretion, which, in turn, can be influenced by special interests or industry (hence, capture) (Dal Bo 2006). (Key authors in this strand include Laffont and Tirole 1993). These analyses of regulatory capture convey the idea that industryspecific regulations are too risky for capture since agencies can be captured by being convinced to act in the private interest rather than the social or public interest. Mainstream approaches helped to justify the deregulation of American industries on the grounds that if a regulatory program could be purchased (captured) by a regulated industry, then regulatory capture could be minimized by shifting the focus of regulation away from industries and toward sectors (Posner 2014: 5–6). The broader focus of regulation was meant to make capture more difficult. During deregulation, some programs were abolished, others weakened in terms of lost authority or became less protectionist; in addition, industry specific programs gave way to sector-wide or economy-wide ones.4 The shift toward non-industry specific regulation (through deregulation at the level of industries) eliminated the need to examine regulatory capture as cast at the level of industry. As we will see in the next chapter, this shift in orientation toward

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industries laid the foundation for what has been referred to as “implicit industrial policy.”5 Again, all three key strands within the mainstream (economics) tradition of capture theory—interest group theories, principal-agent theories, and tollbooth theories—are cast as regulatory failure. As such, regulatory capture has been cast in a binary way—either it’s present or it’s not. Criticisms of this casting of regulatory capture involve the identification of behavior that does not involve barriers to entry or bribes. For instance, the reduction in the scope of regulation does not involve barriers to entry or bribes. Purchasing changes in regulation, as another example, is more likely to be the exception rather than a rule (Moss and Carpenter 2014: 452). Attempts to broaden the definition of regulatory capture, by returning to its roots, are efforts to maintain the concept’s relevance and need for research. Capture theory has antecedents in political science and public administration. Early capture theory had a different, broader focus than that which emerged in the mid-twentieth century. The focus was on corruption as defined by the influence that private interests held to thwart the goals in the public interest. Regulators could be captured if “they develop an orientation toward the views” of private interests (Novak 2014: 29). Under the influence of mainstream economics, with its agent- or individual-based methodological foundation, the analysis of reforming regulation to promote collective solutions gave way to formal critiques of the effectiveness and desirability of government intervention. That is, the creation of political solutions to economic problems came to be replaced by the use of economic theory to suggest political solutions. From such an “economics all the way down” perspective, democratic political solutions were found to be (surprise, surprise) “inefficient.” Consequently, regulatory policies almost always fared poorly when compared with some kind of ideal, theoretical market solution. (Novak 2014: 46)

Broadening the scope of regulatory capture allows for identification of degrees of capture. Further, thinking in terms of a range of capture helps to select tools for correcting. There are reasons why some regulatory agencies are captured and others are not (Moss and Carpenter 2014). By returning to its roots for inspiration (political science, sociology, and law), it is possible to confront and successfully address capture at the margin (weak) provided it can be identified properly. Is regulatory capture present in the rating industry? That depends. There is evidence of conflict of interest and that the rating

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agencies employ lobbyists to discuss issues with legislators. In 2011, for instance, there was apparent conflict of interest between the rating firms when they both lobbied the US Congress (House, Senate), The Treasury, The Federal Reserve, the SEC, and the Executive Office of the Presidency against aspects of Dodd-Frank Act while at the same time warning of potential downgrade to sovereign debt (Braun 2011; Eggen 2011; Beckel 2009). With respect to lobbying, The Sunlight Foundation notes that Moody’s spent nearly $2.8 million for lobbying between 2009 and 2010. Although Standard and Poor’s spent $60,000, its parent company, McGraw Hill, spent nearly $3.1 million on issues involving the rating agencies, issues including “a provision in Dodd-Frank that would hold credit ratings agencies liable for securities fraud. A bill was introduced by Rep. Steve Stivers (R-Ohio), H.R. 1539, to repeal that provision” (Gerring 2011). Lobbying is pervasive enough to prompt Bill Allison of the Foundation to suggest that “they (the agencies) seem to be very successful in forestalling oversight and maintaining their independence”(Eggen 2011). The Center for Responsive Politics also notes that a lobbyist for Standard and Poor’s focused on legislation that updates the SEC designation of credit rating agencies (HR 1181); regulation that enhanced transparency and disclosure by the rating agencies (HR 1445); and establishment of a commission to look into what triggers the financial crisis (HR 74) (Beckel 2009). This evidence supports the statement that the credit rating agencies are especially interested “to safeguard the independence of the credit rating agency process” (Majory Appel, a spokesperson at Standard and Poor’s, as cited by Langohr and Langohr 2008: 454). Evidence of action by agencies seems to suggest regulatory capture. The confirmation of regulatory capture, however, also requires evidence of intent. The above could just as well be attributed to mistakes by the regulatory authority that is supposed to serve the public. That said, if one were to play devil’s advocate, and presume intention, the above suggests the presence of corrosive capture: Corrosive capture occurs if organized firms render regulation less robust than intended in legislation or than what the public interest would recommend. (Carpenter and Moss 2014: 16)

Recent regulatory changes have been cast with the understanding that a way to enhance stability of a financial system, which is in the public interest, is through the improvement of rating quality. Is it? From the perspective of the distinction between investment as a stabilizing activity versus investment as a destabilizing activity,

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improvements to rating quality are a good start, but there is something more if economic and financial stability is the objective of recent regulatory changes. Again, a rating is an opinion, an informational tool, which helps issuers, lenders, and investors make the best decisions that they can, in the context of true uncertainty, about their investments and financing of those investments. Those decisions rest on the accuracy of assessment of creditworthiness. (Bear in mind, this rationale also applies to in-house assessors of credit risk, such as banks and institutional investors.) Under the view that investment is an activity that helps to stabilize an economy, ratings provide information to lenders and borrowers that helps them allocate their funds to the best uses. By doing so, leakages, such as savings, are reinjected into the system as investment. The system seeks balance and stable growth, provided that asymmetric information is reduced, prices are flexible, and so on. Ratings perform, likewise, in the alternative perspective, they provide information to lenders and borrowers who use it to make the best decisions they can. However, those investment and financing decisions will ultimately destabilize the economy through endogenous, complex processes, such as those elaborated by Minsky’s FIH. The implication should not be drawn that alternative economists want no improvements in rating quality. On the contrary, improvements would be a good thing. But, here there is recognition that simply improving rating quality is not enough. There needs to be something more in order to achieve the public interest of a stable economic and financial system. An important component of regulation capture is being clear about what the public interest is. Recent regulatory changes with respect to the rating industry identify the public interest not as the quality of ratings per se, but as the improvement of rating quality as seen to promote economic and financial stability. That is, the public interest is to minimize the potential for harm if rating accuracy (or product quality for this industry) is not as robust as it could be. From a heterodox perspective, this requires different mechanisms than those suggested, for instance, with respect to reduction of conflict of interest (behavior focus) and improvements in transparency (process focus). Quality also requires a methods focus, one that facilitates improvements with minimal restriction to the independence of the rating agencies. From the vantage points of law, sociology, and political science, regulatory capture can be prevented and reversed, especially if it is of a relatively weak degree. Even if it cannot be fully reversed, an outcome can be suboptimal yet still protect the public interest (Moss and Carpenter 2014: 453). Suggestions for capture prevention of

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agencies: involve multiple regulators, empower diffuse interests (such as consumers, producers, investors, special interests that can buttress public interest), employ experts with diverse and independent opinions, create devil’s advocates, involve the press, and have a judicial review of regulators’ decisions. What is encouraging about the contributions of these disciplines is that their open structure aligns them more easily with that of heterodox economics (and their underlying theories of value and distribution) than with mainstream economics. Recall an open system, in contrast to the axiom-deductive approach of mainstream economics where elements such as variables and structural relationships cannot be wholly knowable. As an open system, the historical, social, political, and institutional features and behavior become integral parts of the foundation of the analyses. For instance, whereas the mainstream begins with an analysis of the individual, heterodox economists are much more apt to begin with a class-based analysis that emphasizes historical and institutional contexts and political, sociological, and psychological influences on class or group structures. The openness of these systems permits a knit between the dynamics of accumulation, as cast by the heterodoxy, to be refined by features unique to particular societies and regions. The methodological aspects for cross-disciplinary work are strongly congruent for fruitful research opportunities. In the next section, we examine how recent regulatory changes satisfy the criteria suggested by Moss and Carpenter (2014) for preventing or weakening regulatory capture. Further, the distinction between investment as a stabilizing mechanism versus investment as a destabilizing mechanism is employed to shed additional light on the ability of the new regulations to promote improvements in quality, drawing the implications for the ability of Dodd-Frank, for instance, to stabilize an economy.

Regulatory Revisions—What’s Done Well and What Could Be Better A key goal of the regulatory frameworks is to promote financial stability and protect the performance of their respective economies (the public interest). What we take away from the discussion, thus far, is that the frameworks seek stability by promoting transparency, disclosure, and the reduction of conflicts of interest by addressing the behavior of firms and their rating processes. By doing so, it is hoped that the ratings, evaluations of creditworthiness or default risk, will be more accurate and timely. In turn, lenders and investors can make

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better investment decisions. Nonfinancial firms will receive cost of capital in line with their positions, and they, too, can make better decisions regarding investment and its financing. In this vision, ratings are important element of ensuring that resources are allocated to their most productive uses by facilitating accurate judgments of cost of capital—which supports investment, economic growth, employment, and income. That’s the vision. In this section, we step back and assess what recent regulatory changes are doing well and what they could do better. What the regulatory frameworks, such as Dodd-Frank, do well is put into place systems that oversee or supervise the conduct and processes of the rating agencies. Special offices or agencies, such as the OCR and ESMA, have been created to register and/or license the agencies. The registration processes facilitate improvements in disclosure, transparency, conflicts of interest, protecting confidential information, and accountability. The regulations promote transparency by requiring reports about the adherence to guidelines and new developments in the industry. Reports are disseminated to other governmental agencies and to the public. Further, changes to the methodologies have to be publicly announced (i.e., disclosed) and shown to be consistently applied to the current ratings. Two improvements, however, have become flashpoints: correcting conflict of interest through the reduction of the use of ratings in regulatory requirements, and enhancing accountability by permitting rating agencies to be liable for opinions that cause loss (Partnoy 2011, 2009). Reducing ratings from regulatory uses is thought to weaken the emergence of conflict of interest between agencies and the issuers, as issuers are thought to pressure analysts for overly rosy assessments to widen the pool of potential investors and lower their cost of capital. How likely is it that this change will be effective? Removing the use of ratings from regulatory programs will only modify the degree of conflict of interest, not eliminate it. Recall, conflict of interest ultimately stems from the regulatory license held by the agencies. The regulatory license was conferred long ago when ratings were officially used to demark the difference between investment grade and speculative grade securities for pension funds, mutual funds, insurance companies, and so on. Ratings, or some substitute, will always be needed for this purpose to assist investors. Even if the regulatory license is removed, the need to distinguish the quality of instruments in the legal system (i.e., “legal license”) remains. Clearly, rating agencies perform a crucial role in assessing the creditworthiness of issuers and their issues. As

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such, conflict of interest will exist as issuers will always desire the most favorable outcomes that can be justified. Holding agencies liable seems also like a good idea until one remembers that the ratings still have issues with respect to accuracy. The reasons for inaccuracies have ranged from poor data quality, lack of support for rating analysts, rating through-the-cycle, conflicts of interest, and other problems identified in chapter 2. The outstanding issues of pro-cyclicality and lagged changes—even with the “vanilla” bonds (corporate, sovereign, municipal)—suggests that the dynamics pertaining to credit risk are not being accurately modeled with existing methods of evaluating credit risk. From a heterodox perspective, inaccuracies are more likely attributed to the vision that economic and financial systems are inherently stable. The methods designed around this vision are likely not fully capturing the dynamics leading to instability, particularly those that emanate from nonfinancial industries. Given the ratings are not as accurate as they could be, legislation that allows the agencies to be legally liable risks their being litigated to death. It is understandable that the agencies are keen to weaken or remove that piece of legislation. Doing so will help them survive. Should they survive? Ratings and the agencies are useful. However, they need support to become better in terms of accuracy and timeliness. From their behavior, as noted above, the agencies are indicating their desire to retain as much independence as possible in order to adapt to market conditions and new innovations. However, it is in the public interest to make ratings as accurate as possible. Do the new regulations provide that support? Guidelines that support transparency, requiring each NRSRO to document their compliance with procedures (including rating method and submission of an annual report of their compliance to the SEC), are a good start. In particular, regulation that requires regulators to have statements of rating methods pertaining to their models is a good first step toward creating better, more accurate assessment methods. The SEC, for instance, prescribes documentation of procedure and methodologies (including the forms of data, types of models, assumptions, reliability, and potential limitations.) However, the SEC’s scope stops there in that the approaches and techniques are determined by the agencies’ boards. ESMA (EU) seeks to go farther by examining the robustness of the methods. However, it cannot dictate which methods the agencies should use. What could be better? The methodological aspects of rating creation and performance of due diligence remain controlled by the CRAs.

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Due diligence is akin to product testing in that it checks the quality of the product. As noted in chapter 3, the intensity of due diligence performed by the agencies depends on economic and financial conditions. Due diligence is performed more aggressively with the onset of instability, and less so when conditions are stable. The new regulatory guidelines address the processes or inputs to the rating process, not the outputs of the processes. For instance, rule amendments require an NRSRO to consider internal controls structures that ensure: (1) a new rating method is given an appropriate review process, (2) a new method is disclosed to the public for comment before its implementation, (3) current methods are periodically reviewed, (4) new and revised quantitative methods are validated prior to use, and then periodically reviewed and back tested, (5) it has the competency and information to assess a new class of issuers and their issues, (6) there is process to signal when a method needs to be revised, (7) there is a surveillance system that is periodically verified, (8) the documentation processes are robust, (9) there is a system of internal audit of rating files to support compliance with NRSRO procedures, and (10) there are period reviews of resource needs (SEC 2014b). Although it is strongly recommended, there still is no legal requirement that the agencies perform due diligence; this is essentially the same situation as existed prior to the GFC (Rousseau 2012). In the United States, due diligence is the responsibility of the agencies and of those who use their products. However, reports containing findings on due diligence for asset-backed securities—whether acquired by an issuer, by an underwriter, or by an NRSRO—are required to be made available to the public; moreover, the third parties involved in due diligence must provide evidence of certification. The EU requires that the rating agencies submit their methods to ESMA for assessment, but the EU will not interfere with rating methods selected by the agencies (EP 2009). Both the OCR and ESMA have staff that conducts research into the quality of ratings, but on an ad hoc basis. (ESMA houses the historical performance of ratings). Given the current objectives and structures of ESMA and the OCR, not to mention the range and number of ratings of just the top three rating agencies, the staff is understandably limited in their ability to continually monitor the performance of the products of this industry while performing a host of regulatory duties. By focusing on behavioral issues for particular types of securities, the Dodd-Frank is taking an indirect route toward improving the quality of ratings (White 2013). To improve quality, a mechanism for due diligence to check accuracy and stimulate innovations is needed.

