The Hindu Business Line : Credit rating agencies: Flawed institutions

Credit rating agencies are right in the line of fire in the current crisis in global financial markets for their misleading investment grade ratings for sub-investment paper.

Mr R. Viswanathan in his piece (Credit rating agencies: Answerable to none, Business Line, Nov 3), makes the basic point that rating agencies are supposed to protect investors, but are paid for their services by issuers, creating a conflict of interest.

The obvious answer seems to be to make investors pay for ratings, but there are serious issues of how feasible it is. Unfortunately, this is being seized upon by the credit rating industry to argue there is no alternative.

First question

The first question that must be asked is if credit rating agencies should be for profit institutions as they very much are now. Is it right to combine credit rating with fee-based consulting and allied services in the same institution?

Should they be allowed to list on stock exchanges (which they are), thus motivating their managements to focus more on ‘shareholder value’ (another name for profit maximization). Investors’ interests could well become a casualty in the process.

In fact, Government of India is proposing legislation barring auditors from consulting relationships with audited companies.

It would not be out of place to introduce such restrictions on rating agencies as it is not generally realized that they are also supposed to be more like auditors and regulators and not businesses.

Surprising ratings

Some ratings are, frankly, surprising. One of the most basic and fundamental principles of rating, known and accepted the world over, is that a non-sovereign obligation cannot enjoy a better rating than a sovereign obligation.

Yet, here, in India, we have the astonishing contradiction of some private sector banks being rated higher than Government-owned banks.

Raters were quick to recently downgrade as many as four public sector banks while retaining the prime rating of a premier private sector bank currently in the news for massive derivative losses and a run on its deposits. Quite possibly, the argument could be that no bank will be allowed to fail. That should apply with even more force to public sector banks. What, then, is the logic of an inferior rating for the latter?

Another example is the practice of awarding ‘AAA’ status to portfolios of retail loans – a smorgasbord of thousands of borrowers in different places, professions, income and wealth profiles – many of which are not sufficiently seasoned to even deserve a rating.

It suggests these loans are as good as ‘AAA’ corporate paper, which is far from the truth. The whole exercise appears loan-originator and securitiser-driven to offload the loans in their balance sheets as soon as possible after disbursement with the support of an ‘AAA’ label.

Alternative

Is there an alternative? Egan-Jones Ratings, a little-known US rating agency, gets no fees from issuers.

Its clients are institutions and hedge funds and, perhaps, really well-heeled investors – those who want unbiased, objective advice from entities with no relationships with the issuer. (Check its website which cheekily asks if S&P, Moody’s and Fitch have ever made money for investors).

There is a different model of rating agency funding.

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