Key Points:
– Fitch Ratings’ downgrade of US sovereign credit from AAA to AA+ highlights the principal-agent problem in financial markets.
– Investors have outsourced their risk management to rating agencies, but the problem goes beyond just risk management.
– The complexity of the financial system has been moved somewhere else, and it’s important to understand who is managing it.
– Financial innovations like ETFs have made investing easier, but they have also created knowledge gaps between investors.
– Rating agencies play a role in bridging the knowledge gap, but their role also poses a risk to the financial system.
– It is crucial for investors to educate themselves and participate in the financial markets to understand the complexity underlying the simplified interfaces.
– This article will not provide investment advice and the opinions expressed are the author’s own.
“Complexity is like energy. It cannot be created or destroyed, only moved somewhere else…”
The recent downgrade of US sovereign credit by Fitch Ratings has once again shed light on the principal-agent problem in modern finance. This problem arises from the fact that investors have increasingly relied on rating agencies to manage their risks. However, this issue goes beyond just risk management and extends to the overall complexity of the financial system.
Before the downgrade, financial contracts often referred to “risk-free” or liquid assets as AAA-rated securities. These assets were considered “good collateral” and were a requirement in many financial transactions. However, with the split rating of US credit, the risk of forced liquidation of US Treasuries after another downgrade became a concern.
Over the past decade, the financial position of the United States has deteriorated, making the Fitch downgrade less surprising. While some disagreed with the decision, others felt it was long overdue. Nevertheless, most market participants greeted the news with a collective shrug, indicating that the rating had lost some of its informational value.
The dilemma faced by rating agencies in assessing a sovereign nation’s creditworthiness is the simplification of a complex phenomenon. While these labels help facilitate commerce, their meaning has become cloudier over time. Despite this, the re-wording of financial contracts in recent years has diminished the potential impact of a rating downgrade.
However, the question remains: What are the consequences of this diminished impact? A rating downgrade could potentially lead to a deleveraging effect on balance sheets and encourage fiscal discipline. In the past, such discipline was imposed by the market through increased volatility and reduced financial intermediation. While this may have resulted in healthier balance sheets, it also stifled growth and lowered living standards.
The principal-agent problem also extends to other financial market actors, such as exchange-traded funds (ETFs). These innovations have made investing more accessible and cost-efficient. However, they have also created a divide between investors who simply consume these products and those who understand the underlying complexities of the system.
The conflict of interest with rating agencies arises from the risk they pose to the financial system. Straying from their disciplined analytical approach diminishes their value as a market referee, while strict adherence could potentially cause a meltdown. Bridging the knowledge gap requires acknowledging that complexity can only be transformed, not eliminated, and empowering agents to manage this complexity.
Educating oneself and actively participating in the financial markets are essential to understanding the underlying complexity. While investing has become “easier,” it is crucial not to lose sight of the complex world beneath the simplified interfaces. Instead of panicking or assigning blame when complexity reveals itself, it is important to seek understanding.
This post does not provide investment advice and the opinions expressed are the author’s own. For more market commentary from the author, subscribe to their Substack.
All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image credit: ©Getty Images / chrisroll
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