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The need could form the basis for the creation of a PCRA, along with the provision of benchmarks of rating classes. This idea, as discussed in the next chapter, should not be taken to mean that the government should dictate the methods. But it should be actively developing benchmarks with which to validate results of agencies and to complement the use of interest rate management by the central bank for attenuating conditions conducive to instability. What about regulatory capture? Let’s consider further the suggestions of Moss and Carpenter (2014) for preventing and correcting regulatory capture. Those suggestions were to involve multiple regulators, empower diffuse interests, employ experts with diverse and independent opinions, create devil’s advocates, involve the press, and conduct a judicial review of regulators’ decisions. Dodd-Frank itself involves a number of regulators. The governance structure of the council, for instance, has ten voting members comprised of representatives of Treasury, the Federal Reserve, the OCC, the Bureau of Consumer Financial Protection, the SEC, the FDIC, the Commodity Futures Trading Commission, the Federal Housing Agency, the National Credit Union, and a presidential appointment. There are five advisory members who are representatives of: Office of Financial Research, Federal Insurance Office, State Insurance Commission, State Banking supervisor, a State Securities commissioner. The bulk of the members—voting and advisory—are members associated with various aspects of the financial sector. With respect to the rating industry, its oversight rests with the SEC and the OCR (as within the SEC). If the activities of the rating industry were to predominantly pertain to the financial sector, then these regulatory changes appear to satisfy the criteria for prevention of regulatory capture—multiple regulators and governance structure with diffuse interests that employ experts with diverse and independent opinion. From a heterodox perspective, this structure has some issues. The heterodoxy gives weight to the importance of the nonfinancial sector for economic performance and creditworthiness of firms and sovereigns. The configuration of regulators and governance of the SEC are biased with representation of financial market interests. If the investment of nonfinancial firms is truly the source of instability and changes in creditworthiness, then the regulatory structure, intended to promote financial stability and economic health, is much too narrow. From this perspective, Dodd-Frank needs to be widened to include other aspects of the American economy, not just the financial sector, in order to be more effective. Otherwise, it risks regulatory capture.6 Regulatory oversight needs to involve regulators of

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nonfinancial activities, for instance the Department of Commerce, the Environmental Protection Agency, and the Internal Revenue Service. Clearly, there is room for improvement in terms of involvement of other regulators. The structure also needs to include opinions from industries and sectors and from SMEs. (This will be discussed in the next chapter.) It is interesting to note that more conservative criticisms of the recent regulations on the rating industry include that the ratings should be subject to less regulation in order to allow the discipline of the market to effect changes, when necessary. Safety judgments are placed in the hands of regulated institutions (under the oversight of the regulator). “If this second route is pursued, then the first route— the expansion of conflict-of-interest and transparency regulations, as well as the continued existence of the NRSRO system—would no longer be needed” (White 2010: 224). Further, new regulatory efforts increase the cost of doing business in this industry, hence discouraging new entrants. Without cumbersome regulation, issuers would find it advantageous to shop for ratings and advice, provided that “an institution’s capital requirement (is) geared to the riskiness of the bonds that it holds” (ibid). That said, empirical evidence about the relationship between market structure and rating quality is inconclusive at best (Dal Bo 2006, USGAO 2012), where more recent studies suggest that increased competition has a tendency to generate upward bias in ratings (White 2013). There is also a push to use market-based measures of credit risk for regulatory purposes (Partnoy 2006; Dittrich 2007). This route, however, is problematic, given, as discussed in chapter 3, that the underlying assumptions may be too simplistic to enable these models to perform consistently.

Summary Since CRAs’ role is to contribute to the efficient operation of capital markets, they fall under the scope of securities regulation. Thus, any regulatory effort concerning rating agencies should espouse the twin goals underlying all securities regulation: efficiency and investor protection. Rousseau (2012: 14)

The remark above drives home a point. Many of the recent initiatives discussed above are largely in response to the functions that ratings perform with respect to the market for structured financial products.

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The implication is that activities of credit risk assessors, such as the rating agencies, are primarily the concern of financial interests. Is financial stability just about the operation of financial markets? From a Minskian perspective, financial instability (and stability) pertain to the relationship between the real and financial sectors. As such, the regulation of rating industry needs to reflect that their assessments have a broader, more direct reach, on economic activity both in terms of the nonfinancial corporations that they rate and through the impact that their assessments have as benchmarks and proxies for in-house assessors (and investors). If one is dissatisfied with regulatory improvements introduced by Dodd-Frank, what are the alternatives? One suggestion is to revert back to a hands-off approach to the industry. White (2013), for example, suggests that improvements should be left to the rating agencies, allowing the market to decide who does the best job. He finds that Dodd-Frank simply entrenches the existing structure of the industry by raising the cost of entry for new firms. As the new firms are often the source of innovation, innovations will be more readily forthcoming by deregulating the industry rather than regulating it. Further, if the use of ratings for prudential regulation were scrapped completely, not simply removed from the NRSRO categorization, there would be no need for regulation of the rating industry. Institutional investors will be stimulated to create in-house expertise, and the small investors can look to financial advisors for advice. An implication of White’s analysis is that the government is not capable of providing ratings because to do so would suggest that the government can accurately measure or quantify the credit risk, an activity that the SEC had outsourced to the rating industry. Further, the government faces conflict of interest since it, too, is an issuer of debt instruments that require ratings. The assessment of credit risk is heavily influenced by methodology and vision underlying the current (free-market) approach of corporate finance. The methodology may be suitable for trading existing financial instruments, but may not be comprehensive for evaluating processes associated with capital accumulation. Social and political structures matter for capital accumulation. For, as Heilbroner and Milberg (1995) noted, only when markets are understood to be “social constructs that serve a function, will the role of organizational structure, technological innovation and cultural norms and habits be integrated more centrally into economic analysis” (Heilbroner and Milberg 1995: 105). It is possible, then, that the next frontier for credit risk assessment involves somehow linking a method or methods

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of assessment that accounts for the dynamics of industries and sectors. This would suggest a revisiting of the dynamics underlying the ratios derived from accounting statements. Further, there needs to be a vehicle, an institution, that can bridge interests of financial and nonfinancial sectors and industries in order to bolster due diligence and provide a space to experiment with new methods of evaluating credit risk. A vehicle such as this might minimize the need for comprehensive regulation, thereby allowing the agencies to maintain independence while providing an invaluable service for promoting a key goal of public interest: the promotion of stable economic and financial conditions.

6

Public Credit Rating Agency Fun c ti o ns a nd Struc t u re

D

rawing upon the analyses in the previous chapters we now explore the “what ifs” of a national PCRA. The insights gleaned from the identification of functions and malfunctions, issues surrounding methods of assessing creditworthiness, the effectiveness of government, and regulatory capture are invoked to justify the existence, role(s) and the structure of a PCRA. What did we take away? The credit rating industry performs valuable services to both nonfinancial (and financial) firms and financial investors. The services include the evaluation of creditworthiness of potential borrowers and the issuers, in ways that permit discrimination in the quality or strength of creditworthiness. The rating industry is a leader in innovating methods of assessment and in locating efficiencies in applying those methods to issuers and their issues worldwide. As ratings are disseminated publicly, they provide lenders and investors with information that reduces the degree of asymmetry in the distribution of information. By doing so, they assist lenders in establishing the cost of debt (and capital) to potential borrowers seeking funds for investment. Information regarding the cost of capital assists firms in their investment and financing decisions. Ratings also provide information to financial investors so that they can make better decisions about the composition of their portfolios. Ratings help lenders and investors validate their own internal models of creditworthiness. Through sovereign ratings, the agencies provide proxies of the economic health of countries; the agencies are also beginning to provide country risk evaluations. The rating industry and its firms are in the best position to perform these functions as they have demonstrated their ability to be highly responsive to changes and new opportunities in the markets and industries that they monitor.

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On the other hand, the outputs of the rating industry could be more accurate. Their products can exhibit sluggish and pro-cyclical changes. Ratings can promote instability if and when their accuracy becomes compromised. Further, because of the expense involved, due diligence, or verification of product quality, may not be performed as extensively as those who use ratings (lenders and investors) and those who purchase ratings (issuers) would like. Issues associated with conflict of interest are endemic to this industry for a number of reasons. First, “regulatory license” has necessitated the use of ratings to distinguish the (relative) degree of credit/default risk on instruments that could be used for capital requirements and regulatory purposes. Even if references to ratings are completely removed from all regulation, ratings will still be used for this purpose, at least until something better comes along. Conflict of interest also stems from the structure of remuneration for the creation of ratings. The current system of “issuer pays” for ratings on its debt suggests that the agencies face pressure from issuers for overly rosy assessments of credit risk in order to minimize their cost of capital. If investors pay through subscription services, they pressure the agencies for overly rosy assessments to maximize rates of return on portfolios. The rating agencies are placed in positions of potential conflict of interest either way. The rating industry has also been criticized with lack of transparency over methods and processes and for a market structure that stymies the innovative juices that emanate from competitive pressures. Recent regulatory changes have enhanced supervision over the behavior of rating agencies and their processes in order to increase transparency and disclosure over their conduct and rating processes. There are also efforts to address malfunctions associated with weak accountability for product performance and perceived overreliance on ratings for regulatory purposes. These changes do not directly address the quality and timeliness of the ratings. Recent experiences suggest that issues persist with ratings of corporations (e.g., Enron and Parmalat), municipals (Orange Country in the mid-1990s), sovereigns (Europe and the United States) and structured finance instruments (mortgage-backed securities and CDOs). Has everything been done to bolster the methods, such as ratings, used to evaluate creditworthiness? The independence of rating agencies needed, it is thought, to be protected so as not to stymie the development of new techniques of creditworthiness. Again, assessors with persistently poor opinions will need to either adjust or leave the industry. Methods and techniques of assessing creditworthiness have evolved over the years. What little bits

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of regulation over this industry, prior to the GFC, suggest is that regulators did not stymie the market mechanism to stimulate innovation. The lack of regulation of the rating industry over the years, in fact, suggests that improvements to the accuracy of ratings were stimulated by the market mechanism. Left to themselves, the assessors, such as the rating agencies, have been innovative and responsive to changes in market, industry, and global conditions. Yet, their products continue to throw problems. Is it in the public’s interest to wait until a severe event occurs to learn that some methods of assessment for credit or default risk could have been better? The analyses in chapters 3 and 4 also clarified how one’s understanding of credit risk depends upon the perspective of the inherent stability or instability of a (capitalist) market economy. The predominant, mainstream approaches to the investment and financing decisions of firms and investment’s role in the performance of a macroeconomy rest on a vision of the inherent stability of a market economy. Investment plays a key part in the economy’s ability to balance itself, provided that the conditions—the presence of free markets and price flexibility—permit it to be so. Methods of creditworthiness reflect that vision. The alternative perspective, as perhaps best captured with an extended version of Minsky’s FIH, rests on the idea that investment is an inherently unstable activity. That instability is attributed to the dynamics associated with the quest for profit. The process of tendential regulation suggests that as capital flows both within and between industries, there is a tendency for incremental rates of return to equalize between industries over time. But, there is a continual process of upset or volatility to the incremental rates within industries as firms continually modify their productive conditions as they seek to lower the unit cost of their outputs. Moreover, tendential regulation rests on a slower dynamic of a falling average rate of return for an economy over time. Combined with changing interest rates and global conditions, these dynamics prompt instability in investment activities. Managing interest rates is a good start, but not enough in this context. Instability of rates of return on investment will impact assessments of creditworthiness. A firm can have a strong assessment at one point in time, a weak assessment at another. This is attributed not only to its own decisions on investment and finance, but also to changes in the context within which it operates (industry, macroeconomy, and global) after the firm’s decisions have been made. These changes are not random, but it does require clarification as to what drives default risk. Default risk does not emanate from just shocks or poor policy.

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Default risk fluctuates endogenously with changes in the system’s and industry’s degree of financial fragility. Stabilizing the economy and its financial system is not just a matter of improving quality in the assessments of creditworthiness (e.g., ratings). It is also about stabilizing investment activities. Investment depends not only on confidence of financial investors, who collectively influence the interest rate, but also confidence about strength of cash inflow (relative to outflow) as signaled by profit on new productive investment made by nonfinancial investors (firms). Operationalizing an extended version of the FIH can assist the evaluation of the macroeconomic and industrial contexts in which firms operate and help reduce, although not eliminate, the uncertainty regarding the state of the business climate they face. By doing so, it is possible to design an approach to attenuate the default risk. When a firm accepts “a liability structure in order to hold assets,” it is “betting that the ruling situation at the future dates will be such that the cash payment commitments can be met: it is estimating that the odds in an uncertain future are favorable” (Minsky 1975: 87). This chapter explores the idea that managing default risk could improve the odds of a successful bet. To justify a PCRA, the following need to be addressed: a method to monitor and manage default risk, financing the agency, a way to address conflict of interest (with respect to rating sovereigns and their issues), and a structure that thwarts regulatory capture. Accordingly, this chapter has the following structure. In the next section, the method put forth in chapter 3 is applied to the US economy to provide a set of benchmarks for the overall economy and its industries. Again, this involves using the framework of the FIH to more fully capture the dynamics that influence cash flows and firm liquidity. Default risk is typically related to liquidity risk from the perspective of financial intermediaries. That is, liquidity risk is the ease with which assets can be sold without affecting their price. Liquidity in an accounting sense is rather underdeveloped as there has been little guidance to explain how cash inflows from operations, and accounts receivable, can change in a systematic way. Incorporating the concepts of regulating capital and incremental rates of return can help improve our understanding. In the following section, we explore ways to attenuate or reduce default risk. There is an empirical aspect and there are policy aspects. First, there is provision for mutually supporting indicators with which to monitor the performance of industries and the macroeconomy. These indicators could be the benchmarks put forth in the previous

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section. What’s important is a systematic monitoring of conditions of production and finance, with a particular focus on how those changing conditions influence the default risk of firms (regardless of their form of organization). SMEs are especially important as their size and financing limitations naturally make them more vulnerable to default. Second, two policy suggestions are made. To lower the risk of default for nonfinancial firms, particularly SMEs, industrial policy needs to be constructed with an orientation toward civilian industries, perhaps supported with the assistance of community banks. Another policy suggestion is to implement an insurance scheme for SMEs to protect their trade credits along the lines of insurance schemes offered by export banks, but cast for a domestic context. The financing of such a scheme is discussed. In these ways, the post-Keynesian concepts of Big Bank and Big Government during periods of crisis can be supplemented by the ongoing management of default risk. Key aspects of these discussion are brought to bear on the functions and structure of a PCRA. A PCRA systematically collects and analyzes the industry-level data (with the cooperation of other government agencies), evaluates industry conditions in relation to the macroeconomic environment, and creates indicators or benchmarks that summarize those conditions. Government agencies, accounting firms, and rating agencies perform aspects of these functions, but without an analytical roadmap that can help to locate where and how problems emerge with respect to the risk of default. The performance of individual firms can be assessed relative to industry and macroeconomic health. Suggestions are made as to how to finance a PCRA and structural features that attempt to thwart the potential for regulatory capture of the agency. The subsequent section discusses these functions and how a domestic PCRA structure could be brought to bear at the international level with an international or global agency. In this way, the potential conflict of interest involved while assessing a sovereign’s creditworthiness can be avoided.

