The ratings illusion

The ratings illusion

Context:

• Modern day credit rating agencies were first established after the financial crisis of 1837 in the U.S.
• Such agencies were then needed to rate the ability of a merchant to pay his debts, consolidating such data in ledgers; soon enough, such ratings were being applied to equity stocks.

Background:

• By the 1920s, the big three of the ratings world (including Fitch, Standard & Poor’s) had been incorporated.
• The passage of the Glass-Steagall Act in 1933 helped formulate the separation of the securities business from banking.
• Soon enough, by the 1960s, such ratings had spread over to commercial paper and bank deposits, along with expansion into rating the global bond market (including sovereign bonds).

Loopholes in credit ranking agency:

• Despite vital role in the global financial world, rating agencies fail to inspire confidence, with allegations of improper and inaccurate ratings occurring frequently.
• The National Commission on the Causes of Financial and Economic Crisis in the United States (2011) held the failure of rating agencies to be essential mechanism in the wheels of financial destruction.
• Moody’s has been fined across various geographies for non-adherence to standard rating protocols.
• Such rating agencies can have a global impact, affecting the fiscal fortunes of nations, due to flight of capital.
• Nations perhaps give too much importance to the achievement on such ratings, despite their structural flaws.

Way ahead:

• India must utilise indigenous rating agncies, to help clean house in corporate sector.
• To safeguard investors, SEBI can explore reforms so that credit rating agencies do not provide non-rating advisory services to their clients, even at the cost of reduced profits.
• A fixed operating fee model may also be explored, thereby eliminating incentives to be the “lowest-bidder” with compromised quality.
• Outstanding ratings and sudden downgrades need to be subjected to greater supervision.
• Akin to auditors, corporates should be pushed to change rating agencies on a regular basis.
• The “issuer-pays” model needs to change to an “investor-pays” model, with fees being standardised by the market regulator.
• At the governmental level, our fiscal decisions should be marked by a push towards developing an economy with full employment and innovation, instead of seeking to chase down ratings quarter by quarter.