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Dual Ratings Big text

The principal of Dual Ratings, as applied to the ratings of corporate or sovereign debt, was coined by Sean Egan, of Egan-Jones Ratings Limited, Guan Jianzhong of Dagong Global Credit, and Richard Hainsworth, of RusRatings Limited. Mr. Eagan, Mr. Guan and Mr. Hainsworth are the founding partners of Universal Credit Rating Group (UCRG), which was incorporated in Hong Kong in 2013.

The principle of Dual Ratings works as follows: When a theatre wants to illuminate an actor, it uses not one, but two spot lights. A single spot light, though providing substantial light also creates stark highlights and deep shadows. Two spotlights provide an extra level of perspective, removing false shadows and increasing the dynamic clarity of the actor on stage. Moreover, the spotlights are placed as far apart as possible to increase the all-round illumination.

The rule of two is valid in many places, not just in the theatre. When a patient gets a dramatic diagnosis from a doctor, the wise option is to seek a second opinion. Good practice in corporate governs defines the “four eyes” principle, in which all crucial decisions are checked by at least two separate individuals.

Since credit ratings increase market transparency, it would be reasonable to apply the same “two-spotlight” principle to credit ratings. This leads to the dual-rating principle.

The principle is not new for credit ratings, as can be seen from the survey included below. But the full implications of the analogy with two spotlights have not been systematically applied.

For example, the need for contrasting perspectives can be met if regulators require no less than two ratings, one from a domestic credit rating agency (CRA) and one from an international CRA. It is widely recognised that domestic CRAs can often provide finer grained analysis – more regular, faster, more detailed – than international CRAs. At the same time, international CRAs provide a broader base of comparison, which is essential for globally oriented investors.

Credit ratings issued by CRAs headquartered in the same town do not fully meet the dual-rating principle because analysts tend to acquire “popular” positions from their cultural and social environment, which can then affect the way they weight positive and negative factors in the process of assigning a credit rating. For example, excessively high credit ratings assigned by the three dominant international CRA – all of which have headquarters in New York – were arguably factors underlying the 2007-2008 global credit crisis.

Although the credit ratings assigned by these New York based CRAs are not all identical, there is evidence that there is a systematic under rating of companies in some geographic regions as well as over rating of companies in the USA.

Credit ratings remain an important tool for all investors and regulators. The differences between credit ratings assigned by the dominant international CRA and actual losses suffered during the 2007 and 2008 crisis by investors should not be interpreted as evidence credit ratings cannot be assigned in principle.

The “dual-rating” principle requires the existence of no less than two credit ratings, but not the level of the rating. A critical error is made by risk managers and regulators when they demand both the existence and minimum value (e.g., investment grade) of a credit rating and studies have shown that “investment grade” requirements in normative documents or contracts distort the distribution of ratings around those values.