The performance of credit rating agencies (CRAs) is under the scanner in connection with the crisis in confidence which started with defaults in the sub-prime mortgage market in the US. In this finger-pointing environment the following questions need to be asked about CRAs.
Are CRAs at arm's length from companies which avail of their rating services? Should CRAs be accountable if investment grade securities collapse overnight to junk status? Is it realistic to expect CRAs to anticipate changes in creditworthiness and revise ratings accordingly?
CRAs maintain that they cannot be held responsible if there is financial fraud or when valuations fall sharply since their ratings are mere opinions. Further, their ratings are not recommendations to buy or sell any security. Additionally, ratings are a point-of-time assessment of creditworthiness and carry no predictive information.
CRAs rate the creditworthiness of companies/issuers of debt and bonds/structured securities and their ratings are widely used by market participants. Securities are rated either at an issuer's request or because there is sufficient investor interest for CRAs to provide this service at their own cost. Financial sector regulators use CRA ratings to assign values to securities held as risk capital. In most jurisdictions, it is customary or obligatory for traded securities to be rated.
CRAs perform an important quasi-regulatory function by reducing information asymmetries between issuers of securities and corresponding investors. However, every few years highly-rated companies suddenly file for bankruptcy.
It follows that CRAs should review their ratings at frequent intervals since an unanticipated fall in valuations can snowball into a credit crisis. The underlying assumption is that CRAs can price market risk and its correlation with credit risk in complex derivatives structures.
However, CRAs are not in position to price complex structures since their compensation packages are not attractive enough to recruit staff that has hands-on pricing and transactions experience.
The guidelines for institutional investors invariably stipulate minimum credit ratings for their investments. CRAs provide consulting advice to issuers to help design structured securities that meet such minimum rating requirements. Therefore, irrespective of firewalls, it is likely that the fee-based rating services of CRAs are fraught with conflict of interest with their advisory contacts with clients.
As mentioned at the outset, the repayment problems affecting the sub-prime housing market in the US have led to a fall in the prices of assets spun-off collateralised debt obligations (CDOs) and residual mortgage backed securities (RMBS).
CRAs must have known that some of the CDOs and RMBS securities rated by them at the same level as plain vanilla bonds were far riskier than the latter. In the wake of this turmoil in credit markets Standard and Poor's President Kathleen Corbet resigned on August 31.
Effectively, the international credit rating industry is run on oligopolistic lines with an assured market for its services and dominated by a few privately owned firms, namely Standard and Poor's, Moody's and Fitch.
In India, the rating market is mostly shared among a few rating agencies viz. CRISIL, ICRA and CARE. CRISIL is majority owned by Standard and Poor's and ICRA is "associated" with Moody's.
In the US, established CRAs are designated by the Securities and Exchange Commission (SEC) as "Nationally Recognized Statistical Rating Organizations" (NRSROs) and only NRSRO ratings can be used for regulatory purposes. This SEC practice limits competition as it is a barrier to fresh entry. Additionally, US courts have ruled that CRA ratings are opinions and protected from liability as free speech.
In contrast, Indian CRAs have to be registered with Sebi and it is obligatory for public debt issues to be rated. The Indian debt market consists mainly of government securities and securitisation has not yet happened in any volume. Consequently, the potential for a disaster in Indian credit markets due to inaccurate local ratings is somewhat limited.
However, as financial sector services are becoming increasingly global in their reach, credit downturns spread across nations. And, a credit crisis in one set of countries can pose a systemic risk to financial markets internationally.
For example, a sharp sell-off by institutional investors in G-7 countries can affect financial markets in Asia. Given the cross-border impact of a credit crisis, regulators should focus on improving the functioning of CRAs.
The scandals surrounding the demise of Enron and WorldCom led to charges of conflict of interest in the functioning of accounting-auditing firms which also offered consulting services. Later in 2002, a Public Company Accounting Oversight Board (PCAOB) was set up in the US to regulate accounting firms in their role as auditors of public companies.
At that time, an additional suggestion was that enhanced self regulation would improve the reliability of CRA ratings. Separately, the International Organisation of Securities Commission's (IOSCO) Code for CRAs was made public in December 2004.
This Code focuses on the integrity and transparency of the rating process and the need to steer clear of potential conflicts of interest. However, the Code cannot be enforced except by national regulators.
Financial institutions in the US, Europe and China have been hit by the recent credit crisis. In response, the Federal Reserve and the European Central Bank have injected sizeable amounts of liquidity into their respective markets.
More recently, the poor employment numbers in the US and the continuing pressure from domestic political quarters may force the Federal Reserve to cut short-term interest rates by another 50 basis points at its next policy meeting on September 18. Such "force-majeure" lowering of interest rates carries the moral hazard of providing a safety net for the financially irresponsible while punishing prudent savers (including Asian countries with large FX reserves) who depend on money market returns.
To summarise, the accounting-auditing profession has set up standards and methodologies to better monitor the financial health of companies. These methodologies are updated periodically and take into account advances in financial engineering.
It is time for financial sector regulators to pool efforts to: (a) standardise valuation and risk assessment methodologies used by CRAs; (b) prescribe the minimum periodicity with which ratings have to be reviewed (should also be triggered if market volatility exceeds pre-agreed limits); and (c) specify the do and don'ts for consultations with clients.
