If credit rating agencies are indispensable, can they at least be made accountable for their actions?

There is a need to regulate Indian credit rating agencies not only to make them accountable for their actions, but also to pre-empt any possibility of a ‘cash-for-rating’ scam, which can be prevented only if a strong regulation is put in place

If there is one business in this world that is minting money without being accountable, responsible or answerable to any one, it is the business of credit rating. Whether the economy is in good shape or bad, whether companies are making profits or not, whether investors are earning or losing money, the rating companies are there to make money for themselves, thanks to the wise men in power all over the world, who have given them unfettered freedom to say what they want, without any accountability for their actions.

Otherwise how do you reconcile to the fact that different rating agencies give diametrically opposite rating to the same country, same product, or same sector with same facts and figures. In the first week of August 2011, Standard & Poor’s (S&P), a global rating agency downgraded United States’ sovereign rating by one notch from ‘AAA’ to ‘AA+’ and millions of investors all over the world lost billions of dollars for no fault of theirs. Around the same time, two other international rating agencies, namely Moody’s Investors Service and Fitch Ratings affirmed triple A (AAA) rating of the US government based on the same data, same facts and same figures.

Nearer home, on 9 November 2011, Moody’s Investors Service downgraded India’s banking sector to ‘negative’ from ‘stable’, creating ripples not only in the capital market but also in the corridors of power in our country. But strangely, on the very next day, S&P upgraded the country’s banking sector from group ‘6’ to group ‘5’, citing “high level of stability,  core customers’ deposits, which limit dependence on external borrowings, and that Indian government is highly supportive of the banking system.” Curiously, within a week thereafter, another rating agency, namely Brickwork Ratings has maintained a “stable” outlook for the Indian banking sector based on “rational view of past performance of the banking industry, the positives and the challenges faced by banks, the regulatory environment and the implications of the Euro zone crisis”      
The three rating agencies have given three different ratings for our banking sector all at the same time, based on the same facts and figures, which proves how subjective is the rating system and how much reliable is the rating mechanism, causing a sense of concern among the people of this country.      
There is more to rating than meets the eye. On 11th November this year, S&P committed a blunder by accidentally sending messages to some of its subscribers that it had lowered France’s Triple A sovereign rating. Fortunately this mistake happened just after the Paris bourse had closed and that saved the day for the French investors from a catastrophe. Within two hours, the agency sent out another message saying that it was a technical error and that the rating of the French Republic was unchanged and continued to be Triple A. In the wake of this goof-up, the European Union Internal Market Commissioner had called for a rigorous, strict and solid regulation for credit rating agencies.

During the global financial crisis of 2008, the agencies admitted that they did make mistakes in their ratings, which partly led to the crisis and caused the collapse of the world markets then. The rating agencies gave their best ratings to borrowers before the housing crisis in America. It turned out that many were not able to pay their debts back, resulting in failure of renowned housing finance companies there.

Are the rating agencies indispensable? Over a period of time, rating agencies have become a part and parcel of the economy of the developed and developing countries—either by design or by default. They are expected to perform certain useful but onerous functions like educating investors in the art of investment, protecting the interests of gullible consumers, guiding industries to raise capital and most importantly serve as a guardian of the country’s economy by periodically emitting appropriate signals as to where the economy is headed during both good and bad times for the benefit of the people of the country and of the world, as well. But recent developments all over the world show that these rating agencies are not infallible. Being manned by human beings they make not only mistakes but blunders, too. Hence there is a need to make them accountable, responsible and answerable for their actions and their activities need to be monitored, guided and supervised so that they do the job expected of them objectively with a sense of purpose and great responsibility towards the people whom they are supposed to serve. Following the financial crisis of 2008, the Obama administration quickly enacted a law called Dodd-Frank Wall Street Reform & Consumer Protection Act on 21 July 2010. It is an omnibus law with an aim to create a sound economic foundation to grow jobs, protect consumers and investors, rein in Wall Street and big bonuses, end bailouts of too-big-to-fail, and prevent another financial crisis.

While the Act was touted as the most sweeping change to financial regulation in the US since the great depression, it contains several provisions to protect investors by codifying new rules for transparency and accountability of credit rating agencies, as well. The Act provides for creation of Office of Credit Ratings (OCR) within the Securities and Exchange Commission (SEC) to ensure oversight over Nationally Recognized Statistical Rating Organizations and enhanced regulation of such entities.

There are 76 rating agencies globally in different countries with 10 rating agencies (eight of US, one each of Canada and Japan) approved by the SEC. The big three rating agencies are S&P with ratings revenue of $1.70 billion, Moody’s Investor Services with revenue of $1.47 billion and Fitch Ratings with a revenue of $554 million for the year 2010. Seven other agencies have combined revenue of $196 million, as reported in the media. 
In India there are seven rating agencies at present, which are approved by different authorities and different wings of the central government, depending upon the rating work they undertake. At present, those agencies active in the capital market are approved by the Securities and Exchange Board of India (SEBI), those which are active in rating of bank loans, etc are approved by the Reserve Bank of India (RBI), and others by NABARD, National Housing Bank and by different ministries of the government. However, there are no uniform rules for such approval, nor is there any co-ordination between different authorities to ensure that the rating agency approved by them has the requisite competence to do the job expected of them. To streamline the entire operations of rating agencies and to keep track of the new rating companies coming into India, it is necessary to put in place a regulatory mechanism through a suitable enactment as early as possible. Here are a few important steps required to be initiated by the government in the interest of safeguarding the integrity of the securities market in our country.          
1    There must be an independent regulator for the rating agencies, who should formulate rules and regulations for centralized registration, reporting, monitoring and ethical functioning of all the rating agencies in the country. And all other regulators should go by such registration, instead of doing registration independently.

