Thursday, 4 July 2013

Conventional Ratings Versus Resilience Rating

Ratings are issued by Credit Rating Agencies (CRA) and are supposed to provide information on credit-worthiness and risk for investors. However, as stated in the Wikipedia: "The value of such security ratings has been widely questioned after the 2007-09 financial crisis. In 2003 the U.S. Securities and Exchange Commission submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest. More recently, ratings downgrades during the European sovereign debt crisis of 2010-11 have drawn criticism from the EU and individual countries."

It is true that conventional ratings are being widely questioned. However, the issue that is most frequently being raised is that of potential conflict of interest, lack of transparency and anti-competitive practice. This is an aspect of ratings that is outside of the scope of this short note. The point, in fact, is quite different. Traditional ratings have been conceived in a non-turbulent, non-globalized economy. Today, they are outdated. Different approaches are necessary. Conventional ratings don't work because they cannot work. You cannot analyze turbulent fluid flow using laminar flow techniques.

In a turbulent regime, a fundamental characteristic of a business is its resilience, or the capacity to face shocks or sudden and extreme events (known as Black Swans). Because our global economy will be characterized by increasingly frequent and intense shocks, resilience is becoming a salient characteristic of any kind of business. Resilience is, in fact, a new economic and business indicator. It can be applied to a corporation, a system of corporations, a market, a system of markets, or to countries.

Resilience is best computed based on complexity and has been introduced for the first time in this innovative form by Ontonix. It is measured on a scale from 0 to 100% and may be measured on-line. Given the immense degree of uncertainty in today's economy, stratifying ratings into 20+ classes is disputable - we prefer 5. There is not enough precision in the economy to justify many more. We can, nevertheless, attempt a "comparison" of conventional ratings and resilience ratings. This is illustrated in the figure below.

Even though one may see the above as an attempt to establish some form of equivalence, there is no equivalence. Traditional ratings and resilience ratings have nothing in common, as they computed on totally different grounds and based on radically different philosophies.