Monitoring and Managing Default Risk through Liquidity Risk Recall, there are two types of default—voluntary and involuntary. Voluntary default risk occurs when a firm decides not to honor its debt service commitments, even if it is able to do so. Involuntary default risk, in contrast, occurs when a firm is unable to service its debt due to an inadequate margin of security, where a firm’s margin of security consists of the cash and financial asset buffers that it holds

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in an effort to insulate itself from the whims of the market. As a firm’s buffer decreases, involuntary default risk rises, as well as its (market) liquidity risk. Again, default risk for Minsky has a strong emphasis on lender’s risk, as opposed to borrower’s risk. Following Keynes’s lead, Minsky understood borrower’s and lender’s risks as the risks that impact the decision to invest (“the volume of investment”). Borrower’s risk is the risk a firms faces about the strength of return on an investment. Lender’s risk is the risk of default (voluntary or involuntary). Confining default risk to lender’s risk suggests that default risk enters in a rather narrow way in Minsky’s (and Keynes’s) explanation of a firm’s investment and financing decisions. Default risk involves an analysis of the structure of debt as it appears on a firm’s balance sheet. It also involves a lender’s evaluation of the firm’s cash buffers and financial assets and the firm’s willingness to honor its debt service commitments. The management of default risk is primarily the concern of lenders. With respect to voluntary default, lenders must be diligent in reminding borrowers to honor their contractual commitments. In the case of involuntary default, lenders monitor firms’ margins of safety, advising them how to manage their margins should they fall too low. This construction seems to suggest that the performance of a firm’s productive activities is rather peripheral to an evaluation of default risk. As such, the concept of liquidity—as pertaining to the salability of assets—is market liquidity. If Minsky’s FIH were to provide an alternative route for the assessment of credit risk, a route based upon the inherent instability of investment, default risk needs to reflect more directly the performance of firm’s activities. In this way, default risk would become a shared concern of both lenders and firms. Firms are just as concerned about defaulting as their lenders. To do this requires a rethink of liquidity. Besides market liquidity risk, there is another sense in which liquidity risk is cast—the risk that the anticipated strength and structure of cash inflows (which result from sales, accounts receivable, and income from assets) falls short of cash outflows. This is the accounting sense of the liquidity concept. Liquidity in the accounting sense is what underlies Minsky’s cash flow framework. Problems of liquidity in the accounting sense can lead to problems in the sense of market liquidity. Default risk is ultimately about liquidity problems in the accounting sense—more specifically, when will a firm not have sufficient funds to service its debts? Viewing liquidity in this way allows for a clearer distinction between, and sources of, internal liquidity, external liquidity, and market liquidity. Internal liquidity results from the realization or sale of goods, whereas

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external liquidity is obtained from financial intermediaries and markets. (This distinction is related to that between external finance and internal finance where the focus is the source of intended investment activity, particularly for the expansion of capacity). Obtaining sufficient funds for payment obligations, then, requires understanding how internal liquidity is created. That, in turn, requires an understanding of the productive activities of firms, particularly nonfinancial firms. Thinking in this way about default risk creates a better knit between the dynamics of both the real and financial sectors at the level of the firm. It also clarifies the narrowness of Minsky’s (and Keynes’s) conceptions of lender’s and borrower’s risks as stemming from the relatively weak integration of the real and financial sectors. Although Minsky’s apparatus has the ability to capture financing and investment decisions, providing a way to link financial and real sectors, his analysis of productive activity needs to be extended. This weakness can be traced to Keynes, whose marginal efficiency of capital (MEC) was an attempt to link the real and financial sectors by treating capital assets similarly to financial assets. The MEC is a rate of return that balances the demand price of a capital asset (equal to its discounted cash flows) with the supply price of that asset. The MEC declines with persistent increments to capital stock (new investment) and with rising prices of capital assets (especially near the peak of a cycle). This is closest that Keynes can get to an explanation of a falling rate of profit. It is not technically a rate of profit, however. The MEC is simply a rate that balances the supply and demand prices for a capital asset. As the dynamics of productive activities are relatively underdeveloped, the role of the financial sector, as shaping the path of the economy, comes to be overemphasized. So much so, that Minsky’s viewpoint is often referred to as the “Wall Street” perspective. This weak integration is also evident with mainstream. According to mainstream macroeconomics, if instability emanates from the financial sector, there is strong focus on conditions that influence external liquidity risk. However, if instability comes from a shock to the real sector, impacting productivity of labor, there is no analysis of internal liquidity risk, which risk requires an analysis of the conditions of sale of output in combination with the conditions of producing output. The mainstream overlooks key aspects of the dynamics of internal financing of investment. The orthodoxy has a very weak theory of internal liquidity risk, at best. The extension of the FIH, as suggested in chapter 3, incorporates an incremental rate of return that, in turn, reflects the behavior of regulating capital. Again, the incremental rate of profit (rʹ)

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is defined as the change in profit (∆R) divided by a change in the capital stock or, equivalently, prior period investment (It-1): rʹ = ∆R/It-1. Capital accumulation (gʹ) is the change in investment (∆I) divided by the change in capital stock (∆K), or prior period investment: gʹ = (∆I/It-1). Similarly, incremental debt service on a unit of new debt is the interest rate (iʹ). In terms of rates, an economy is hedged when the incremental rate of profit is greater than either capital accumulation or interest (rʹ > gʹ or rʹ > iʹ); speculative when the incremental profit rate is less than capital accumulation, but still greater than the interest rate (gʹ > rʹ > iʹ); and Ponzi when the incremental rate of profit is less than the interest rate (iʹ > rʹ). It is difficult to pinpoint precisely the transitions between the regimes for two reasons. First, there will always be some imprecision in how the data series have been constructed to fit the theoretical concepts. Second, the incremental rates tend to be volatile since they are influenced by transitory elements. Current profits, for example, can be influenced by transitory imbalances in supply and demand, which makes the near-term rate of return on new investment volatile. Moreover, competitive pressures force firms to innovate in order to maintain and enhance profitability and protect, if not increase, market shares. Competition reflects the quest for profit through the activity of investment. The concept of regulating capital makes it clear that the firms’ rates of return are not stable. Rather, they fluctuate as the success or failure of investment decisions is determined in the marketplace. In contrast, the models of mainstream investment and financing decisions presume that the rates of return to investment are either stable or slowly changing. The mainstream is, thus, unable to explain fluctuations in the rate of return, at least without resorting to the unanticipated shocks to either the financial sector or the real sector. The assumption of stable rates of return throws the adjustment of investment to the interest rate (financial conditions). In a sense, the rating agencies, and even the market-oriented approaches, are attempting to fill the void by providing information about changes in productive conditions before they are reflected, indirectly, through firms’ financial statements. Benchmarks. Next, we attempt to incorporate the incremental rate into the framework to obtain a prototype of benchmarks for detecting the performance of overall macroeconomy and the industries that comprise it. The benchmarks reflect the dynamics underlying the cash flows of firms and how those dynamics influence the industrial and macroeconomic contexts in which firms operate. A better understanding

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of investment’s behavior may reduce some of the uncertainty surrounding the business environment in which firms operate. The selection of the United States, and selected industries within it, is attributed to the quality and availability of data at the industry level. Like the country applications in Schroeder (2004, 2009), the framework is placed on a dynamic basis by defining the variables as rates rather than levels. Rather than work with the amounts or levels of profit, investment, and debt service, we work with their rates in order to monitor how these variables change over time and how they relate to each other, particularly the incremental rate as an indication of the strength of profitability of recent (new) investment and the interest rate as indication of financing conditions on new investment. The incremental rates are calculated for the US economy as a whole, for selected industries and subindustries. The quality of American data makes the United States an ideal candidate for exploring the use of the incremental rates. The incremental rate of return (IRR) is easy to construct since the underlying data series are highly accessible. The OECD, for instance, provides national and industry level data; industry data for the United States is available from 1987 to 2010. (The availability of OECD data for other countries varies). The US Bureau of Economic Analysis (BEA) provides national industry level data from 1997 to 2013; national data has a longer time spans. The basic calculation of the incremental rate of return requires the creation of a profit series and an investment series. The definition and scope of the profit series will have a strong influence on the interpretation of the IRR’s movements. Please note that one can use nominal data rather than deflated data, as “the current cost incremental rate is simultaneously a real rate” (Shaikh 2008: 192, fn9). We begin with the calculation of the IRR for the national economy. Two versions of the IRR are calculated—one using OECD data and the other using BEA data, as a way to check the degree of congruence in the two data sources. The OECD data comes from the Structural Analysis (STAN) database. The selected data series are value added, compensation of employees, indirect tax, and gross fixed capital formation. They all are nominal or current cost. Profit is defined as value added minus compensation of employees and indirect tax. The difference in two consecutive observations in the profit series is calculated (for instance, profit 1980 – profit 1979 give the change in profit for 1980). Each observation in the differenced series is divided by the prior year’s observation in fixed investment to obtain the incremental rate. For example, rʹ(1980) = IRR(1980) = [(profit 1980 – profit 1979)/investment1979] *100. Likewise, a similar series is constructed

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20 15 10 5 0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 –5 OECD

Figure 6.1

NIPA

Incremental rate for the US economy (1997–2013): OECD vs. NIPA

Source: OECD STAN database, National Income and Product Accounts (BEA), and author’s calculations

using National Income and Product Accounts (NIPA) data from the BEA. Gross domestic product is taken from line 1, BEA table 1.1.5; employee compensation data is located at line 2, BEA table 1.12; indirect taxes from line 19, BEA table 1.12 ; and private gross domestic investment is line 14 from BEA table 1.1.5. The resulting IRR series are presented in Figure 6.1. The series are similar in that they capture the high and low points at the same time, or nearly so, and their averages are similar. High points in 1999, 2004–2005, and 2010; low points in 1998, 2000– 2001, 2008–2009. For the years in which the data series overlap (1998–2010), the average IRR based upon the OECD data is 9.3, and 10.1 for the NIPA data. Differences in the series can most likely be attributed to revisions in the NIPA data taking time to be reflected in the STAN database. For either series, the IRR is sensitive enough to be relatively low in crisis years, such as 1998 (the Asian crisis), 2000–2001 (the dotcom bubble collapse and 9/11), and 2008–2009 (the financial crisis). The IRR suggests strengthening in the American economy during 2002 to 2004–2005, from which point economy begins to soften. Note that the economy seems to soften prior to the onset of the crisis (in 2007). It would appear that that occurs about the same time that consumption began to slow in the United States (see Figure 6.2, NIPA table 2.3.1, line 1). After verifying that the OECD and the NIPA provide similar results, the NIPA data is used to delve deeper into the American economy. Figure 6.3 compares the IRR, as an indicator of the strength of the economy, with an interest rate, as indicator of financing conditions. With the NIPA data, the series can be broadened to 1976–2013. The IRR calculation is refined by the removal of direct tax, corporate

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6 5 4 3 2 1 0 –1

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Figure 6.2 Growth rate of real personal consumption expenditures: United States (1990–2013) Source: National Income and Product Accounts (BEA)

25.00 20.00 15.00 10.00 5.00 0.00 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 IRR

Figure 6.3

interest rate on inv grade debt

IRR vs. interest rate: United States (1976–2013)

Source: National Income and Product Accounts (BEA), Federal Reserve, and author’s calculations

transfer payments, and interest payments on debt (personal and government) from the profit calculation. Direct tax series is located from NIPA table 1.12, line 14; corporate transfer payments is sourced from NIPA table 1.12, line 21; personal interest payments on debt are located at NIPA table 2.1, line 30; and, finally, government’s interest payments on debt came from NIPA 3.1, line 22. The interest rate selected is that associated with investment grade debt (as classed by Moody’s category Aaa); data was obtained from the Federal Reserve (table H15). The relationship between the IRR and the interest rate records weakness (iʹ > rʹ) when the American economy flagged: the crisis in the early 1981–1982 (contractionary monetary policy of Federal Reserve); the recession of the early 1990s; the Asian crisis (1998); the dotcom bubble (2001); the recent financial crisis (2008). Because of

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25.00 20.00 15.00 10.00 5.00 0.00 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 IRRMA3

iMA3

Figure 6.4 Smoothed IRR vs. interest rate, 3-year centered moving averages: United States (1977–2012) Source: National Income and Product Accounts (BEA), Federal Reserve, and author’s calculations

volatility in the data, the series were then smoothed by using a threeyear, centered moving average, Figure 6.4. Figure 6.4 suggests that the American economy is remarkably resilient and able to withstand a variety of challenges posed to it over the years. The incremental rate lies above the interest rate on investment grade securities. This suggests that profit on a unit of new investment exceeds the cost of debt on a unit of additional finance. That picture may be something of an illusion, however. If personal and government property income is removed from the IRR calculation, the American economy appears to have suffered severely from the late 1970s to the early 1990s, and has been struggling, at best, ever since. Personal property income is the rental income of persons without capital consumption allowance (NIPA table 1.12, line 39), whereas government property income is its income receipts on assets (NIPA table 3.1, line 8). These are unproductive activities. The result of these adjustments results in Figure 6.5. The smoothed versions of the series are presented in Figure 6.6. During this period, the economy appears to be quite fragile with respect to its productive activities, and rate of return on productive investment struggles to cover the interest on new debt. The IRR lies well below the interest rate for 1979–1991. The economy appears to gain strength whenever the relationship in these rates reverses, for instance, in the early 1990s, early 2000s, and 2011 to present. However, a note of caution is in order. If one looks at the underlying growth of investment (relative to that of profit), these reversions could be due not to improvements in profit, but to slumps in investment. Looking ahead to Figure 6.9, where growth of investment is illustrated, one finds dips in investment at the time the IRR

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20.00 15.00 10.00

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5.00

–10.00 –15.00

IRR

interest rate on inv grade debt

Figure 6.5 IRR without property income (personal & government) vs. interest rate: United States (1976–2013) Source: National Income and Product Accounts (BEA), Federal Reserve, and author’s calculations

15.00 10.00

0.00 –5.00

1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

5.00

–10.00 IRRMA3

iMA3

Figure 6.6 Smoothed IRR (without property income) vs. interest rate, 3-year centered moving averages: United States (1977–2012) Source: National Income and Product Accounts (BEA), Federal Reserve, and author’s calculations

and the interest rate reverts. The use of the incremental rates is insightful, but care needs to be taken with their interpretation. Please note also that this, smoothed version suggests the transition into a weak(er) state occurs prior to the weakening of consumption. This suggests that the recent financial crisis was not driven by consumption. The influence of income from property is striking. Without it, the national IRR struggles to exceed the interest rate on investment grade debt. This would seem to suggest that the American economy has been bolstered, at least, in part, by unproductive activities. Motivation toward this shift could be due to the erosion of employee compensation over the years. Rental income from property is a strategy to bolster one’s standard of living, provided he/she is in a position to own property. Figure 6.7 illustrates how compensation as a percentage of

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70.0 68.0 66.0 64.0 62.0 60.0

56.0

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58.0

Compensation/NI

Persons Rental Income/NI

Figure 6.7 Employee compensation and rental income of persons (% of national income): United States (1976–2013) Source: National Income and Product Accounts (BEA) and author’s calculations

90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

0.0

Comp & Rental

Corporate Profit

Figure 6.8 Compensation & rental income vs. corporate profits (% of national income): United States (1976–2013) Source: National Income and Product Accounts (BEA) and author’s calculations

national income stands in relation to rental income of persons (lines 2 and 12, respectively, from BEA table 1.12). Compensation of employees as a share of national income in 2013 is the lowest it has been in the last 40 years (60.7%). The share of rental income is rising, but not fast enough to offset the decline in compensation. Corporate share of national income, on the other hand, is the highest in the last 40 years (Figure 6.8) with a share of 14.8 percent in 2013; data for corporation share of national income is located at line 13, BEA table 1.12. Another interesting aspect to note is that the average IRR for the United States has changed over time. The average IRR between the years 1930 and 2013 is 8.5 percent (without property income); it

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15.0 10.0 5.0 0.0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 –5.0 –10.0 IRRMA3

%InvestMA3

Figure 6.9 IRR vs. % change in (real) investment, 3-year centered moving averages: United States (1997–2012) Source: National Income and Product Accounts (BEA) and author’s calculations

was 13.8 percent with property income included. Over the period 1980–2013 the average IRR (without property income) dropped to 3.5 percent, it also dropped to 9.7 percent with property income. Between 1997 and 2013, the range of industry-level data from the BEA, the average IRR (without property income) rises to 4.5 percent; with property income included, the average IRR falls to 8.9 percent. This may well reflect the influence of processes associated with financialization. However, an investigation of this phenomenon is beyond the scope of this book. Since we are interested in the dynamics of productive activities, the IRR without property income captures more clearly those dynamics. How does the IRR compare with gʹ or the rate of change in investment? It turns out that the IRR leads movements in the rate of change in investment. Figure 6.9 presents the three-year moving averages of the IRR and percentage change in (real) investment (base year 2009=100). The figure suggests that the movement in the IRR leads changes in the growth of investment by approximately two years. With the national IRR, one can use IRRs at the industry level to begin to ascertain the relative performance of the industries. According to the regulating capital concept, industries with higher than the national IRR are industries for which one would expect growth and at least stable, if not rising shares of GDP; industries with less than the national IRR would be expected to show sluggish growth and decreasing shares of GDP. Examples are provided here for US manufacturing and selected components of it. The issues of property income and corporate transfer payments are not part of the calculation of these industrial IRRs. Please note that industrial IRRs are not advised for

140 80.0 60.0 40.0 20.0 0.0 –20.0 –40.0 –60.0 –80.0 –100.0

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1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

USA

MFR

Food, bev & tobacco

Textile mills and products

Minerals - nonmetallic (D22T23)

Machinery & Equipment (D26T28)

Paper and paper products (D17)

Chemicals & chemical products (D20)

Figure 6.10 3-year moving averages of selected industrial IRRs: United States (1998–2012) Source: National Income and Product Accounts and author’s calculations

industries whose production processes entail large amounts of industrial capital (such as mining and some subindustries of transportation) or industries that are not for profit (for instance, the arts, education, health and social services, and government). The IRR could be calculated for construction provided that an adjustment is made to remove the income of self-employed persons; retaining that income artificially inflates the calculation of profit for that industry (the same is true for agriculture). (Please see Shaikh 2008 and Dumenil and Levy 2002 for their discussions of the nuances of calculating rate of return for various industries). Again, for reasons of consistency and level of detail, the NIPA data are used to calculate industry IRRs. At the time of writing, the last observation is 2013, whereas the OECD data ends in 2010. Data on value added, compensation of employees, and taxes on production and imports came from NIPA’s “Components of Value Added by Industry” and investment data came from Investment in Private Fixed Assets by Industry (table 3.7ESI). Calculations of the industrial IRRs revealed that the average IRR for overall manufacturing was 8.8 percent, better than the overall US economy, which was at 4.5 percent. Food, beverages, and tobacco’s average IRR was 15.4 percent, minerals (nonmetallic) was 0.3 percent, machinery and equipment was 8.8 percent, paper was 0.4 percent, and textile mills and products was -1.5 percent. Their three-year moving averages are illustrated in Figure 6.10.

