Iceland is a good example of the fallibility of the rating agencies. During Iceland's financial crisis, no one – and least of all the rating agencies – seemed to wonder why three banks from a tiny island with no history of banking could out-earn foreign banks despite borrowing at a relatively high cost.
Iceland is a good example of the fallibility of the rating agencies.
After the three main banks in Iceland were privatised in 2003 they went on a borrowing spree, mostly in Europe.
From 100% of GDP in 2004 these three banks grew to roughly ten times the Icelandic GDP in mid-2008, shortly before they collapsed in October 2008.
No one – and least of all the rating agencies – seemed to wonder how sustainable their growth was and why three banks from a tiny island with no history of banking could out-earn foreign banks despite borrowing at a relatively high cost.
In the sorry saga of the Icelandic attempt at becoming a centre of international finance, the rating agencies played a rather dismal role. This story was carefully traced in a 2010 report by a special investigative commission set up at the behest of the Icelandic Parliament.
When international financial institutions started analysing the Icelandic banks they did not like what they saw: the banks borrowed at high cost and ownership relations were opaque.
For a while, in late 2005 and 2006 their ratings went down only to bounce back and stay high, even as nothing much changed in how they were run.
The rating agencies not only rated the banks, but also their products.
In 2008, one of the banks, Glitnir, set up special purpose vehicles in Ireland, filling them with illiquid assets, some of which did not meet standards set by the European Central Bank for collaterals. These SPVs were rated by Moody’s as A1 and by S&P as A+.
As late as September 2008, Glitnir used these SPVs as collateral for loans from the European Central Bank.
Given the poor quality of the assets it is clear that those SPVs have since collapsed in value and were of little comfort to those who held them as collateral.
The rating agencies’ fee structure has been under scrutiny. But with rating agencies as with auditors there has been far too little focus on their role in the financial crisis.
Not only did these agencies fail in the case of Iceland, but also in higher profile cases like in the collapse of Lehman Brothers. The US Justice Department is demanding 3.2bn in penalties from S&P, accusing them of having knowingly inflated the ratings of risky mortgage investments.
Big banks and other financial institutions do not necessarily rely blindly on these agencies but many smaller firms do; when ratings for sovereigns change they have usually been foreseen by market players long before.
When it comes to sovereigns, the political impact of changed ratings may be far greater than the financial impact and that might well be the case for the UK.
Until a decade ago, news of changed ratings was firmly confined to business papers and business sections. Few people outside business circles would have known the names of these agencies.
Now, names like Fitch, S&P and Moody’s are familiar even to those who have little or no interest in finance.
The breathless media reporting on changes in the agencies’ ratings indicates the stranglehold finance now has on politics.Like this article? Sign up to Left Foot Forward's weekday email for the latest progressive news and comment - and support campaigning journalism by making a donation today.