Death, violence, parents abandoning their sons and daughters and other horrors used to be common in childrens’ stories and fairytales. Take Goldilocks and the Three Bears. The original tale revolved around an ugly old hag. Unlike her young, golden-haired replacement, who promised to be a good girl after having been caught stealing from the bears, the punishment for the old lady for the unauthorised eating of porridge was impalement on the steeple of St Paul’s Cathedral.

The softening of life’s darker side reflects broad shifts in societies in the last two centuries. A better understanding and measurement of risks across the board is reflected in medical advances, scientific discoveries and mathematical progress.

A similar recasting has happened in finance, too. In the decades leading up to the financial crisis, global debt markets grew as never before precisely because it was assumed that risks could be measured and managed. At the centre of this transformation were credit ratings. A simple proxy for risk, the use of credit ratings allowed regulators, banks and investors to have an easy-to-use reference point. This had benefits, and fuelled growth across the globe. But the existence of ratings led to sloppy risk assessments: the work was subcontracted to the likes of Fitch, Moody’s and Standard & Poor’s.

The agencies have had no shortage of critics for failing to spot risks in the repackaging of billions of dollars of risky mortgages into top-rated mortgage-backed securities. Now, they are again in the spotlight. European politicians have attacked them for recent downgrades of eurozone sovereigns.

It is the US, however, rather than Europe, where so far there has been a more ferocious bite into the use of ratings.

A year ago, the Dodd-Frank financial reforms made it illegal for US regulators to use ratings for regulatory purposes. They must “modify their regulations to remove any reference to, or requirements of reliance on, credit ratings in such regulations and substitute in their place other standards of creditworthiness”, says Section 939A of the Dodd-Frank Act.

A year on, there is still a lot to be done to achieve this. The US rules have put the spotlight on two big obstacles towards a less ratings-focused financial system, one which the rating agencies say they support.

First, there are no alternatives to ratings that are as simple. Options include allowing financial institutions to use their own internal models and relying on a risk formula devised by regulators. Internal models need to be closely policed to avoid them being used to understate risks. Formulas from regulators are criticised for being too rigid, and for not necessarily capturing shifts in risk over time. Indeed, in one study, increased risks in an auto loan securitisation translated into lower risk capital charges.

Second, the US law clashes with Basel rules which are at the centre of global bank regulation. Already, as the US works to implement Basel II, there are examples of direct run-ins. If there are no solutions, then the amount of capital that US banks have to hold against certain types of risks may be much larger than that required of their European counterparts.

There are likely to be different solutions for different parts of the markets. For example, there are detailed proposals on how regulators could modify formulas to make them workable for Basel II. Similarly, regulators like the Securities and Exchange Commission have suggested alternatives including credit spreads and internal ratings.

Ratings will still play a big role, however. Regulators tell me it will be much harder to police a system with so many components. Moreover, regulators are already struggling with limited resources. To prioritise, they are likely to look most closely at assets and liabilities marked as less risky than how they are viewed by rating agencies. If a bank is seeking a low capital charge for a junk rated bond, then regulators will look twice. If a bank agrees that a triple-A rated bond is top-notch, will it get much extra scrutiny?

Recent history suggests it is not the most risky parts of the markets regulators should look at, but the ones that are believed to be the least risky. Closer scrutiny of triple A mortgage-backed securities and “risk free” government bonds would have served the financial system well. A world seen through rose-coloured glasses is fine for children, but not for risk professionals.

Copyright The Financial Times Limited 2018. All rights reserved.

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