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Using the IRRs as a way to assess the states of the industries is straightforward for some industries, not so for others. For instance, the textile industry’s average IRR was -1.9 percent (less than the overall average IRR for the United States). Its growth of (real) investment was -66 percent between 1997 and 2013 (relative to the American economy’s 37 percent), and, accordingly, its share of GDP declined from 0.3 percent to 0.1 percent. The food, beverage, and tobacco industry’s average IRR was 15.4 percent (larger than the American economy’s); its share of GDP remained stable at about 1.5 percent, and its pace of investment was 67.4 percent. Even though manufacturing’s average IRR exceeded that of the US economy during this time period, its share of GDP actually fell as its growth of investment was sluggish at 21 percent. Why would this be the case? This would happen when it is possible for firms to invest overseas and earn even higher rates of return. Shaikh (2008) provides estimates for global IRRs using OECD data available for 1970–1990, and the manufacturing IRR worldwide is consistent with that experienced by the American economy. However, there will undoubtedly be countries included in the OECD database with greater IRRs in manufacturing than the United States. This is what likely sapped the strength of the US manufacturing sector. Interesting to note that the industries where value added gained share of GDP were the not for profit industries (education, health, and social services, the arts and entertainment) and real estate and rentals. These examples are indicative of the potential for using IRRs as benchmarks with which to evaluate performance of industries and overall economies. Again, the idea is that firms whose incremental rates are better than their industries’ own are in a position to expand their market share as their investment is yielding returns that are above the pace of the industry; again, consideration must be given to the global context in which industries are developing. It is possible that some of the civilian industries that are currently struggling could find new life with industrial policy with an orientation toward supply support. The use of the incremental rates is not recommended for the government as their activities are not profit driven. However, IRR for the overall economy might be used for evaluating an economy’s degree of fragility or country risk. Figures 6.5 and 6.6 suggest that the American economy has been in a heightened state of fragility for quite some time.

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Attenuating Default Risk—with a Little Help from Industrial Policy and an Insurance Scheme What we take away from the previous section is that managing default risk is tricky because of the lack of stability of investment, as further evidenced by the incremental rate of profit. The lack of stability does not suggest that movements are random. Firms’ quest for profit is reflected by their investment and financing decisions in a business environment characterized by true uncertainty. The quest for profit, through size and market share, could be understood as a quest for stability, stability in income (or “internal liquidity”) in order to complete payment obligations. With a method to support the identification of when firms are likely to experience elevated level of default risk, based upon swings in cash flows and changes in the incremental rate on new investment and the rate on financing new investment, the next step is to find ways to attenuate default risk. Attenuating or reducing default risk entails the creation of a set of mechanisms that support the realization or sale of output—stabilizing firms’ revenues. Again, the idea is to improve the odds of firms’ successful “bets” with respect to their investment and financial decisions. Two suggestions are made here. The first suggestion is to implement an insurance scheme for nonfinancial SMEs to safeguard their trade credits against commercial non-repayment risk. The second part involves the creation of an industrial policy oriented toward civilian industries. These two policies would enable the government to stabilize flows in a way that is complementary to post-Keynesians’ Big Bank and Big Government approaches to policy. Whereas Big Government’s expenditures can soften the ill effects of an economic downturn and a Big Bank, through interest rate policy and its lender-of-last resort function, can thwart the development of, or soften the onset of, financial crises, industrial policy and a supporting insurance scheme can assist soften cycles by stabilizing cash inflows. In turn, this support reinforces income and employment. By supporting sales of goods and services in these ways, volatility in investment spending can be reduced. The insurance scheme could stabilize investment flows by providing cover to the trade credits of SMEs. The structure could be akin to insurance provided by export-import banks, such as the US ExportImport Bank, which provides insurance and/or guarantees to support overseas transactions. As is well known, SMEs are an especially vulnerable form of organization because of the riskiness of new, small

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ventures in the context of competitive, volatile markets and their limited access to funding. Another aspect of vulnerability is exposure to partner firms or/and clients not paying for goods and services in a timely manner, often as a way to offset pressures for short-term funding. Governments make a point to make payment on time on commitments to SMEs, but corporations are known to use payment delays as a source of funding (Lobel 2014; EC Enterprise and Industry 2014). By doing so, larger firms transmit short-term funding problems to other firms. For SMEs, that’s deadly, and it impacts financial institutions that provide funding for their investments. SMEs have a special need to be supported. Legislation that gives SMEs the ability to add late penalties and interest charges on amounts due to them is a good start, but insurance schemes along the lines of those provided by export banks for overseas transactions are even better. Supporting smaller firms in this way gives them confidence in extending trade credits and obtaining new credit on more favorable terms. Again, stabilizing their cash receipts would also help stabilize the supplies of goods and services that they obtain from other firms for use in production. Supporting sales would not only bolster profitability of investment but also support employment and household income and consumption. Smaller firms would be better able survive and compete in competitive market places. Firms could also sell the insurance instrument to a third party to shore up working capital. Firms that apply for the insurance would need to satisfy eligibility requirements such as: age of the firm, minimum number of staff, positive net worth (not bankrupt), making products within the domestic borders using domestic personnel (citizens and permanent residents), and having its main office (domiciled) in the country. Why not large firms and corporations? Large firms and corporations—500 employees and over—are excluded because their size, power in the marketplace, and supply chains naturally give them advantages over smaller firms for locating and obtaining both outlets for their products and external finance on favorable terms. Other reasons include the need to support SMEs in local communities. Strengthening the networks of SMEs can reinvigorate these communities, especially in less densely populated areas. As big as they are, corporations can’t be everywhere. When corporations relocate production and support staff, they can leave a vacuum in the incentives to invest and employment opportunities for the local businesses that remain. The failure rate of small firms is higher than that of larger firms. This is why it is important to stabilize their flows and give them the best chance to survive. It goes without saying that firms are going

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to have problems. Having a link to a government agency that oversees insurance schemes becomes helpful for referring firms to sources of assistance to sort out problems of production, resources, client base, and so on. SMEs might find that they have a better chance of survival if they can be retooled for another industry, and if a firm fails, owners and employees can find direction on how to re-skill. As many countries already have departments or agencies that target assistance to SMEs, an insurance scheme can be implemented through these agencies with the assistance of related government departments. How could this be funded? To alleviate liability of the government, and protect its fiscal position, the insurance scheme can be supported through a pool of “rainy day” funds. The fund could be based upon a tax invoked on an “as needed basis” targeting banks, non-bank financial institutions, institutional investors, and all other entities and individuals who actively use the ratings, directly or indirectly.1 (Recall, the refutation of Ricardian equivalence permits alternative ways to use tax and debt to support the government’s objectives). The size of the fund can be determined with the assistance of insurance companies. In this way, the insurance industry can be confident that it would not be left holding the bag on claims during an economic downturn. The insurance scheme needs to be just that—insurance. Instruments such as credit default swaps and guarantees are not ideal as they essentially shift risk in counterproductive, potentially destabilizing, ways. For instance, credit default swaps can shift the risk to banks. When an economy becomes recessionary, it is natural to expect that financial pressure on SMEs will likely increase. Banks would face additional pressure on their positions as swaps kick in when some SMEs begin to underperform. Under an insurance scheme to stabilize cash flows, government is in a better position to convince banks to continue to lend to firms needing short-term working capital during bouts of instability. So long as a firm’s net worth is positive, the banks are likely to get their funds back. Likewise, government guarantees are not ideal, as claims would become due at the same time that the government’s position would come under pressure through automatic stabilizers and weakening tax revenue. It is interesting to note how Minsky’s classification aligns with the rating structure of an export bank, such as the Export-Import Bank of the United States. Table 6.1 categorizes the credit profile of nonfinancial firms into six types. The strongest two types (CC0 and CC1) are similar to Minsky’s hedged firm in the sense that there is very little disruption to payments expected and the firm has the ability to withstand unforeseen shocks (both margin of security and cash inflows

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Table 6.1 Rating structure for Export-Import Bank of the United States CC0: Exceptionally good or sovereign equivalent (negligible risk of payment disruption, able to withstand foreseeable events) •  Excellent to very good cash and income (profit) inflows •  Excellent to very good liquidity •  Low, if any, leverage •  Exceptional position with the industry, strong management, and transparent  (disclosure of financials and ownership) CC1: Very good credit quality (very low risk of payment disruption, able to withstand foreseeable events) •  Very good to good cash and income flows •  Very good to good liquidity •  Low to very low leverage •  Strong position within its industry, strong management, and transparent CC2: Good to moderately good credit quality (low risk of payment disruption) •  Good to cash and income flows •  Good to liquidity •  Low to moderately low leverage •  Good positions within its industry, management, and transparent CC3: Moderate credit quality (moderate or moderately low risk of payment disruption) •  Moderately good to moderate cash and income flows •  Moderately good to moderate liquidity •  Moderate to moderately low leverage •  Moderate position its industry with proven management CC4: Moderately weak credit quality (moderately high risk of payment disruption) •  Moderate to moderately weak cash and income flows •  Moderate to moderately weak liquidity •  Moderate to moderately high leverage •  Moderately weak business profile with limited management capabilities with  adequate disclosure CC5: Weak credit quality (high risk of payment disruption) •  Moderately weak to very weak cash and income flows •  Moderately weak to very weak liquidity •  High to very high leverage •  Weak business profile with poor management track record and disclosure Source: Adapted from Export-Import Bank of the United States, Credit Classification Definitions for Nonfinancial Institutional risk (medium- and long-term transactions)

are very strong). The next two types (CC2 and CC3) correspond to the speculative firm, moderately low risk of payment disruption (a margin of security that is good with moderate to good cash inflows). The last two types align with Minsky’s Ponzi firm, moderate to high risk of payment disruption (low or weak margin of security, and cash inflows are moderately weak to very weak). What the FIH provides is a basis for an explanation of how firms shift endogenously through the

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categories as a result of their investment and financing decisions. As the business cycle proceeds, a firm gradually becomes less risk averse to using short-term debt. It is often the case that in an upswing, shortterm interest rates are typically less than long-term interest rates. As the use of short-term debt increases, debt service payments increase. Payment commitments on debt are easily accommodated so long as the cash flows from operations are strong. However, hedged firms are more likely to become fragile as cash flows from operations weaken. Weakening cash flows are attributed to a shock to the cost of production, such as wage or tax increases. However, as the composition of its debt burden shifts toward short-term debt, a firm becomes more vulnerable or sensitive to rising interest rates. Minsky, however, emphasized that it is speculative and Ponzi firms, not hedged firms, that are most adversely affected by rising interest rates. The effects of refocusing firms or re-skilling workers is more easily achieved with an articulated industrial policy. Since World War II, there have been two experiences with industrial policies in market economies. Although both rely on the market mechanism, one approach relies more heavily on this mechanism than the other. That is, one approach seeks to harness the market mechanism with the understanding that a capitalist market economy is inherently unstable, whereas the other holds the confidence that the market mechanism can provide a stable outcome under the right conditions. Governments that demonstrated a healthy skepticism of free markets include countries such as Germany, France, Japan, and Korea, whereas the United Kingdom and the United States have pursued paths that are more reliant on market mechanism. France and Germany chose a long-run orientation for the development of their industries, in which the governments helped to create a strong relationship between large banks and nonfinancial firms. Germans referred to this approach as “supply support,” their pseudonym for demand management (Eatwell 1982: 84). The idea of supply support is to help ensure that the development of industries proceeds in a way that the output of goods and services produced would be realized or sold. A key component was the provision of short-term funding when instability strikes. Stable industrial development, in turn, would support their social safety nets and reinforce the demand for output. Supply support is complementary to a social welfare system with mechanisms that support the labor market’s adaptation to changes in the global environment. Further, the social services available to workers motivate them to re-skill and adapt to new working conditions should an occasion arise to do so. Asian economies

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followed suit, to varying degrees, but without the strong tradition of social welfare systems (Kwon 2007). These experiences suggest an understanding that markets are unstable and government influence helps to shape solutions that involve development of industries and social safety nets that are mutually supporting and more resilient to the whims of the markets. The recent sovereign debt crises are posing a serious test to this approach. The United Kingdom and the United States chose a more shortterm approach that involved less involvement of the government and more reliance on the market mechanism (Eatwell 1982). Consumption evolved as industries developed and employment followed. Lee (1997) notes that when push came to shove, the British government chose to support its industries in a way that pushed the system toward liberal militarism over orientation of its economy. The same can be said of the Americans. According to Lee (1997), technocratic pragmatists further undermined the public interest by helping to pursue liberal militarism with their support of defense industries over civilian industries (Lee 1997: 110, 135). In contrast, German industrial development, for example, centered on the provision of goods and services that support civil rather than military industries. Of course, the United States and United Kingdom do not rely entirely on free markets. Some industries are strongly influenced by the government to achieve social outcomes. In other words, their industrial policies entail social components. Galbraith (2007), for instance, has forcefully argued that the United States has long had an industrial policy when it came to certain sectors such as education and health. The policy is through soft budgeting, which, he notes, was the same approach as used by the former USSR. The difference is that with the States, soft budgeting is accompanied by the market (decentralized) mechanism whereas the USSR employed centralized planning. The soft budget approach is applicable to industries involved with social goals rather than consumption. Supply support for the British and American approach is more subject to the whims of the market. In a sense, the German government has been managing default risk for decades. The relationship between large banks and corporations helped secure short-term funding during weak business climates, and by doing so protecting the medium- and long-term development plans for the Germany economy—and the synergies between the social, public, and private realms. A PCRA can, similarly, enhance the connectivity between the real and financial sectors. A PCRA could, for instance, build a structure of benchmark default rates or indicators defined on industrial-level data, which proxies the

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cash flow concepts of firms. The indicators monitor rates of change of cash inflows relative to cash outflows, or changes in the margins of security, and they can be used to compare corresponding data for firms within the industry. In this way, the nuances of industries can be captured (with the input of experts). With a robust set of benchmarks, firms that engage with the industrial policy set by the national government can apply for an adjustment that boosts (modestly) their evaluations of creditworthiness and, hence, lowers their cost of debt and capital. It is important to emphasize that firms that use assessments of creditworthiness as part of their business activities are not obligated to use PCRA’s system of benchmarks; this must be made clear in order to protect the PCRA and the government from liability. How would managing default risk compare with the traditional tools of industrial policy? Traditional tools of industrial policy are tax breaks or indirect subsidies, direct subsidies, protection of infant industries, government procurement, research and development policy, trade policy, technology importation and attraction of foreign direct investment, and preferred access to credit (such as interest rate subsidies) (Noland 1990). Managing default rates seems to be similar to managing or subsidizing interest rates. However, managing or subsidizing interest rates ultimately allows the financial sector to continue to steer external funding and investment flows. Managing the default rates, on the other hand, offers the opportunity to establish and manage social goals collectively. Forging industrial policy while embedded in complex processes, which cannot be modeled fully, would also reduce the influence of technocratic pragmatists. The ability of a government to influence the long-term direction of its country depends on the degree of reliance on the international markets. The link between international trade and industrial policies needs to be explicit (Eatwell 1982: 84). Industrial policies as have been traditionally cast, for example, subsidies and price supports, are more limited now by free trade agreements. The management of default risk could provide a new tool for allowing governments to orient their industries toward more progressive, social goals, rather than simply allow consumption to grow as it supports the goals of liberal militarism.

