Thoughts on Fitch Ratings

By Okey Ikechukwu

Our people say everyone should be careful about the predictions of a fortune teller, or seer, who could not foresee the collapse of his house, or the coming of the downpour that took the house away. Our people also say that it is not forgetfulness when a man who has the duty of saying “watch out” at the approach of danger fails to do so; such that danger overtakes him and his society. I state the above, just-invented proverbs, with reference to the presumed superior and reverential status we have come to attach to the pronouncement of S&P, Fitch, Moody and similar organizations of the family of supposed economic fortune tellers.

But more about that later.

A Thisday Newspaper front page report of last Thursday had this title: “Fitch Ratings: Nigerian Banks Progress towards New Capital Requirements”. The report said: “Nigerian banks are making significant progress in raising core capital to meet new paid-in capital requirements, and they are generally on track to meet the end of first quarter 2026 deadline set by Central Bank of Nigeria (CBN). Fitch Ratings, one of the global rating agencies, disclosed this in a statement posted on its website yesterday”.

Problem number one here is that Fitch is doing us the great favour of revealing to us facts it obtained from our own Central Bank. Alright, I get it: Fitch is explaining the implications of these facts, which implications are also available to anyone who checks the records. But no matter.

The Fitch report was also reported to have told us that the ongoing recapitalization would support a recovery in capitalization from the impact of naira devaluation and provide fuel for business growth, among other things. Listen: “Fitch-rated banks have made notable progress towards compliance. Almost all have raised capital or formally launched the process to do so. The two largest banks, Access Holdings and Zenith Bank, are the first to secure enough fresh capital to meet the N500 billion requirement for an international licence”.

Good news, but then again what are we dealing with here? Revelation, intuitive insight? What is it that we celebrate when we hear of a positive Fitch rating? What makes us feel so terrible, or terrified, about a negative Fitch rating?

There was a major financial crisis between 2007 and 2008, tagged the subprime crisis, which the three big credit rating agencies, Fitch, Moody’s and S&P did not see coming. At least they were nearly as dumbfounded, and confounded, as everyone else. In all fairness, the ratings of these Big Three are usually taken seriously; especially when thinking or speaking of the creditworthiness of governments, corporations, and financial institutions. But, like every human endeavour, these ratings have their limitations and intimations of bias here and there.

It is to the credit of these rating agencies that they are respected enough globally for many investors, governments, and financial institutions to rely on their offerings – particularly Fitch Rating – for some important policy decisions. Fitch Rating, for instance, deploys well laid out, arguably transparent, criteria and painstaking reports to back its ratings. It also has global reach and covers a broad range of entities; including sovereign states, credible corporations, banks, and structured finance products.

Notwithstanding the foregoing, however, there is the possibility, or at least veiled suspicion, of possible conflict of Interest now and again; because issuers often pay for their own ratings. When we also consider that these agencies base their ratings mostly on historical and current data, it become easy to understand why they are sometimes accused of not being forward looking; and of being ill-equipped to predict sudden downturns.

Thus, while Fitch ratings provide valuable benchmarks in many situations and cases, those who use the ratings alongside other financial analysis and risk assessment tools stand a better chance of being secured. That is why many organization, investors and economic trend analysts and students of political economy compare ratings from several agencies, as a form of due diligence, before taking positions on many economic issues.

Let us recall that Fitch, Moody’s and S&P neither anticipated, nor knew how to respond to, the 2008 subprime crisis. They also had no clear ideas about how to deal with the full impact of the crisis. Before the calamitous downturn, these agencies had given very high ratings, such as AAA, to Mortgage-Backed Securities (MBS) and Collateralized Debt Obligations (CDOs) that were actually high-risk. This would not have happened if these agencies were as perspicacious as they are taken to be. That the securities quickly lost value and led to the, arguably global, financial crisis when the housing market collapsed, is traceable to this lapse.

On closer examination, the conclusion that inflicts itself on us, regarding the 2008 global fiasco, includes the fact that Fitch and Co. were using what can best be described as a flawed model for the matter they were dealing with. They stood squarely on historical data, which data is likely to easily underestimate the likelihood of future, potential or precipitate widespread mortgage defaults.

There is also the fact, hinted at earlier here, that once it is known that issuers of securities paid for their own ratings, the suspicion that rating agencies could give favorable – or at least tendentious – ratings can be taken for granted. Added to the above is the charge that Fitch as a rating agency is guilty of overreliance on Structured Finance; such that it is always dealing with complex financial products, wherein it is difficult to accurately assess all the risk factors; leading to the possibility of underestimating the risks and dangers involved in certain transactions.

