Inherently flawed

C. P. Chandrasekhar | Updated on October 19, 2012


Recent experience has revealed a number of potentially harmful features of the credit rating system.

The system consists of a small set of agents who take on the job of assessing the financial soundness of various kinds of debt and debt-related instruments and of the entities issuing them.

It ostensibly allows for a division of labour in which the responsibility of assessing the soundness of debt instruments is left to a set of institutions that specialise in such activity and combine qualifications, experience and scale to better undertake the task on behalf of investors who are inadequately equipped to do so.

A fundamental flaw inherent in the system is that, since the rating agencies are private, the agent being rated must pay the rating agency for its services.

So, potentially, debt issuers can shop around for lenient rating agents and rating agencies can attract business by cultivating an image of being soft.

In principle, an issuer of debt is free to opt in or remain out of the rating system. And investors can rely on or ignore the guidance implicit in a rating.

But having been adopted as an instrument of self-regulation of the private financial system, ratings get included among the signals that fund managers must respect when choosing instruments. If investors look to them, issuers have no option but pay to get rated.

Love-hate relationship

However, recurring financial crises have revealed much to discredit this system. Institutions, instruments and countries have been given high ratings in the run-up to these crises and often till the crisis actually breaks.

Such ratings, by encouraging investors to rush in, contribute to the speculative boom that underlies the crisis. Once the crisis occurs, rating agencies opt for sharp downgrades to save their reputations, worsening the credit crunch. Having burnt their fingers they also tend to be biased towards downgrades of other instruments and entities and are slow to revise ratings upwards, contributing often to contagion or delayed recovery.

Despite such evidence and the criticism that followed, ratings agencies continue in business. This is because doing away with the private ratings system would necessitate a greater role for public regulation.

It is also because of the strange love-hate relationship between the rated and the raters. Governments such as India’s embraced rating by global firms or their subsidiaries in the belief that it would help attract foreign investors. So long as the ratings were good they basked in the glory. When rating downgrades occurred they complained, but the rating agents remain unaffected by this asymmetric and contradictory stand.

(The author is Professor of Economics, JNU)

Also read: >There’s no option

Published on October 19, 2012

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