Functions and Features of a Public Credit Rating Agency (PCRA) What we’ve seen, thus far, is a possible method to assist with an assessment of credit risk, a method based upon an understanding

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that investment is inherently unstable. A government agency—a PCRA—could use something like this in order to monitor economic and financial conditions in an economy and its industries as a way to detect changes that are conducive to rising default risk (lower creditworthiness). It should be stated upfront that the idea of a PCRA, as cast here, is not meant to replace the credit rating firms. Rather, this function is meant to facilitate improvements in the quality and timeliness of ratings and other schemes to measure creditworthiness. Moreover, any benchmarks it provides are for information only and not intended to compete with the products of the agencies. That said, if a reliable set of benchmarks can be generated, it is conceivable that they could be used alongside interest rate policy to moderate economic performance. Functions. What functions could a PCRA perform? How would it be financed? What are the ways to avoid conflict of interest when rating sovereign debt? How could it avoid potential regulatory capture? These are some of the issues that need to be addressed for proposing a PCRA. The functions flow from the understanding that investment is inherently unstable, which impacts the stability of the economy and its financial system. It is in the public’s interest to stabilize investment. One must not conflate the idea that investment is unstable with the idea that changes in investment are random. Investment has exhibited cyclical patterns in mature economies. This fact has been documented for decades, beginning most systematically with Wesley Mitchell’s efforts at the NBER. Swings in investment may appear random or stochastic from the viewpoint of mainstream economics because of its underlying vision that investment is an activity that helps a system adjust toward balance or a balanced growth path. In contrast, investment is an expression of firms’ need to expand as they seek stability and security through profit expansion (and size). Those efforts ultimately render investment as destabilizing. The functions of a PCRA both overlap and counterbalance those of the rating agencies and other assessors that need to discern creditworthiness. For instance, a PCRA needs to empirically detect and monitor the economic health and financing conditions of industries, sectors, and the overall economy.2 The PCRA is an institution where productive conditions and financing conditions are monitored concurrently, as investment and financing decisions of firms are interdependent. A PCRA need not create data on entirely its own. Undoubtedly there will be national agencies/departments that gather this information. The configuration varies across countries according to the institutional division of labor. For instance, in the United States, such

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national agencies include the Census Bureau, the Bureau of Economic Analysis, Small Business Administration, the Federal Reserve in the United States, and the Internal Revenue Service. Input from the Conference Board and NBER could assist with the study of business cycles and rating changes. Data gathered by a PCRA leads to another function: to support studies that validate ratings and other measures of creditworthiness. Due diligence is a labor intensive and costly process. The agency’s in-depth monitoring of production and financing conditions with the support of other national agencies/departments would give it an advantage to assist the due diligence process. The studies would undergo peerreview process that has internal and external aspects. Staff that conducts validation studies do so under the supervision of a division officer and from time to time their studies can be compared across the divisions in an effort to share information and to critique aspects. Peer-review processes that are solely internal can introduce conflict of interest. Conflict of interest needs to be avoided as it potentially compromises quality. It is possible to contract minor rating agencies to cross-check and critique validation studies. Contracting aspects of these studies out to small rating agencies may be worth considering as part of an effort to promote competition in the industry, loosening its market structure. Of course, discrepancies between the ratings, their performance, and PCRA’s benchmarks warrant further scrutiny. Another function of a PCRA is to conduct studies that evaluate models of cash flows, credit risk, and measures of rates of return with the intent to improve models. This also should involve a peer-review process, the results of which, like the validation studies, can be made accessible by the public, thus promoting dissemination of information. A PCRA can also facilitate discussion of the studies, emerging issues, and industry trends by conducting semiannual meetings. These meetings would provide opportunities to openly discuss improvements to the techniques of evaluating creditworthiness. Provision of this information could help reduce information asymmetry and would promote transparency. However, from a heterodox perspective, the attention paid to asymmetric information and transparency, although worthwhile, is not as important as the destabilizing influence of investment through the quest by firms for profit. If models are not capturing that, they will clearly overlook the key dynamics and not be as accurate as if they did. A PCRA could also create benchmarks or sets of indicators that summarize the economic and credit conditions within each industry and for the economy as a whole. No one indicator can capture the

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development of economic and/or financial conditions due to the complex nature of the investment and financing decisions of firms. There are leads and lags involved in the dynamics of the development of fragility in the economy. The incremental rate is a signal for changes in the strength of returns on new investment, which, in turn, leads to changes in the growth of output, income, and employment. A single, composite indicator is too sluggish as the informational content of individual series is diluted, especially if leading indicators happen to be combined with composite or lagging indicators. With respect to method, industry benchmarks could be based upon the concept of regulating capital or conditions of production. The incremental rate of return, as representative of regulating capital, can be created at the level of the industry and macroeconomy and used to compare the performance of firms.3 With an initial assessment of its net cash flows, including an estimate of its incremental rate, a firm can be initially mapped into the corresponding default or credit scale, similar to the credit classifications of the EXIM bank. Its placement can be adjusted according to its relationship to the regulating capital for its industry. A firm that is performing better than the regulating capital is uplifted a notch to reflect that strength; a firm that is underperforming is dropped a notch. Of course, consideration needs to be given to the host of nuances characteristic of industries and their states of development and associated markets, and unique issues associated with firm types such as SMEs. Expert opinion and expertise of staff are important for those adjustments. Using a classification such as the EXIM’s as a guide has the advantage that it provides correspondence of its scale with the scales of the rating agencies. Benchmarks for complex securities are problematic as the scope of information about them is much more limited than with other securities. However, this should at least be attempted. The verification of the private ratings on this form of securities, if rating agencies continue to do this (Durie 2012), may be supported with the involvement of investor watchdog groups. A PCRA could provide a platform where investor concerns can be raised and discussed. A PCRA’s ability to recommend default rate adjustments could complement a central bank’s management of interest rates, for shortand medium-term volatilities in particular segments of the economy. For instance, rather than raise a policy interest rate over the entire economy to stem speculative investment in a particular sectors, housing, for instance, the PCRA could recommend that the default risk adjustments on loans to property investors be raised. In this way the adjustments can be targeted toward stabilizing industries or sectors

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that overheat, or, conversely, need support. As such, a PCRA would be able to detect that and recommend adjustments to the insurance policies. For instance, as firms become more risky, the fee on the insurance can be increased not only to take some of the steam out of the economy but also to increase the pool of rainy day funds to contain an event, when it happens. Central banks would then be free to focus on other aspects of their national financial systems. The stabilizing activities of a PCRA would be enhanced it were coupled with an industrial policy and insurance scheme, as discussed above. These are just some of the ways that a PCRA could help stabilize income and investment, enabling a smoother path for completing payment obligations. The promotion of stable income would also mean stabilizing tax revenues of governments (local and national). Stable tax revenues makes it easier for governments to service debt and to make changes necessary to ensure the effectiveness of government’s efforts. Note that effectiveness does not necessarily mean the outsourcing of government’s functions to achieve greater efficiencies. Because of their size, governments have the opportunities to benefit from division of labor and economies of scale. Effective government policies are those that progress toward achieving public interest. Although the discussion has concentrated on firms, a PCRA could also assist other entities that are rated by the rating agencies and other assessors. These include consumers, for instance, who are rated by credit bureaus (or consumer rating agencies). Credit bureaus are to consumers as rating agencies are to large firms and governments. In the United States, there are three key firms that construct credit reports— Experian, Trans Union, and Equifax. As in the case of firms, a PCRA can provide benchmark ratings for the consumer rating industry and also provide a forum to discuss developments and trends, as well as the opportunity to validate the work of the agencies that comprise the industry. The above functions are not exhaustive, but merely suggestive to help promote the public interest. In this context, the public interest is in locating ways to stabilize inherently unstable flows of investment and improve the quality of ratings. These goals are not necessarily one and the same. Structures. The functions above suggest that a PCRA needs to be split into divisions to facilitate efficiencies, focus, and develop expertise. Given the emphasis on monitoring developments in, and benchmarks for, the industries, and potential for linking it to an explicit industrial policy, it would seem prudent to create divisions that focus on the industries, financial services sector (banks and

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non-bank financial institutions), nonfinancial sector (agriculture, manufacturing, and services), and households. Subdivisions or teams can be created to focus on issues with respect to particular firm types (corporations and SMEs). Each division then could liaise with the relevant government departments/agencies to draw upon their expertise and knowledge of the both the historical development and future trends of the relevant industries/sectors and forms of organizations. For instance, in the United States a division that focuses on nonfinancial firms could liaise with the associated agencies within the Department of Commerce, the US Census Bureau, the Internal Revenue Service, and the Small Business Administration. A division pertaining to financial firms can liaise with the Securities and Exchange Commission (the Office of Credit Ratings), the Federal Reserve, and the Office for the Comptroller of the Currency. For consumers, a division could engage with the Federal Deposit and Insurance Corporation, the Consumer Finance Protection Bureau, and the Department of Housing and Urban Development. This divisional structure to a PCRA and its engagement with multiple regulators satisfies one of the criteria that Carpenter and Moss (2014) suggest in order to avoid regulatory capture. Other criteria include: empower diffuse interests, employ experts with diverse and independent opinions, locate devil’s advocates, and involve the press. These criteria could be satisfied by creating a structure that reflects the structure of the US Export-Import Bank. A director and a deputy director are appointed by the president and approved in the Senate, both have four-year terms. There is a board of directors that adopts and amends bylaws that designates vice presidents or officers of various aspects of the agency’s functions and divisions. One of the board members must represent small business. The divisions noted above fall under a research department, which is headed by an officer. There is an external affairs department to provide communication to the public and promote intergovernmental cooperation. These two departments organize semiannual roundtable discussions involving members of the advisory committee. This committee represents members of society who are influenced in one way or another by credit activities. There could be, say, 20 representatives from: (1) industries (nonfinancial), (2) nonindustrial/non-profit borrowers (e.g., consumers and universities), (3) banks and institutional investors, (4) the rating agencies and bureaus, (5) academics (experts with diverse opinions), (6) devil’s advocates (e.g., consumer, investor, labor, and environmental activists), and (7) the press. Special attention is made to ensure representation of people of color and women. The

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broadening permits representation of other segments in the economy whose activities and lives are influences by ratings. The roundtable discussions can evaluate new research finding of PCRA staff and identify new issues and trends to address. The PCRA also has legal, operations, and education departments. In these ways, a PCRA can avoid capture and establish cooperation between other government agencies and the various facets of society affected by the use of credit. It is interesting to note that Langohr and Langohr (2008) assessed the stakeholders’ (financial investors, intermediaries, and issuers) positions on the need to regulate the rating industry. Financial investors, represented by the Investment Company Institute (ICI), expressed concerns over: strengthening oversight, disclosure of procedures/ policies/standards/resources, provision of information about rating agency performance/methods, and making the agencies legally liable for their products (ratings). The intermediaries’ stance (securities firms, banks) was represented by the Bond Market Association. It expressed concern over the degree of oversight (which should be as little as possible as government regulation would reduce diversity of opinion), competition (barriers to entry are natural, not anticompetitive), and the sole use of quantitative models. The issuers (represented, among others, by the Association of Corporate Treasurers [UK] and Association for Finance Professionals [USA]) expressed at various times: the need for action (confidence is diminishing in the quality of ratings), need for increased competition, improved oversight, strengthening enforcement, and the need for a minimum regulatory framework. Stakeholders are quite varied. In the discussion above there is one type of issuer that has been left aside—governments themselves. A PCRA would be placed in an obvious conflict of interest if it were to evaluate the debt of the national government. Solutions put forth for how a government could rate its own debt include: (1) using a different method for a sovereign, (2) issuing guidelines for conflict of interest, (3) implementing protection mechanisms against political influence (Gavras 2012: 36–37). The position taken here is: don’t. Rather, in the next section, we will explore the creation of an international or supranational PCRA as an alternative to national governments rating their own debt instruments.

An International Credit Rating Agency Up to this point, the functions and structure of a PCRA have been examined at the national level. The creation of a PCRA has been downplayed because of the potential conflict that governments will

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face with the rating of their own securities. Rating of sovereign debt by an independent government agency such as a PCRA is possible, but needs to be accompanied by a system of checks and balances, such as a committee process to approve changes to the benchmark ratings. The problems associated with rating sovereign debt may be better confronted in an international context. There is also scope for an international credit rating agency (ICRA) created within an international organization that performs functions similar to those mentioned above for a national PCRA. At the international level, cross-country studies can be performed to assess and cross-check the performance of sovereign ratings; this agency would also be capable of perform cross-country analyses of the ratings of the other issuers of debt securities. Studies can also be conducted about the cyclical nature of sovereign creditworthiness, for instance that due to the cyclical nature of tax revenues. Round tables can be held with representatives of the national PCRAs to assess research and developments. The Bertelsmann foundation proposed the creation of an international non-profit credit rating agency (INCRA) in 2012. The idea is to improve ratings on sovereign debt by reducing conflict of interest with the issuer pays model. The issuer pays model is replaced with an endowment funded by governments, NGOs, civil society foundations, and financial services industries. A problem with this, as we saw earlier (chapter 5), is that regardless of the type of remuneration structure, conflict of interest can never be fully eliminated due to legal license conferred on ratings to assist with the distinction between investment and non-investment grade ratings. INCRA is also being proposed on the basis of needing to include socioeconomic and political elements to the rating criteria of sovereign debt, arguing that the major CRAs do not give much emphasis to these elements in determining a sovereign’s ability and willingness to pay. Further, the methods of the CRAs are not as transparent as they could be. A couple of things stand out. There are rating agencies that do offer assessments with indepth treatments of socioeconomic and political aspects of an economy. The Economist Intelligence Unit is one assessor, publishing its EIU country reports. The Political Risk Services group publishes the International Country Risk Guide. Although considered minor relative to the big three, these assessors do incorporate political and social aspects into their assessments. These alternatives are available should investors wish to seek them. If one were to examine the sample scorecard contained in its Country Ratings Report (Bertelsmann 2012), one would see that the economic components often mirror those of

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the major rating agencies. Like the major rating agencies, there is little depth of analysis provided on the industrial activities of the economy. These activities support incomes for both firms and workers—and generate tax revenues that enable a sovereign to service its debts. An ICRA could be organized within the United Nations’ Department of Economic and Social Affairs (DESA). DESA has extensive experience with the establishment of international norms and standards. It possesses the capabilities to create and analyze large databases. DESA also holds expertise with international community engagement, construction of international policy, and dissemination of research. This organization has a much more progressive orientation in its approach to economic development for both developed and developing countries. Its programs emphasize sustainable development, poverty reduction, more equitable distribution of income, and so on. Last, but not least, it already holds an established network of national and regional partners who assist in the creation of national development strategies (see DESA 2012). These are important attributes for an ICRA to have in order to counterbalance the influence that private rating agencies have with respect to pressuring sovereigns, through warnings and downgrades of sovereign ratings, into conservative fiscal positions that promote the continued degradation of ecosystems, depletion of natural resources, reduction of workers’ rights and working conditions, and devolution of public services and social safety nets. DESA has begun to think of the ‘“creation of a United Nations observatory of credit rating service providers,” which would, among others, “certify credit rating products and build consensus on [common] standards for rating methodologies,”’ (DESA 2013). However, a concern is its approach—would it be grounded in methods reflecting the inherent stability of investment or inherent instability? As seen above, it makes a big difference as to how to evaluate creditworthiness and attenuate credit/default risk. As with national PCRAs, an ICRA could liaise with other international organizations such as the Organization for Economic Cooperation and Development (OECD). The OECD monitors and creates benchmark country risk premium associated with export credits and other trade transactions. It also oversees the consistency of similar ratings created by national export credit agencies (e.g., US Export-Import Bank). And, of course, the ICRA would naturally be networked with the national PCRAs. As a keen observer noted, “launching such an agency at the supranational level would be complicated, requiring international cooperation and considerable good

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faith” (Gavras 2012: 36). An ICRA would seem to be ideally situated at the United Nations.