Perhaps the most compelling reason to handle the offerings of rating agencies with some caution, especially bearing the events of 2008 in mind, is the fact that they appear not to react quickly enough to budding signs of trouble. The danger signals, which latter morphed into the House Fire of 2008, became visible in 2007. But Fitch and similar agencies did not quickly downgrade securities. The behaviour delayed market corrections and made the full-scale crisis inevitable. It is now a matter of history and record that, following the 2008 crisis, regulators began to scrutinize rating agencies more closely. They also began to demand greater scrutiny. These demands led to reforms; like the Dodd-Frank Act and to changes in how structured products are rated.

Of course, Fitch has improved its methodologies since then. We shall get to that, after explaining the qpurport of the Dodd-Frank Act.

The collapse of major banks and financial institutions, like Lehman Brothers, exposed weaknesses in the financial system. The evidence of high-risk Lending, wherein subprime mortgage lending and securitization led to widespread defaults and market instability emerged. This exposed the failure, or at least limited capacity, of Credit Rating Agencies, like Fitch, Moody’s, and S&P; and the problem posed by their sometimes overly questionably optimistic ratings on risky financial products.

The Act was an institutional response to the need for better regulation, to ensure that shadow banking, derivatives trading, and proprietary trading by banks came under serious and rigorous scrutiny and regulation. It was also the outcome of a public outcry, demanding that calls for government bailouts cannot be open ended; and that stricter rules should be put in place to prevent future crises of the 2008 variety.

Thus, the Dodd-Frank Act came out with several provisions, to give rating agencies and everyone else a marked lane to travel on. One of such provisions was the Financial Stability Oversight Council (FSOC), which monitors systemic risks in the financial system. Another is Consumer Financial Protection Bureau (CFPB), which protects consumers from predatory financial practices. The Volcker Rule, for instance, limits banks from engaging in risky proprietary trading, is yet another provision of the Act.

In addition to the foregoing, there is the Increased Oversight of Credit Rating Agencies, which introduced accountability measures for agencies like Fitch; such that greater transparency became evident in their ratings. There is also the Stronger Derivatives Regulation, which requires derivatives (like credit default swaps) to be traded on transparent exchanges. These measures provided have improved financial stability, reduced risky practices, and increased consumer protection.

Now, to the matter of why fitch Ratings had to do some things differently.

The global shock of 2008 for national economies and economic actors, and the institutional scandal that nearly overwhelmed Fitch Ratings after the 2008 economic crisis, were fundamental game changers. Fitch and other credit rating agencies were roundly lambasted for underestimating the risks attendant upon mortgage-backed securities and other complex financial instruments. It was in response to the new demands for greater proof of responsible engagement that Fitch implemented some improvements to its methodology and governance templates.

The significant changes subsequently introduced by the Fitch include Enhanced Criteria for Structured Finance, which meant stricter criteria for rating mortgage-backed securities (MBS) and collateralized debt obligations (CDOs). There was also increased stress-testing, to account for extreme economic downturns, in addition to greater scrutiny of loan-level data and originator quality.

It all came down to increased Transparency and more detailed disclosures on rating methodologies and assumptions. The agency put out publicly available stress test results and sensitivity analyses, alongside clearer explanations of rating changes and outlooks. These were in addition to stronger Corporate Governance and Conflicts of Interest Management rules; with rating analysts and commercial teams disaggregated, in order to minimize conflicts of interest.

Then you have the introduction of an independent review function to oversee rating decisions, with stricter policies on interactions with issuers. The more conservative sovereign and bank ratings, as well as revised criteria for rating sovereign debt to better incorporate fiscal and economic risks, were some of the new measures. With these came more stringent assessments of bank liquidity and capital adequacy.

These new measures were meant to place greater focus on systemic risks and the contagion effects in global finance, all in aid of regulatory compliance and oversight. The efforts to comply with new regulations, such as those introduced by the Dodd-Frank Act in the U.S. and ESMA regulations in Europe, crated a new rule for more rigorous internal controls and oversight by regulators and periodic review of methodologies to ensure they reflect evolving risks.

Then what? While it is true that much has changed with the ratings agencies, to strengthen investor confidence and improve the accuracy of their credit ratings in assessing financial and economic risks, the question still is: what has really changed; especially given the “profound revelations” from Fitch Ratings about the status and health of some of our banks?

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