What is the issue?
- Nations give too much importance to credit rating agencies despite their structural flaws and inconsistent record.
- This calls for reforming the ways in which rating agencies operate.
How did the rating ecosystem evolve?
- Modern day credit rating agencies were first established in early 19th century U.S., which rated the ability of a merchant to pay his debts.
- Soon, such ratings were being applied to equity stocks and demand also rose for independent market information, offering trustworthy analysis.
- The big three of the ratings world (Moody, Fitch, and Standard & Poor) had already reached a commanding positions in the 1920s.
- By the 1960s, ratings had spread over to commercial paper, bank deposits, and the global bond market (including sovereign bonds).
- Despite their vital role in the global finance, rating agencies are marred with frequent allegations of impropriety and inaccurate ratings.
What were some of the highprofile rating failures?
- Rating agencies are accused of having failed to predict the 1990s East Asian crisis and then for overly under-rating them when the event unfolded.
- The U.S. Department of Justice launched an investigation in 1996 into a potential improper pressuring of issuers by Moody’s.
- Such agencies have been subject to a range of lawsuits, especially after Enron’s collapse and during the recent subprime mortgage crisis in the U.S.
- Moody’s had been completely oblivious of the building bubble in the run up the sub-prime mortgage crisising in the U.S. in 20017.
- Subsequently, the “National Commission on the Causes of Financial and Economic Crisis” had held that the the failure of rating was partly responsible.
- Also, Standard & Poor’s (S&P) paid $1.4 billion for rubber stamping risky mortgage bonds as safe.
- Recently, the relegation of Greece, Portugal and Ireland to “junk” status is said to have lead to a sovereign-debt crisis in these countries.
- This had worsened the unemployment situation and the Euro zone stability.
What are some structural issues?
- Popular rating agencies can have a global impact, affecting the fiscal fortunes of nations as they can potentially trigger capital outflows.
- Inconsistencies - In Indian, ratings have had a mixed record and SEBI had to intervene in some cases and tighten rules and disclosure norms for agencies.
- Many Indian economists also believe that there is a lack of due recognition for India’s economic achievements in most reports of foreign based ratings.
- Notably, such inconsistencies have led to moves by Russia and China to set up their own ratings agencies to provide better information to investors.
- Conflict of Interests - Most rating agencies generate a significant portion of revenues through non-rating activities, which makes them structurally flawed.
- Despite maintaining an iron curtain between their rating and non-rating businesses, common management gives ample scope for conflict of interests.
- Numerous studies have showcased that rating agencies seek to provide issuers, with non-rating services, along with potentially influencing a higher rating.
What is the way forward?
- The services offered by rating agencies are indeed crucial in the market and hence we too need to nurture strong indigenous rating agencies.
- But we also need to place multiple safeguards to minimise market distortions, by ensuring greater supervision over anomalous upgrades or downgrades.
- Corporates can be mandated to change rating agencies on a regular basis and “issuer-pays” model needs to change to an “investor-pays” model.
- Also, SEBI can explore options to bar credit rating agencies from providing non-rating advisory services.
- Above all, government fiscal decisions should not be skewed towards chasing ratings and rather be focused on employment generation and innovation.
Source: The Hindu