Summary A national PCRA has the potential to not only promote private investment but also stabilize it. It has been justified here, on the grounds that investment is inherently unstable. Investment is not just influenced by the confidence of investors, but by the confidence that investors hold about the profitability of their investments. Capitalism runs not on confidence per se, but on confidence about expected profitability. If one understands how the quest for profit drives investment and financing decisions, one has a better grasp of how financial statement of firms will change over a cycle. Taking some of the uncertainty out of the realization of goods and services and stabilizing cash inflows means that firms have confidence to invest, and lenders have the confidence to finance their investments. Stabilizing income flows also supports the bond and stock markets by taking some of the uncertainty of rate of returns on portfolios held by institutional investors. It could also support the stabilization of tax revenues for the government. It clears the way to understand how heterodox economists can contribute to the development of alternative industrial policies that can counterbalance the cyclical tendencies of a capitalist market economy that emanates from the instability of investment. Industrial policies have traditionally been justified on the grounds of mainstream economists (particularly Marshall) and the need to alleviate market failure attributed to externalities, such as economies of scale, or imperfections, such as transactions costs, asymmetric information, and resource constraints. The traditional fiscal policy implications of this approach are: “(1) protection from foreign competition, (2) direct subsidies, (3) subsidies through tax code, (4) preferential access to credit, and (5) (support) through government procurement” (Noland 1993 as cited in Norsworthy and Tsai 1998: 12, fn 1). The argument has been lodged that during 1990s, macroeconomics, not microeconomics, came to be used as implicit industrial policy. The idea is that the government should not control the development of industries through specific policies, but rather shape the context in which industries operate (Norsworthy and Tsai 1998). Recent, renewed interest in industrial policy appears to be due to the limited scope of fiscal and monetary policy tools, particularly in light of the GFC. Justin Lin has been particularly prominent, likely due to his executive position at the World Bank (2008–2012). Lin

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suggests that countries use comparative advantage to identify industries for which they are most competitive. Then, governments should support those industries by providing additional infrastructure and then let the market mechanism (free markets) take its course. The argument dovetails with Stiglitz’s suggestion that growth-enhancing investments need to incorporate learning and knowledge accumulation and research. These investments will narrow the difference between average practices and best practices within industries, and that could include agriculture and services in addition to manufacturing (Stiglitz, Lin, and Monga 2013; Greenwald and Stiglitz 2013). In other words, “Industrial policy has to be shaped to take advantage of society’s comparative learning and learning abilities (including its ability to learn to learn) in relation to its competitors” (Greenwald and Stiglitz 2013: 61). Further, that “government must establish an environment that is conducive to creating a learning economy through public investments which support private-sector investment in learning sectors” (Greenwald and Stiglitz 2014: 426). Industrial change will occur as learning by workers increases their productivity and competitiveness in their associated industries. It would appear, then, that the management of industrial change ultimately boils down to fine-tuning labor markets. The heterodox community has something different to offer. Rather than fine-tune labor markets and workers, this viewpoint emphasizes managing default risk. Based upon a cash flow framework, benchmarks could be created to assess the position of the economy, industries, and firms within them. To do so required more explicit treatment of a rate of return, such as the incremental rate of profit. Moreover, the framework permits both the accounting and market concepts of liquidity risk to be integrated in such way that there is a more cohesive knit between the real and financial sectors of the economy. The categorization of firm types is amenable to efforts to do so by accounting firms and government agencies, such as export banks. However, the latter, like the rating agencies, do not have an analytical framework to use to help isolate and anticipate issues. Application of the framework to the United States suggests that this approach has potential. Moreover, it could support an industrial policy by helping to manage default risk in ways that support firms, particularly SMEs, and industries. A PCRA could provide a way to knit social and private realms in a more transparent way, and help reduce the influence of the financial sector and unproductive activities that ultimately sap an economy from long-run growth.

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Again, the intention here is not to suggest that a PCRA create independent or shadow ratings for each and every issuer or issue that is traded. To do so would effectively replace private rating agencies in evaluating the creditworthiness of borrowers. The intention here is for a PCRA to support the rating industry to achieve better outcomes. If a PCRA were placed in a position of calculating individual ratings, then, as an independent government agency, it might find itself liable for miscalculations, not to mention the reputational risk that the state would incur. It is possible that as a PCRA becomes better acquainted with the nuances of evaluating creditworthiness, the agency could begin to shift toward creating its own unique method(s) to offer for use.

7

Conclusion

In seeking to promote the public interest of economic and finan-

cial stability, we find that the approach one takes is integrally related to the vision that one holds about the role of investment and the inherent stability of a (capitalist) market economy. The information contained in the opinions of the rating industry facilitate private and public investment. Investment is a mechanism through which capital is redirected to more profitable uses. On this, orthodox and heterodox economists agree. However, they hold polar views when it comes to investment’s influence on the economy. Orthodox or mainstream economists view capital mobility, which is effected through investment activities, as being key to promoting balance through the allocation of resources between industries, to their best uses. That state or path may change with changes in technology, preferences, and resource availability, but it is characterized as balance. Here, the removal of impediments to efficiencies—which supposedly impede balance and the maximization of social welfare—is an objective of government policy. As per mainstream economics, the ideal state of an economy is characterized by a uniform rate of profit. The ideal state is demonstrated with the help of a general equilibrium framework and the neoclassical conception of (perfect) competition. As such, it is not the profit rate that channels leakages (savings) back in to the economy as injections (investments)—that role is given to the interest rate. From the heterodox vantage point, capital mobility between industries, as capital seeks to expand through more profitable investment opportunities, tends to equalize profitability between the regulating capitals of industries. However, the quest for higher profitability on investment within industries creates turbulence as the investment introduces technological advances (embodied in new capital equipment) into production processes. Under pressure of competition, the configurations of capital must change in ways to lower the unit costs of output. So long as the unit price of output is stable, profit margin

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rises. However, competition pushes firms to adapt technology to not only lower unit cost, but also unit price. Firms may not achieve greater profit in the short term, but could do so in the medium to long terms by undercutting their rivals and offsetting lower profitability with larger market shares within their industries. Collectively, the implication is that there is a natural tendency for the (average) rate of profit to fall. In this context, investment activities are inherently unstable as they respond to changes in the (ever-changing) average rate and incremental rates of return. If one were interested in pursuing this line of thinking as a basis or method for evaluating creditworthiness, where would one turn? The FIH captures the investment and financing decisions of firms by classifying firms as hedged, speculative, or Ponzi, using a cash flow accounting framework. That analysis can be brought to bear on the behavior of the macroeconomy over a cycle. What the FIH, as originally cast, does not do well is explain endogenous changes to the profitability of investment. Without an explanation of the profitability of investment, the turbulence is created through the exertion of market power held by firms, which, as such, cannot be anticipated. The quest for market power is a symptom that firms need to stabilize cash flows, it is not the inner dynamics that generates the instability. The exposition in this book sought to address this deficiency by incorporating the incremental rate of return and the regulating capital concepts to capture those inner dynamics. As such, the investment’s dependence on profit is allowed to endogenously shape business conditions that firms face, at the levels of firm, industry, and the macroeconomy. Those changing conditions will influence the evaluations of creditworthiness of firms. That is, evaluations of creditworthiness change as conditions of firms change in the context of ever-evolving industrial and macroeconomic conditions. Moreover, the fiscal positions of the sovereign change through tax revenues and expenditures. In this context, the goal to achieve better methods of creditworthiness is a worthy endeavor, but will not be enough to stabilize the economy and its financial system. It is interesting to note that when incorporating financial dynamics into the framework of mainstream economics, mainstream economics has provided explanations as to how balance sheets (cyclically) respond to shocks either in the real or the financial sectors. Changes in balance sheets influence cash flows. Minsky takes a more direct approach in that he focuses on how investment and financing decisions influence cash flows. Counter to claims that Minsky’s theory is a theory about irrationality (see, for instance, Benston and Kaufman

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1995 and Bernanke 1983); Minsky’s theory is very much about the rationality of these decisions in the context of true uncertainty. This is different from rationality as cast in the mainstream’s rational expectations hypothesis, which supports the reduction of uncertainty to risk. Assessments of creditworthiness involve an historical component and a prospective component. A lender needs to assess how well an applicant has managed investment and financing decisions in the past (the historical component) and how new investment will impact a firm’s cash flows (the prospective component). Evidence of success with respect to past investment and financing decisions is contained in financial statements. The proposed new investment is evaluated in light of the health and maturity of the firm, industry, and the position of the macroeconomy. What an extended FIH can do, which the orthodoxy cannot, is provide an explanation of how a firm endogenously changes its structure over time as it seeks to compete in the marketplace. Those changes will appear as changes in profitability, margins of security, and in the firm’s position (market share) within the industry in which it operates. Trends in these variables—and the relationships between them—can help us understand the prospective component of credit or default risk. Predominant methods of credit risk assessments, such as rating opinions, lack a vision of the endogenous dynamics that drive changes in creditworthiness, making it more difficult to isolate and anticipate problems that result from them. The same can be said for predominant assessments of sovereign default risk. Rather, the approaches overlook and are unable to fully capture the turbulent dynamics that the FIH emphasizes. This is key to understanding episodes of instability. Evidence suggests that instability is the norm. It may ebb and wane, but it is still the norm. The volatility of investment is assessed with the creation and application of a simple volatility indicator to selected, developed countries. The results suggest that although there is a wide range of volatility of investment, countries with relatively higher rates of volatility are not necessarily associated with higher rates of GDP. Moreover, countries with high rates of volatility in investment are more likely to be associated with slower rates of change in GDP/capita. Countries that actively use industrial policy to manage and stabilize their economies experience slower annual rates of capital accumulation, yet they also tend to have lower volatility and better performances with respect to GDP/capita. It seems that the quest for high rates of capital accumulation came at the expense of increased volatility, with knock-on effects for insecurity of firms (financial and nonfinancial) and workers.

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The rating industry exists as it provides products (ratings) that contain information that investors seek outside the release of accounting data. The industry also provides information about the states of industries and the overall macroeconomy. The sluggishness and pro-cyclicality of ratings suggests that they are not fully capturing dynamics. Assessments of economic health seem to be better facilitated with an approach grounded in the FIH. It provides a method that a government agency could use to detect changing economic conditions that impact firms’ risk of default. The pilot provided in the book breaks a new path toward this end. Not only was it able to identify historical episodes of instability in the American economy, but it anticipated problems in the run-up to the recent financial crisis and sovereign debt woes. Besides all this, it revealed how reliant the overall performance of the American economy has become on unproductive activities (e.g., income from property). The importance of unproductive activities masks the impact of flow of capital abroad in an effort to obtain higher rates of return. What the financial crisis did, in effect, was shake that veneer of apparent economic health and reveal how increased reliance on unproductive activities has raised the degree of financial fragility in the economy, rendering the economy more susceptible to bouts of instability. This is not in the public’s interest. Even with the basic prototype, presented in chapters 3 and 6, comparing the phases with the events suggests that the movements in the incremental rates may be able to anticipate problems. When the economy is robust, having a healthy business climate, it is able to withstand adverse events. When the economy is very fragile, it is more susceptible to bouts of instability after some shock. At the level of the macroeconomy, the framework identifies the weak spots in the US economy and begins to signal weakness ( iʹ > rʹ) earlier than the pundits have noted. For instance, according to the NBER the American financial crisis began in 2007, whereas the framework suggests increased problems much earlier (in 2005). This makes sense as a weakness in the productive sector—which employs the lion’s share of workers—preceded a slowdown in wage growth, which would make it difficult to service mortgages. The source of the GFC was not the housing market per se, but the housing market in the context of weak macroeconomic environment. Moreover, it illustrates the importance of the distinction between productive and unproductive activities. Productive activities are activities that directly increase the wealth of a nation, whereas nonproductive

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activities do not. Production of goods and services constitute productive activities, whereas activities of “distribution, maintenance of social order and personal consumption” are unproductive activities, although they are necessary for the process of social reproduction (Shaikh and Tonak 1994: 28). Unproductive activities expend or consume a net portion of wealth without directly creating new wealth. Activities in the financial sector are unproductive activities as they transfer new wealth, but do not create new wealth. It is not surprising that the American economy has shown such a strong growth in financial services industry in recent years. By letting the financial sector guide investment flows, this sector has evolved in a way that has enabled unproductive activities, and itself, to become a more integral part of how an economy performs. This appears to have raised the degree of financial fragility in the American economy, rendering it less resilient to bouts of instability. Increased calls for enhanced competition in the rating industry (Darbellay and Partnoy 2012; Darbellay 2013; and White 2010) reinforce the perception that market competition will push the industry to create better products. The independence of the rating industry is not questioned here. The industry, moreover, has been largely unimpinged by regulation for decades. Over this time, it has had the experience of free market mechanism for stimulating the development of its products and markets. Yet, those products continue to throw problems. It is not in the interest of the public to learn after a serious event that there were issues with product quality in this industry. Rather, it is in the public’s interest to catch problems as early as possible. This requires a proactive mechanism of due diligence that continually assesses product quality of the assessors of this industry, and of all assessors of creditworthiness, because of their key role in facilitating investment and financial activities. Due diligence is currently cast the responsibility of the assessors and users of ratings. Government agencies that have recently been introduced to oversee the rating industry do perform studies, but these studies are conducted on an as-needed basis, much like the efforts of the assessors themselves. A PCRA would be national, independent, and initially charged with validating the ratings of PCRAs and researching the relationship between changes in credit risk, ratings, and the business cycle. Its establishment is justified, in part, to systematically conduct due diligence of the products in this industry. The scope of its examinations, research, and governance would be cast broadly in order to evaluate the creditworthiness of the wide array of borrowers in an economy’s

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industries and sectors: nonfinancial firms (corporations and various forms of SMEs), financial firms (banks and non-bank financial institutions), and issuers of asset-backed securities, consumers, and governments. The pilot presented in this book suggests a method that could help validate the quality of ratings. But, this should be just one set of methods to rigorously evaluate the robustness of rating performance. It is possible that the more minor rating agencies could be contracted to validate the results of the major agencies, which would also promote competition and performance (loosening up the structure of the rating industry). Other functions of a PCRA include the provision of sets of benchmarks for monitoring industries and the macroeconomy for changes in business climate and overall creditworthiness, disseminating information to the public, facilitating improvements in cash flow and credit risk models (with the assistance of stakeholders), and supporting the management and attenuation of default risk. A PCRA would also allay concern as to whether recent regulatory changes are regulating outcomes by regulating processes. Although the regulatory agencies, such as the Office of Credit Ratings and the European Securities and Markets Authority, can monitor and make suggestions, they do not have the power to dictate methods and processes to the rating agencies. Nor should they. The agencies need to maintain independence in order to be able to respond effectively to market changes. However, there needs to be a platform that provides them with the support that proactively monitors the quality of their products. By taking on this challenge, a PCRA can not only provide that support but, by doing so, also facilitate the verification and adaption of new methods much more quickly than if the rating agencies did so on their own. Moreover, by providing a space for all rating agencies, not just the NRSRO, a PCRA can support the presence of smaller agencies, in essence, giving them a level playing field to pitch their methods against the dominant agencies. It is in the public interest to do so. Moreover, a set of default risk benchmarks could be used alongside interest policy to attenuate instability. Adjusting benchmarks for selected segments of an economy can target sectors that are overheating or that need support. Doing so complements the management of policy interest rate, which impacts an economy nationally. At the start, there needs to be an agreement about social objectives. With those social objectives, industries are identified according to the degree to which they could contribute to those objectives. There needs to be strategies in place about supporting investments that need to take place within these industries.

