Should Credit Rating Agencies be Publicly Controlled?

By Saliem Fakir · 15 Sep 2011

Picture: www.journaloffinance.in

Credit rating is a weighty obligation. Credit rating agencies (CRAs) can either boost a country’s fortunes or bring it down.

CRAs are privately owned agencies that specialize in investigating the credit worthiness (ability to pay back) of governments and companies. CRAs assign credit ratings for issuers of debt-like securities (such as, bonds in the case of governments) that can be traded.

The record of CRAs, though, has been mixed and has been scrutinized for some time now.

In 2003, the Financial Policy Forum, an America non-profit that monitors disruptions and inefficiencies in financial markets, published a special policy report, which argued that CRAs systematically failed to anticipate currency crises from 1979-1999. Most sovereign debt defaults are associated with currency crises. The same report showed that rating agencies tend to be reactive, especially for emerging markets.

People have been losing even more faith in CRAs since the 2008 financial crisis. CRA’s stand accused of “being asleep at the switch” in the run up to the sub prime mortgage bubble that caused the crisis. CRAs vouched for companies, loans and financial instruments that turned out to be awash with toxic debt. For example, Lehman Brothers was given a “triple A” rating shortly before it went bankrupt.

Disturbingly, some CRAs also helped their clients, especially investment banks, design the instruments that brought about the financial crisis. Yet, rating agencies are still allowed to “play god” when it comes to determining the future of entire nations and their people.

A downgrade for a country means that it has to borrow money at higher costs or investors will simply lose confidence in the country being a safe-haven for their investments.

The United States of America (US) had first-hand experience of this conundrum recently when Standard & Poor’s (S&P), one of the biggest CRAs, unceremoniously downgraded its credit worthiness. The effect of such an opinion was to lower the value of the US dollar and increase its borrowing costs. The downgrading would cost the US roughly US$75bn extra in interest charges and potentially 600,000 jobs.

At the time of its downgrading, the US government contested S&P’s rating; quickly pointing out that the agency had made an accounting era of US$2.4 trillion. Whether it was true or not, the US learnt a bitter lesson from the very medicine it has applied to others in the past.

The US is not alone in its struggle with CRAs.

Debt-ridden European countries such as Portugal, Ireland, Italy, Greece and Spain (the PIIGS) also didn’t take favourably to the evaluations of CRAs following the Greek crisis. German finance minister, Wolfgang Schaeuble, was so enraged that he called for the “smashing” of CRA oligopolies.

Economists are also climbing in.

Amartya Sen, the Nobel Laureate and economist, in a June 2011 issue of the Guardian newspaper, specifically noted that international financial institutions and CRAs “lord it freely” over democratically elected governments and unilaterally command them. Richard Koo, a prominent economist based in Japan, was even more scathing, arguing that CRAs are “poised to destroy the global economy once again.”

For example, when it comes to fiscal policies during times of recession where governments are in a quandary as to what to do, CRAs have preferred fiscal austerity as opposed to fiscal stimulation.

Argentina is a good example of a country that adhered to International Monetary Fund (IMF) and CRA formulas for austerity, only to find their advice disastrous. After a decade of hopeless IMF policies, Argentina was forced to forsake their ‘wisdom’ and took matters into her own hands. Argentina defaulted, devalued its currency and took the route of increasing its deficit spend, rather than continue with the IMF’s recipe for austerity.

Argentina proved to the world how the IMF and CRAs’ approach was so wrong. Following its own unilateral interventions, the Argentinean economy was able to grow and the country was also able to pay its debt between the periods 2002-2009. This would not have happened if it stuck to the IMF/CRA model of rescue.

Presently, a slow war is brewing. Those who have long had the power to bring unaccountable private agencies to book are now wanting to either reform or do away with private CRAs because their own economies are being affected by the opinions of these agencies.

In the past when developing countries complained to these very same developed economies about the unfairness and one-sidedness of CRAs, their chorus of complaints was met with deaf ears.

