Standards'R'Poor.....

....or, if you prefer, "Bad Moody's", or "Son of a Fitch".

The credit rating agencies, always quick to downgrade a company's debt the day after it had defaulted, used to be the harmless laughing stock of the financial markets. However, their incompetence took on a darker edge during the recent financial crisis. Although the major cause of the crisis was the toxic combination of irresponsible monetary policy and financial market deregulation, the willingness of these agencies to grant the supposed imprimatur of a AAA rating to all kinds of incomprehensible securities did much to deepen and prolong it.

Now, perhaps even more damagingly, they seem to be engaged in a contest to prove which of them is the toughest. S&P got the ball rolling by announcing that it would regard a voluntary rollover by banks of their holdings of Greek debt as a form of default, and Fitch has hinted it would take the same view. It's hard to fathom the logic here: investors voluntarily roll over their holdings of all kinds of instruments every day of the week without anybody suggesting that this means the borrowers are in default. S&P's threat risks torpedoing the best remaining chance of preventing Greece's debt problems from triggering a genuine default and possibly setting off a severe financial crisis.

Not to be outdone in the idiotic machismo stakes, Moody's promptly followed S&P's outburst by downgrading Portugal's debt to junk status, citing the possibility that the country could well need a further official bailout. Well, if that wasn't the likeliest outcome before -- and arguably it wasn't: Portugal's financial position is far less dire than that of Greece -- it's certainly become a whole lot more probable now.

A year or two ago there was widespread agreement on changes that needed to be made to avoid an early repeat. A return to tighter financial regulation: a start has been made. Strengthening bank balance sheets: good progress in most countries. Curbing the influence of the ratings agencies? Nothing has happened, and now the markets are being jerked around again.

Dealing with the agencies isn't just a matter of cracking down on a bunch of irresponsible incompetents, satisfying though that might be in its own right. There is, in fact, a strong case to be made that the ratings agencies, as they currently operate, directly add to the level of risk in the system.

Many investment funds are governed by mandates that require them to purchase only investments that meet defined ratings criteria. This makes life easy for fund managers (and explains why so many of them have single-figure golf handicaps), but it obviously has disastrous consequences for the proper assessment of risk. How much of the toxic junk that was peddled in the middle of the last decade would have been bought if fund managers had been forced to take responsibility for the quality of what they were buying, rather than just sheltering behind a rating awarded by some unqualified and inexperienced analyst?

Ratings-based mandates also risk creating needless market disruption in times of financial stress. A lot of investors who may have been quite happy to sit tight on their Portuguese debt holdings will be forced by their mandates to offload them immediately, now that the great oracle at Moody's has spoken. This is the key mechanism through which Moody's ratings action may well become a self-fulfilling prophecy. It's not that the fund managers have any great faith in Moody's analysis -- nobody's that stupid -- rather, it's that their investment rules leave them no choice in the matter.

The EU and ECB are reportedly looking at ways of sidelining the agencies or somehow neutralising their impact during times of crisis. It's a pity the opportunity wasn't taken to deal with the issue during the past couple of years, before this latest, potentially disastrous attempt by the agencies to flex their muscles.