How to avoid the next (worse) crisis?
Much has been written about the global economic crisis, its causes and its consequences. We could say that to a large extent we actually understand what has happened and why. The point, however, is to look to the future and to learn from past mistakes. In particular, we would all like to understand how to avoid the next crisis which, because of the increasing fragility of the global economy, with all likelihood will be more severe than the current one.
Of all the causes which have contributed to the crisis we identify ratings, and rating agencies in particular, as the single key factor. According to the Financial Crisis Inquiry Committee in January 2011:
Credit rating agencies play a pivotal role in the economy. They process, filter, and funnel information from the financial industry and economy in the form of ratings onto the markets. Markets and investors rely on this information.The processes that lead to a rating are:
- massively expensive
- not transparent
- not suited for a turbulent economy
It is not difficult to imagine how conflict of interest fits into the picture. However, credit rating agencies are tremendously powerful and continue to thrive in a business-as-usual fashion, as if nothing had happened. That is a reflection of immense power. In effect, a downgrade of a country’s economy by a single notch means billions of losses for that country. Overnight. Now that’s power.
Until we can break the above scheme, there is no real reason to believe that situation will change. However, breaking the scheme is, given the power concentrated in the hands of the rating agencies, almost a practical impossibility. Therefore, a different approach is necessary. If credit rating agencies are left to operate then they will surely spark another crisis. This is because the global economy has been crippled and is very fragile. It cannot take a second severe blow. And on a good crisis many people make fortunes. So, every now and then we must have a crisis, whether we like it or not.
However, there exists a mechanism that may be leveraged to change the situation. If you cannot jump over an obstacle, go around it. Here is how.
There are two tremendously powerful pieces in the global puzzle:
- The People
- The Internet
The immense power of the internet, together with millions of individuals, can be combined to create a new approach to rating that is beneficial to investors, to the economy and without the need of the rating agencies. The opportunity is phenomenal. Here is the logic:
- A radically innovative web-based rating scheme has been launched recently by Universal Ratings.
- The system is based on a technique that measures the Resistance to Shocks (RtS) or resilience, NOT the Probability of Default (PoD) of a corporation.
- A PoD measure is irrelevant in a turbulent economy. It has no physical meaning and significance.
- A measure of resilience is more relevant in today’s economy.
- Resistance to Shocks provides more useful information for investors than a PoD measure – it reflects better a company’s state-of-health.
- The newly introduced Resistance to Shocks scheme is based on new science – it is model-free.
- This means the method is objective an unbiased – the results don’t depend on which math model is used.
- Because Resistance to Shocks (resilience) is a physical quantity, not an artificial PoD, it can be computed using only one method.
- The new rating scheme is accessible also to SMEs. There are over 40000 listed companies and over 200 million private ones. All should have a rating.
- Since YOU do the rating, you trust the results.
This crisis offers a tremendous opportunity. Because the authorities behind global finance will never agree to change the rules – it is in their interest to maintain the status quo – the least investors can do to defend themselves is to resort to a new and ‘democratic’ rating system that will safeguard them from purchasing products known to be toxic. In order to avoid investing in companies close to default, investors must be aware of their real state of health.
Publishing financial reports which do not reflect correctly the real state of health of a company makes life much easier for rating agencies. Since it is the rated companies which pay for the rating, the circle is closed. This must change. Until the early 1970s the investors paid for rating reports. When the rating agencies changed their business models, and started to charge the rated companies for their services, this allowed conflict of interest and opacity to enter the picture. The rest is history. The point is this:
Investors should pay for ratings, not the rated companies.
Every business in the World should be able to afford a rating.
The system we have put in place takes the concept of rating even further. With our approach, the process of measuring one’s own Resistance to Shocks becomes part of everyday business. It becomes a standard corporate processes. An in a turbulent economy, this is certainly a good investment.
Never waste a good crisis.