Now the tables have been turned and the menace of CRAs has come to bite the very hands that had for so long fed them. All of this smacks of belated hypocrisy.

How did CRAs become so powerful? Since the early 1970s, deregulation of the sector has ensured that moral hazards prevail unchecked.

The US, in particular, passed legislation in 1975, which allowed for the creation of the Nationally Recognised Statistical Rating Organization (NRSRO). Such accreditation effectively increased the barrier to entry for smaller firms and led to the consolidation of the industry by the big three.

According to a 2009 paper by Pragyan Deb and Gareth Murphy of the London School of Economics, of the top three global CRAs, S & P and Moody’s control 80% of the market. Fitch, the third biggest rating agency, lags far behind with approximately 15% of market share. All of the top three agencies are based in the US and dominate the global financial markets with their advisories.

Any attempt at reform is being met with heavy lobbying from the agencies themselves. In effect, increasing concentration only furthered the moral hazard of ‘notching’ and risky behaviour. Notching itself was used to bend client’s ears where CRAs would inflate ratings if you behaved well or downgraded you if you showed signs of dissension.

Conflicts of interest arose because of the way in which revenues were generated after the deregulation of CRAs.

CRAs switched from the old system of the investor-pay model to an issuer-pay model. In an investor-pay model, the investor subscribes for a rating and in an issuer-pay model; the issuer pays for the cost of the rating.

If an issuer wants a rating they pay a fee, otherwise rating agencies use publicly available information.

Evidence compiled over the years shows that this switch of source of revenue for rating agencies tended to also result in large issuers getting far more favourable ratings than before – the ‘notching’ effect coming into play.

So what is it that can be done?

In the short-term, given how embedded and dependent we are on CRAs, tighter governance rules and transparency should be demanded from CRAs.

One of these would involve disclosures of who they are providing services to in order to ensure that there is no conflict of interest.

There are also calls for CRAs to be regulated through some sort of international regime.

In the US, during the financial crisis hearings, regulators and investors called on CRAs to be held legally responsible for the advice they give and to be subjected to a fine if they are found to be negligent. This may prove easier said than done because it requires strong regulatory expertise and the capacity to police.

Others recommended breaking the oligopoly of the CRAs by removing barriers to entry in the sector so as to allow greater competition. However, just this one solution on its own may lead to other problems. Too many players in a market may just encourage other sorts of perverse behaviour like ‘rate-shopping’, as borrowers seek a second or third opinion until they find the most favourable rating.

There are also proposals to limit CRAs’ revenue sources to an investor-pay model and have the rest of the revenue subsidised by the state – and in so doing, increase public control and supervision of CRAs.

Asian countries, which will see the biggest growth in financial needs and investment, are considering a regional credit agency model that is publicly controlled.

China is already experimenting with its own CRA, the Dagong Global Credit Rating Agency, which may in the future play an Asia-wide role. The promising thing about the Chinese CRA is that it adopts a completely different approach for assessing a company or country’s risk. In a recent evaluation of 50 countries, Dagong’s assessments were diametrically opposite to how existing CRAs rated the risk profile of some developed economies. For instance, it rated South Africa stable and the US, riskier.

The Chinese model looks at institutional strength and long-term wealth creation potential rather than wealth and the debt burden in the present. Its key measure is how a country will be able to turn a disadvantage into an advantage and differs with other CRAs where disadvantage is simply a disadvantage.

South Africa, which is part of the emerging markets’ group, BRICS, and other global groupings like the G20, should raise the flag on the issue of CRAs. Clearly, reform is not working and what is needed is a radical overhaul in the way that ratings are done. South Africa should push for global regulation of CRAs.

What we need is robust assessments with a greater deal of public accountability for how these decisions are made. Publicly held and managed CRAs may be the way to go.

Fakir is an independent writer based in Cape Town.

Read more articles by Saliem Fakir.

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