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.
