Vincent Reinhart responds to an argument that ratings agencies replaced investment banks in evaluating sovereign debt and underwriting. The explanation, presented in a paper by Marc Flandreau, Juan Flores, Norbert Galliard, and Sebastián Nieto-Parra, is possible but far from unique. Modern markets have made gathering information cheaper and larger capital flows have decreased fees to be extracted from underwriting, pushing investment banks into other services. These and other explanations are equally possible, argues Reinhart.
Resident Scholar
Vincent Reinhart |
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I appreciate the opportunity to comment on the paper, "The default puzzle: underwriters and sovereign bond markets." Marc Flandreau, Juan Flores, Norbert Galliard, and Sebastián Nieto-Parra have written a careful and comprehensive study, commendable in the manner in which they examine the mechanics of sovereign debt issuance over the past two centuries. Having documented the government sales of debt, they go on to offer a plausible mechanism to explain changes in patterns over time.
They direct our attention to market mechanisms, specifically the middlemen in transactions or the entities that make the invisible hand work. The events over the past two years have shown such focus to be important, as it is precisely problems at those middlemen that help to explain the contraction in financial trading, the increase in market spreads, and the drying up of new lending recently witnessed. Concern about such middlemen includes understanding their incentives, capital positions, and balance sheets. In that regard, this paper takes to heart limits of arbitrage arguments, which could help explain why financial markets act sometimes at variance to behaviour expected from atomistic agents exploiting all opportunities for trade.
To put it simply, the authors construct underwriting league tables for four periods. They essentially recreate what Bloomberg magazine would have looked like in the 1820s, 1870s, 1930s, and most recently. They show how those league tables evolved in significant ways. They then offer a plausible explanation that explains those changes by the rising role of rating agencies. Before the dominance of rating agencies, investment banks had the responsibility for signaling sovereign creditworthiness by supporting after-issuance market-making in that debt. When rating agencies became the dominant purveyor of this stamp of creditworthiness, investment banks laid-off that responsibility and no longer needed to support the markets for the debt they had underwritten.
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Vincent R. Reinhart is a resident scholar at AEI.
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Sunday, November 22, 2009
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