2    The rating agencies should have complete transparency in their operations, and periodical reporting of all aspects of rating to the regulator should be made mandatory.

3    The rating agencies’ promoters, directors and the top management should be screened by the regulator for their credentials, competence and their antecedents to ensure that only the deserving and competent people run this business.

4    Only by putting your money where your mouth is you can be made accountable for your actions. For this reason, the government should set up a Bondholders’ Protection Fund (BPF) to compensate certain type of investors (like senior citizens, etc) in rated bonds, debentures, etc. when there is a default by the issuers. The rating agencies should contribute funds to this BPF on a pre-determined ratio, and such a fund should be managed independently by trustees appointed by the regulator. The detailed mechanism of managing the fund can be decided by the regulator.

5.    The rating agencies should mandatorily communicate to the investors holding the rated bonds, whenever they downgrade an issuer or the bonds concerned, thereby helping the investor to take a decision to hold or sell the bonds and thus protect their interest.
6.    The regulator should put a cap on the fees charged by the rating agencies, and the fees charged for each rating should form part and parcel of the rating report to ensure transparency in their dealings.

7.    Every rating agency should set up a separate independent rating committee, whose members should not only be experts in the respective fields, but should not have any pecuniary relationship either with the rating agency or the issuer concerned whose instruments are rated in order to ensure that there is no conflict of interest.

8.    There should be complete ‘Chinese walls’ between the rating activity and non-rating activity handled by the agency and any non-rating business handled by the agency for a client should be clearly mentioned in the rating report on the said client.

9.    Whenever the rating agency downgrades an issuer or a bond, it should be given enough publicity in the national dailies with the largest circulation to serve as a communication to the general investors about the revised rating allotted to the issuer or the instrument.

10.    All rating agencies should publish their profit & loss account and balance sheet annually with all the data that goes along with the annual report. They should comply with all the requirements complied with by a listing company, like quarterly results, shareholding pattern, changes in directors, etc even though they are not listed, with a view to ensure transparency and better corporate governance.

11.    Every year a list of all companies and or instruments rated by them along with the periodical upgrade or downgrade affected by them should be published not only on their website, but also in leading national dailies in the month of April every year.

12.    The rating agencies that rate housing projects should certify the correctness of all claims and statements made by the builders after thorough verification and any variance observed by them should be communicated to the respective home buyers periodically.

13.    The rating agencies that rate educational institutions should be answerable to the students of the rated institutions for any variation in the claims and statements made by the managements of the institutions concerned.

14.    The regulator should have the authority to levy penalty for any wrong doing by the rating agency, including deregistration and winding up of the company, if so warranted.

15.    The regulator should periodically inspect the operations of the rating agencies to ensure that their operations are run on sound lines and that they are fit to continue to run the business of ratings.
16.     The rating agencies should lead by example whenever they rate a company for corporate governance, so that the standards followed by the rating company should form as a model for others to follow.

17.    The most important of all is that the aforesaid stipulations and any other conditionality felt necessary to regulate this business should be codified through a central enactment so that the business of rating grows on healthy lines and the public at large, investors and the consumers really benefit from their expertise and they in turn become more responsible and accountable to the society in which they operate.          
These are some of the broad contours of the proposed legislation to bring the rating agencies within the ambit of law, and the earlier it is done, the better it is for the economy. We have had several scams in our country recently. Two of them are cash-for-votes scam and cash-for-loans scam. It is time for us to take preventive steps to the extent possible to ensure that our country is free from any further scams, and to pre-empt any possibility of cash-for-rating scam, the government should initiate the steps suggested above early.

 (The author is a banking and financial consultant. He writes for Moneylife under the pen-name ‘Gurpur’)

Pop Rating House
1 decade ago
Everybody may shows his credit rating expertise posting his analysis on the Pop Rating House facebook page
Nagesh Kini FCA
1 decade ago
The raters also need to be regulated. On the international plane by OECD or UN agency and not IMF or WB who are perceived to be US bodies.
Imagine in the case of rating US they goofed by trillions of $ and got away y with a knock on knuckles from the US President.
In India two gave contrary ratings in the case of Indian banks where also they seem to have blundered badly.

Since lay people perceive Rating Agencies to be greater than God, their Reports on Indian entities need to be submitted to Indian Regulators for vetting, more particularly when they have been to be deficient in delivery.
R Balakrishnan
1 decade ago
With all these caveats, no one would want to be in the ratings business. Ratings are like journalism. The moment you say that these kind of rules apply to journalism or an investment advisor, they will stop this business.
Ratings are opinions and if the world wants to use it as a convenient way to pass the buck, it is not the rating agencies' fault. Only because investors do not do their work or are incapable of doing so, do rating agencies exist.
we can use them as an assist, but holding them accountable for all their views would be unfair.
Yes, if they are fraudulent or dishonest, do so. But, if their views are an issue of competence or perception, why bother?
Do investors want iron clad guarantees on everything?
Rating business is a complex one and a regulator has to be more competent than a rating agency to regulate one. Yes, there can be a code of conduct, but if you have a regulator poking their nose in to matters which they do not understand, too bad.
What about the fund managers who did not do any homework on their own, but blindly depended on rating agencies?
A rating is only a supplementary tool for a decision and cannot be a primary one. The professional investors should be able to justify why they put money in to complex instruments without understanding anything themselves and then conveniently putting the blame on rating agencies.
Replied to R Balakrishnan comment 1 decade ago
I agree...

The public at large is too lazy to do its homework. It is always looking for scapegoats to pass the buck of their own inefficiencies.
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