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A key question is how to fund the PCRA in a way that minimizes the impact on the insurance industry and government sector. There needs to be consideration of how different funding approaches may implicitly shift risk between the stakeholders. A funding pool for a PCRA can be created, and later supported, through one-off taxes or duties placed upon wealthy individuals (particularly corporations) and entities that use ratings of rating agencies, either directly or indirectly. Direct issuers include issuers and firms and financial institutions that rely on agencies’ assessments of counterparty risk. Indirect users are those entities that use ratings to cross-check their internal systems, such as financial intermediaries (all banks), institutional investors, credit card companies, finance companies, mortgage lenders, and credit unions. The more diverse and global a bank’s activities, the higher its duties, regardless of the fact that it may be an indirect user; it needs ratings to validate its internal systems. The agencies should themselves contribute to the fund for checking the quality of its products. The PCRA’s budget could be rounded out with government support. The insurance scheme, which attenuates default risk, can be supported by a separate “rainy day” fund that acts as collateral to protect insurers who work with the program to provide insurance policies. An insurance scheme targeted at SMEs to protect their trade credits reduces their vulnerability to the vicissitudes of the markets. Their ventures are especially risky as they do not have the range of funding opportunities that corporations do. SMEs often face payment delays when their partners seek to locate short-term funding. Those delays act to transmit instability. Again, legislation that gives SMEs the ability to add late penalties and interest charges on amounts due to them is a good start, but insurance schemes along the lines of those provided by export banks for overseas transactions is even better. Credit default swaps and government guarantees are not as ideal. Credit default swaps shift the credit risk of SMEs within the financial system; the risk is at times enhanced due to the procyclical nature of default risk. Government guarantees shift the burden to governments, which exacerbates the pressures on their fiscal positions in the event of a downturn. The involvement of insurance companies can help determine both the size of the rainy day fund and the size and timing of the duties required to support it. A PCRA’s effectiveness could be supported by an industrial policy. Justification of industrial policy is integrally related to the vision of how capitalist markets operate. The emphasis on the optimality of free markets by mainstream economists had led to justification of industrial policies based upon the presence of market imperfections

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or failures, government failures, and network failures. Heterodox economists do not see cycles and instability as the result of market failures, rather they view these phenomenon as the natural result of well-functioning markets. The approaches to industrial policy for market economies are linked to the orientations of investment’s role as a stabilizing or destabilizing activity. Whereas recent developments in industrial policy in mainstream theory emphasize the importance of productivity of labor for achieving better outcomes in productive investments, the argument put forth here is that productivity can be enhanced when workers understand that they are working to secure a better quality of life and society for the next generation and that there are mechanisms that support the viability of the firms for which they work and which enable them to re-skill and transit between jobs, as the situation warrants. Suggestions were made as to how to orient industrial policy in a more progressive way to manage the development of fragility. By emphasizing the distinction between external and internal sources of liquidity, there is a possibility of managing industries’ development by monitoring and managing default risk. In a sense, this is what governments, like Germany’s, effectively do when they create synergies between its financial and nonfinancial industries to ensure supply support for their output of goods and services. A PCRA, especially in combination with industrial policy and insurance scheme, has the potential to allow governments to slip the twin choke holds of fiscal austerity and interest rate management. By doing so, it is hoped that progressive social goals can be established and that developed countries can wrest control of investment flows from the hands of financial institutions. That said, it may still be possible for the involvement of a network of community and state investment banks to facilitate targeted investments associated with a reinvigorated industrial policy. In this way, the financial sector can engage in a more supportive way with social goals. However, it should be noted that complete elimination of the endogenous development of financial fragility, instability, and cycles will not be completely eliminated due to the presence of time lags between the identification of problems and reaction by government. There is also the issue of spillover effects on trade and financial sectors, which are beyond the control of national governments. The hope here is that stability and security can be advanced, not squarely on the back of workers, but by a new social contract supported with a more thoughtful approach to industrial policy.

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It is interesting to note that within the heterodox orientation there is an inherent suggestion on how to time wage increases for workers. The position of the regulating capital gives an indication of the ability of the industry to accommodate a rising wage rate (Botwinick 1993). A higher wage rate can be accommodated and sustained so long as it remains within certain limits. These limits are set by the profit margins of regulating capitals, unit costs of sub-dominant capitals and costs of obstructing the wage increases. For instance, a wage increase must not threaten the regulating position of the low-cost producers. Wage increase in this industry impacts the entire system (all other industries) by prompting change in the (relative) price of production, which reflects lower profitability in the industry that permitted the wage increase. This happens as the growth of supply in the originating industry slows relative to demand, causing its relative price to rise. This happens with no change to the productivities and employment of labor (this result seems contingent upon the wage rising while the economy is in a healthy state). Again, the process of changing relative prices (of production) to equalize rates of return between industries happens because of competitive processes, not the exertion of monopoly power. The adjustments to the industry’s cost and pricing structures occur through capitalist competition. It is important that the rise in the wage rate occurs during an upswing so that supply has support from demand to soften downward pressure on profitability. The results are a higher wage, higher relative price for the industry’s product, and a decline in the general rate of product. So long as the wage increase is contained, the effect on the generate rate of profit will be minimal. Capitals less efficient than the regulating capital may not survive a higher wage rate. Their profitability is hit harder because as relatively inefficient producers, they have higher labor costs. On the other hand, capitals that are more efficient than the regulating conditions of production will have an easier time of absorbing the wage increase and perhaps increase market share relative to weaker producers. (Please see Botwinick 1993: 174–80 for more details.) According to a heterodox perspective, the stabilization of cash inflows is important for protecting and reducing default risk—and stabilizing employment, investment, and growth. Again, stabilizing investment and growth stabilizes employment and income (for both firms and workers). Stabilizing income stabilizes governments’ tax revenues (income, sales, and property). Stabilizing tax revenues not only makes it easier to assess the funding needs of governments, it would also facilitate their ability to shape their positions so that less

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external debt is needed to achieve their policy aims. Overall economic growth may be slower, but it will be more stable and smarter with an industrial policy that actively supports communities by supporting civilian industries on which they depend. A PCRA can facilitate that aim. National PCRAs could be supported by an ICRA housed, arguably, at the United Nations. This agency would be charged with conducting similar analyses for sovereign ratings, acting as an important check for the work performed by PCRAs. It would also create benchmarks for sovereigns’ ratings. By acting as a counterbalance for the influence that private ratings have over the positions of fiscal budgets, the ICRA could act as a check on the degradation of social safety nets, natural resources, and workers’ living standards, equality, and economic opportunities around the globe. PCRA provides a platform for innovative solutions for assessing creditworthiness across the sectors (large and small firms, households) with links to media for release of information to the public. The rating agencies’ involvement with these efforts helps improve the quality of their product, and by doing so, potentially allay the concerns of investors, lenders, and firms (issuers). Although this book has examined rating agencies critically, the thrust is that their services have been valuable over the years. The rating agencies are ultimately responsible and accountable for their opinions. Government can help improve the quality and timeliness of those opinions—and design ways to manage and attenuate the risk of weakening income flows. There is opportunity, though, to not only improve the quality of their products but also to enhance regulatory changes to promote a key goal of public interest: stability of the economy and its financial system. It is in the public’s interest for the government to engage with the economy in a defensive way, as if an economy is inherently unstable, rather than presume inherently stability and engage in an offensive manner by further deregulating its economy (and hoping for the best). It is possible that the simple distinction between visions of inherent balance (mainstream) versus inherent instability (heterodox) could be of use to policy makers and regulators. Understanding why models employ certain assumptions can help identify the vision of inherent stability or balance, a vision that may not accuractly characterize the behavior of a capitalist system. The predominant financial and economic models carry those assumptions. While trying to understand the nuances of new financial innovations or policy is a worthwhile endeavor, the suggestion here is to not lose sight of the methodological

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differences that characterize the two visions. Innovations and policies based upon unrealistic assumptions will end up exacerbating instability rather than attenuating it. Policies and regulations that defend an economy and its financial system from inherent instability are likely to be much more effective in achieving social goals. Regulators and policy makers may find it much easier to perform their roles if they do not lose sight of the distinction.

Not es

2

Functions and Malfunctions of the Rating Industry

1. For instance, they have recently branched into the evaluation of the viability or health of banking systems, the health of countries (country risk), and the debt instruments of universities. 2. The SEC instituted the NRSRO designation in 1975.

3

Private Credit Risk

1. There are other types of market economies, but they rely on mechanisms other than a generalized process of exchange to allocate resources and distribute goods and services. Our focus is on firms within a capitalist market economy. 2. When it occurs, creditworthiness on trade credits is evaluated by credit reporting agencies. 3. There is a residual of one-twelfth of current assets that can be financed by long-term debt (Merrett and Sykes 1963: 399). 4. The WACC calculation employs market values of debt and equity, not book values. 5. The expected return on bonds is approximately by the yield to maturity, provided bankruptcy risk is low. The expected return on common stock can be estimated by the dividend discount model (if the firm has a stable growth). The capital asset pricing model (CAPM) can also be employed; the CAPM requires a risk-free interest rate and an estimate of the market risk premium (adjusted for the beta of the firm’s stock). The expected rate of return on preferred stock is estimated by the perpetuity formula (Brealey, Myers, and Marcus 1995: 284–86). 6. Merrett and Sykes (1963: 413–22) expressed reservations over Modigliani Miller (1958), maintaining that the flexibility of the capital market helps to offset risks borne by shareholders. 7. Loss-given-default is the percentage loss of the bond’s value in the event that a firm is either liquidated (beyond hope) or restructured (able to continue, but with a different structure).

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8. The linear probability model and the linear discriminant function are related in that one can obtain the discriminant function coefficients by defining the qualitative dependent variables as proportions of population with characteristics of the second group. 9. Changes to those assets can be modeled with a diffusion process (Sobehart and Keenan 2002: 126). 10. After the notation of Langohr and Langohr (2008: 279–80): dVA = μ VAdt + σAVAdz, where VA is the value of the firm’s asset, dVA is the change in the assets, and dz is a Wiener process. 11. It is possible to extend the framework to households. 12. Prior to the New Keynesians, Modigliani and Jaffee argued that interest rates will be higher than their equilibrium levels. This is known as disequilibrium credit rationing. 13. The New Keynesian strands of credit restriction and rationing share four basic assumptions. The first is that financial transactions are thought to have an intertemporal nature, whereas economic transactions are static. This assumption is based upon the observation that debt contracts exchange a sum of funds (from lenders to borrowers) at a point in time for a commitment to receive a certain stream of debt service payments over time. For a bond, debt service is comprised of interest rate payments with the principal returned at the maturity of the bond. For a loan, debt service consists of both interest rate payment and part of the principal. For equity, investors exchange a lump of funding for a sequence of dividend payments and/or capital gain. The second assumption is that credit is not equal to money, where the money supply is defined to be monetary base. This assumption is based upon the observation that there are differences in the growth rates of money supply and credit. Growth of credit and the growth of money supply do not necessarily grow in tandem. Credit can grow more slowly than the money supply when the economy is fairly slack. It can grow more strongly than the money supply if the economy is expanding or robust. The last two assumptions are related. Financial markets are assumed to be imperfectly competitive because of the presence of asymmetric information. This, in turn, leads to the assumption that the presence of asymmetric information creates market failures (Knoop 2010: 116–17). ) 14. The relationship between the interest rate and the return on a loan can be complicated by adverse selection and risk shifting; the nonlinear relationship was later examined by Stiglitz and Weiss (1981) and Allen and Saunders (2002). 15. If conventional probabilities are assigned to events in the context of true uncertainty, entailing a lack of sufficient knowledge during their creation, they are called subjective probabilities. Subjective probabilities are subject to “quick and substantial changes” when new information or knowledge becomes available. This implies that the decisions based upon subjective probabilities will change and influence the pace of economic processes, such as investment and financing of investment (Minsky 1975: 65).

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16. Hartley (1997) addresses the concept of the representative agent in the context of gauging risk premiums. “With a heterogeneous population and multiple types of agents and bonds, there will always be difficulty in measuring risk premiums. . . . unless we define the representative agent as the marginal producer, the measured risk premiums will be different than predicted. Defining the representative agent as the marginal producer, however, means that the agent is quite ephemeral. Any change in the distribution of the riskiness of bonds, for example, will result in a change in the representative agent” (Hartley 1997: 17). 17. Moreover, New Keynesian approaches to credit rationing often rely on the assumption that firms are risk neutral, and, as such, break the link between the investment and financing decisions (Wolfson 1996: 445).

4

Sovereign Credit Risk

1. The basic structure to a general equilibrium model is that given preferences of individuals, resource endowment, and technology, an equilibrium set of prices can be shown to exist to clear the markets, and under certain conditions (e.g., assuming non-reproducible inputs) yield uniform rates of return to factors of production. 2. Debt service is equal to bonds if bonds have a maturity of one year. Bonds with longer maturities entail a coupon rate, which is a proportion of the face value of the bond at the time of redemption (Wickens 2011: 93). 3. “Although often regarded as a requirement for sound fiscal policy, a balanced budget is unnecessary for fiscal sustainability” (Wickens 2011: 106). 4. “For a country as a whole, the PV of future non-interest current account balances must be greater than or equal to its external debt” (IMF 2013a: 6). 5. Ricardian equivalence is a microeconomic concept that pertains to the first part of the two-step process of policy evaluation (Palley 2013). When evaluating economic policy it is important to distinguish how the policies influence the economy at the micro level (via households and firms), that is, how policy may or may not influence aggregate demand. In other words, the effectiveness of fiscal policy to influence the economy depends on whether fiscal policy can influence aggregate demand. From that point, the analysis shifts to the macro level to examine how aggregate demand influences the real economy. 6. Ricardian equivalence is compatible with all macroeconomic frameworks that share its microfoundations (Palley 2013). 7. Please note that there is a distinction made between solicited ratings and unsolicited ratings. Solicited ratings are instigated by issuers, unsolicited ratings are not. Unsolicited ratings are created by the agencies in order to provide their opinion on the creditworthiness of an issuer based solely on publicly available information. There has been concern expressed about the accuracy of the ratings and the use of these ratings

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8. 9. 10. 11.

Not es to prompt a government or firm to buy a rating in an attempt to improve the score (with the provision of additional information and discussion with management). For the more dynamic or volatile variables, Fitch employs a 3-year, centered moving average. International Swaps and Derivatives Association. Buchanan also took issue with the New classical’s adaptation of Ricardian equivalence because of the use of rational expectations. Please note that Eurostat data for Spain is incomplete.

5

Regulatory Capture

1. Recent research suggests that even before government regulation, the courts used ratings in order to set standards. This early usage by courts created early standards or norms that employed the output of the rating industry to “assess the behavior of trustees, bankers and brokers” (Flaundreau and Slawatyniec 2013: 11). Not only did the rating agencies have a legal license long before they gained a regulatory license, the presence of a legal license made it easier to institute the regulatory license. 2. See Carpenter and Moss (2014: 13–15) for supplementary definitions of public interest, intent, and regulated industry. 3. Corrosive capture could reduce the flow of new firms into the industry, but more likely the focus is on deregulation of the industry (Carpenter and Moss 2014: 17). 4. Agencies that survived had considerable public support. 5. The analysis of regulation also shifted away from locating design and implementation errors to examining perversities in regulation by locating key systemic characteristics (Posner 2014). 6. This is not to imply that the heterodox community has nothing to say about financial market reform. The post-Keynesian economist Thomas Palley recommends a ten-part plan to alleviate financial instability, some of which is encapsulated in the Doff-Frank Wall Street Reform and Consumer Protection Act of 2010: (1) Comprehensive financial market regulation (based upon function, not form); (2) Lenders to have stub ownership of the loans they create; (3) Stock options in management bonuses ought to be long dated; (4) Limits on leverage according to equity capital requirements; (5) Liquidity requirements for lenders; (6) Regulation of the CDS market and pushing all transactions through a market clearing mechanism; (7) Not permitting purchase of CDS insurance by those who do not own the instruments; (8) Making contingent convertible bonds part of financial companies’ capital structure (these bonds can act as “canary in the coal mine”); (9) Central banks to reduce reliance on interest rate for conducting monetary policy (ABRRs instead); and (10) Carrying out political reform that limits influence of financial firms. (See Palley 2012) for more details).

Not es

6

177

Public Credit Rating Agency

1. “Indirect use of ratings” mean the use of an external rating structure to validate an internal rating system. 2. The scope of this function includes not just SMEs and corporations, but also all other segments of society that rely on credit at some point in their lives. 3. The closest concept to the regulating capital on offer by mainstream economics is the representative agent. However, Hartley (1997: 17) discusses, in the context of determining risk premium on bonds, how problems with using the representative agent in the mainstream context, stem from being unable to define the concept clearly. If the representative agent is envisioned to represent the average agent or issuer, there is no consensus on how to define “average.” The representative agent concept is also problematic if cast as the marginal issuers as the margin shifts with changing conditions.

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Index

A. M. Best, 11, 108 Abel, Andrew, 79 accountability, lack of, 21 Afonso, Antonio, 79 Alcubilla, Raquel Garcia, 11, 20 Allen, Linda, 33, 36, 64, 174n14 Allison, Bill, 115 allocation of investment, 17 Altman, Edward, 35–6, 41, 62 Amemiya, Takeshi, 35 Anderson, Raymond, 33, 61, 93 Appel, Majory, 115 asymmetric information, 15–16 Australian Securities and Investment Commission (ASIC), 111 Baesens, Bart, 11–12, 19–20, 33 Bank for International Settlements (BIS), 85 Beaver, William, 34, 55, 68 Beckel, Michael, 115 Benston, C., 162 Bernanke, Ben, 47, 163 Bertelsmann foundation, 155 Bierman, Harold, 28, 31 Black-Scholes method of options, 35–6, 62 Boehm, Frederic, 113 borrower’s risk, 53, 70–1, 130–1 Botwinick, Howard, 51, 53, 169 Braun, Stephen, 115 Brealey, Richard, 30–1 Bubak, Vit, 89 Buchanan, James M., 90, 103, 113, 176n10

Bureau of Economic Analysis (BEA), 133–9 Carpenter, Daniel, 5, 105, 111–12, 114–17, 121, 153 CDS-implied rating (CDS-IR), 89 Chang, Ha-Joon, 107 China, 11 Choi, Daniel, 79 Choi, Young, 56 Clarke, Simon, 111 Code of Conduct, 12–13, 108 see also International Organization of Securities Commissions Coffee, John, 20 Committee of European Securities Regulators (CESR), 108–9 Commodity Futures Trading Commission, 121 conflict of interest, 18–19 cost of capital, 17 credit default swaps (CDS), 37, 88–9 Credit Rating Agency Duopoly Relief Act (2005), 23 creditworthiness, evaluating, 13 cycle theory, 42 Dal Bo, Ernesto, 113, 122 Darbellay, Aline, 1, 12–13, 19, 106, 110–11, 165 Deakin, Edward, 35 Del Pozo, Javier, 11, 20 Department of Economic and Social Affairs (DESA), 156

192

Inde x

discrimination, 13–15 dissemination of information, 16 Dittrich, Fabian, 122 Dodd-Frank Act, 17, 109–10, 115, 117–18, 120–1, 123 Dominion Bond Rating Service (DBRS), 11, 108 due diligence, 6, 20–3, 40, 65, 119–20, 124, 126, 150, 165 Dumenil, Gerard, 50, 52, 140 Durie, John, 151 Eatwell, John, 146–8 Egan Jones, 10–11, 108 Eggen, David, 115 European Commission, 108 Evans, Paul, 79 EXIM bank, 6, 151 expected default frequency (EDF), 36, 89 Falkenstein, Eric, 34, 68 Federal Housing Agency, 121 Federal Reserve, 115, 121, 135, 150, 153 Fimalac, 10 Financial Instability Hypothesis (FIH), 4 see also Minsky, Hyman Fiscal Policy Committees, 103 Fisher, Irving, 42 Fitch background, 10 CDS-IR and, 89 global long-term ratings, 14 global short-term ratings, 14 key criteria for corporate ratings, 38–9 methods of rating, 37 NRSRO designation, 11 regression analysis, 87–8 regulation and, 106 scales of ratings, 14–15 sovereign factors and indicators, 81, 84

Fitzpatrick, Amy, 28–9 Flandreau, Marc, 106, 110 Foley, Duncan, 50, 56 Freehills, Herbert, 111 Galbraith, James, 147 Gapen, Michael, 90 Garcia, Joao, 89 Gavras, Panayotis, 7, 154 Gerring, Matthew, 115 Gertler, Michael, 47 Global Financial Crisis (GFC) CDS spreads and, 88 failures specific to, 109 housing market and, 164 policy and, 157 rating industry and, 1–2, 6, 19 regulation and, 23, 105, 108–9, 111, 120, 127 taxes and, 94 Gray, Dale, 90 Greenwald, Bruce, 158 Hartley, James, 50, 175n16, 177n3 Hawtrey, Ralph, 42 Heilbroner, Robert, 123 Holmes, Mark, 79 housing market, 151, 153, 164 incremental rate of return (IRR), 133–41 industrial policy, 7, 43, 114, 129, 141–8, 152, 157–8, 163, 167–8, 170 internal systems, validating, 17–18 international credit rating agency (ICRA), 155–7, 170 International Monetary Fund (IMF), 73, 78, 80–2, 88 international non-profit credit rating agency (INCRA), 155 International Organization of Securities Commissions (IOSCO), 12–13, 23, 108–11 see also Code of Conduct

Inde x Japan Japan Credit Rating Agency, 11, 108 market mechanism and, 146 registration for rating agencies, 110 volatility and, 57–9 Jarrow, Robert, 36 Kealhofer, McQuown, and Vasicek (KMV) model, 36, 40 Keenan, Sean, 28, 37 Keynesian economics credit theory, 45–7, 49 cycle theory, 42–3 MEC, 131 Minsky and, 49, 55–6, 102 PCRA and, 129 rational expectations and, 91 risk and, 129–31, 142 Kharas, Homi, 76 Kirman, Alan, 50 Knoop, Todd, 47, 56, 174n13 Konzelmann, Suzanne, 90–1, 103 Korea, 57–9, 146 KPMG, 98 Kregel, Jan, 76 Kroll Bond Rating Agency, 11 Kwak, James, 112 Kwon, Huck-ju, 147 Laffont, Jean, 113 Langhor, Herwig and Patricia, 13, 19–20, 36, 41, 62, 108, 115, 154, 174n10 Law, Siong-Hook, 79 Lawson, Tony, 56 Lee, Simon, 147 lender’s risk, 53–4, 70–1, 130 Levy, Dominique, 50, 52, 140 Levy-Yeyati, 80 Lien, Bobby, 28–9 Lim, Cheng, 90 Lin, Justin, 157–8 liquidity, enhancing, 16 Lobel, Ben, 143

193

Malaysia, 11, 79 Marcus, Alan, 30–1 marginal efficiency of capital (MEC), 42, 131 market-implied ratings (MIRs), 37 McGraw Hill Financial, 10, 111, 115 Merrett, A. J., 29, 31, 45, 173n6 Mexico, 11, 110 Milberg, William, 123 Miller, Merton, 31, 45, 173n6 Minsky, Hyman, 6, 26, 43–4, 49–50, 53–6, 66, 68, 102–3, 116, 127–8, 130–1, 144–6, 162 on determination of investment and its financing, 70–2 see also Financial Instability Hypothesis Mitchell, Wesley, 60, 149 Modigliani, Franco, 31, 45, 173n6, 174n12 Monetary Policy Committees, 103 Moody’s background, 10 CDS Implied EDF model, 89 competition and, 21 Credit Rating Agency Duopoly Relief Act and, 23 global long-term ratings, 14 global short-term ratings, 14 interest rate and, 135 key criteria for corporate ratings, 38–9 KMV model and, 40 lobbying, 115 methods of rating, 37 NRSRO designation, 11 regulation, 106 scales of ratings, 14–15 scoring, 86–7 sovereign factors and indicators, 81, 83 Morningstar, 10–11

194 Moss, David, 5, 105, 111–12, 114–17, 121, 153 Mueller, Dennis, 62 Musgrave, Richard, 103–4 Myers, Stewart, 30–1 Nasica, Eric, 72 National Bureau of Economic Research (NBER), 59, 149–50, 164 National Credit Union, 121 Nationally Recognized Statistical Ratings Organizations (NRSROs) competition and, 21 conflict of interest and, 19 designation, 11–12, 107 GFC and, 109–10 PCRA and, 166 Rating Agency Reform Act and, 107–8 ratings by asset class, 10 regulation and, 119–20, 122–3 SEC and, 107–8 Noland, Marcus, 148, 157 nongovernmental organizations (NGOs), 155 Norsworthy, John, 157 Novak, William, 114 Office of Credit Ratings (OCR), 109, 118, 120–1 Organization for Economic and Cooperation Development (OECD), 52, 85, 133–4, 140–1, 156 overreliance on ratings, 20–1 Palley, Thomas, 79, 176n6 Partnoy, Frank, 20, 110, 118, 122, 165 Patel, Nihil, 89 perpetuity formula, 173n5 Persson, Torsten, 79 private credit risk

Inde x current thinking on investment and its financing, 26–32 evaluating volatility, 57–60 gauging default or credit risk, 32–41 implications for assessing default risk and ratings, 60–6 implications of visions for creditworthiness, 44–56 key criteria for corporate ratings, 38–9 overview, 25–6 two visions of investment, 41–4 pro-cyclicality, 19–20 public credit rating agency (PCRA) attenuating default risk, 142–8 functions and features of, 148–55 international credit rating agency (ICRA), 154–7 monitoring and managing default risk, 129–41 overview, 125–9 quality control measures, 40 quantitative assessment techniques, 34–5 Rahman, Muhammad, 79 Rating Agency Reform Act (2006), 107–8, 176n6 ratings allocation of investment, 17 asymmetric information, 15–16 conflict of interest, 18–19 cost of capital, 17 discrimination, 13–15 disseminating information, 16 evaluating creditworthiness, 13 evaluating overall health of country’s economy, 17–18 functions, 13–18 improving market efficiency, 17 lack of accountability, 21 liquidity and, 16 malfunctions, 18–21

Inde x market structure and competition, 21 overreliance on, 20–1 rating methods, 19 regulatory purposes, 16 sluggishness and pro-cyclicality, 19–20 solicited and unsolicited, 20 transparency and, 19 triggers, 21 validating internal systems, 17 ratio theory, 55 rational expectation, 56, 62–3, 91, 93–4, 163 Rault, Christophe, 79 Raybaut, Alain, 72 Real Business Cycle (RBC) school, 43 reduced-form models, 36–7, 64 regional rating agencies, 11 regulating capital, 4, 51–4, 68–9, 71, 75, 128, 131–2, 139, 151, 161–2, 169 regulatory capture early regulation of rating industry and recent market failures, 106–11 overview, 105–6 rating industry and, 111–17 regulatory revisions, 117–22 Ricardian equivalence, 5, 74–80, 90–4, 102–3, 144 Romer, David, 80 Rousseau, Stephane, 108, 120, 122 Russell, Heather, 89 Sachs, Jeffrey, 76 Samuelson, Paul, 42 Sarbanes-Oxley Act (2002), 107 Saunders, Anthony, 33, 36, 64, 174n14 Sawyer, Malcolm, 103 Say’s law, 41–2, 55 Schroeder, Susan, 50–1, 75, 107, 133

195

scoring methods, 26, 32–5, 40, 60–1, 68, 86–7, 93 Securities Act of 1933, 21, 106 Securities and Exchange Commission (SEC) due diligence and, 65 NRSRO status and, 11–12, 107–10, 123, 173n2 Rating Agency Reform Act and, 107–8 rating industry and, 123 regulation and, 115, 121 Sarbanes-Oxley Act and, 107 transparency and, 119 Securities Exchange Act of 1934, 108 Sent, Esther, 56 Sesum, Vojislav, 89 Shaikh, Anwar, 26, 48, 51–3, 62–3, 69, 77, 92–4, 133, 140–1, 165 Sherman, Howard and Paul, 60 Simonsen, M., 76 Sinclair, Timothy, 1 Slawatyniec, Joanna, 106, 110 sluggishness and pro-cyclicality, 19–20 Snowden, B., 91 Sobehart, Jorge, 28, 37 solicited and unsolicited ratings, 20 Soros, George, 26, 62–3, 69, 93–4 sovereign credit risk assessing or rating, 80–90 fiscal sustainability and Ricardian equivalence, 75–80 Fitch’s sovereign factors and indicators, 84 heterodox critique of Ricardian equivalence, 90–4 Moody’s sovereign factors and indicators, 83 overview, 73–5 recent behavior of tax revenues, 94–101 Standard and Poor’s sovereign factors and indicators, 82

196

Inde x

Standard and Poor’s Australia and, 111 background, 10 competition and, 21 Credit Rating Agency Duopoly Relief Act and, 23 global long-term ratings, 14 global short-term ratings, 14 key criteria for corporate ratings, 38–9 lobbying, 115 methods of rating, 37 NRSRO designation, 11 regulation and, 115 risk and, 89 scales of ratings, 14–15 scoring and, 86–7 sovereign factors and indicators, 81–2 State Insurance Commission, 121 Stiglitz, Joseph, 47, 158, 174n14 Stivers, Steve, 115 Structural Analysis (STAN) database, 133–4 Sturzenegger, Federico, 80 Svennson, Lars, 79 Sykes, Allen, 29, 31, 45, 173n6

scoring and, 34 Standard and Poor’s and, 115 Tsai, Diana, 157 Turnbull, Stuart, 36 US Bank Act of 1933, 12, 106

Tamari, Meir, 34 Tapia Granados, Jose, 59 Tescari, Stefania, 52 Tirole, Jean, 79, 113 transparency heterodox vision and, 68 as indicator, 82 interest rate risk and, 55 IOSCO and, 12 lack of, 19, 66, 126 PCRA and, 7, 150 regulation and, 22–3, 108–11, 115–19, 122

Weiss, Andrew, 47, 174n14 White, Lawrence, 19, 107–8, 110, 120, 122–3, 165 Wickens, Michael, 77–8, 175n2 Wisksell, Knut, 42 Wolfson, Martin, 67, 175n17 World Bank, 57, 59, 83, 85, 157 Wray, Randall, 103

Value-at-Risk (VAR), 37 Van Gestel, Tony, 11–12, 19–20, 33 Vane, H., 91 Vaona, Andrea, 52 Vasicek, Oldrich, 36 Vernengo, Matias, 77 volatility credit risk and, 36, 62 cycle theory and, 42 default risk and, 142–3, 151 indicators, 34, 57–9 investment and, 56–7, 60, 163 New classical economics and, 43 ratings and, 3, 20, 74, 88 regulation and, 71, 127, 132 sovereign credit risk and, 82–5 sovereign debt and, 3 sustainability and, 74, 90, 93 through-the-cycle ratings and, 87

Xiao, Yinbgin, 90 Zaleha, M. N., 79