Even the Sage of Omaha could not escape it. So powerful is the public wrath against n (CRAs) that when Warren Buffett—the closest thing global finance has to a saint—testified before US lawmakers in June on the role of CRAs in the financial crisis and didn’t come out railing against them, the public crucified him.
Across the spectrum, the consensus is that CRAs are definitely to blame for the housing bubble: So US financial reform efforts—the Senate passed its Bill on Thursday—has had to incorporate this. And the consensus extends to other upheavals, too. The European Central Bank is wary of the way Standard and Poor’s (S&P) downgraded Greece in April, which triggered a full-blown European crisis. Emerging economy crises in the 1990s had also prompted questions about sovereign ratings.
A Chinese CRA last week exploited this brouhaha to release its own sovereign ratings. But, taken to its extreme, this practice could unleash a “beggar-thy-credit-rating system” where every nation tries to out-rate another, as this newspaper noted.
But what about India: Does the consensus extend here, too? Not to the same extent, because CRAs here aren’t the government-enforced oligopoly they have operated as in the US. In 1975, US regulators anointed a few of them “nationally recognized”, skewing the whole market. The Securities and Exchange Board of India (Sebi) hasn’t made the same mistake.
Still, in light of the global debate, Sebi felt compelled to release fresh guidelines in May for CRAs, making sure the business stays transparent. After all, this business has been known to goof up in India, too: A 2009 National Institute of Securities Markets study pointed to two cases from the 1990s. As in any other country, the concern about conflict of interest—an obvious one in the current model where the issuer pays for the rating and could hence influence it—exists here.
Yet, this concern has become so burning that it is leading many in the West to demand radical reform: a whole new business model. But if we examined the possible alternative worlds—and those in India who pride themselves on staying ahead of the global financial-regulation curve should do so—they don’t turn to be all that plausible.
One alternative world is where CRAs aren’t needed at all. Some in the West argue that a robust market for bonds or credit default swaps can do a better job. Information would be priced in quicker, but these markets could as much reflect the risk of a bond’s illiquidity as its default. And, by now, we should have figured out that this kind of crowd, swayed by sentiment, isn’t always wise. So while we are stuck with CRAs, are there alternatives to the issuer-pays model?
One thought that comes to mind is to have the regulator pay for ratings. But perish it. Even if Sebi created another independent body for this, the moral hazard would be unimaginable. Investors won’t bother with due diligence if they see a regulator somehow sanctify a bond issuance.
And investors should be doing their homework, which is why the thought of the subscriber or investor paying for the rating is tempting. In fact, US CRAs billed subscribers, not issuers, till the 1970s. That changed when new technology—photocopiers—made it difficult to expect a rating from leaking into the wider market. But the model also changed on account of the 1975 regulatory blessing that arguably convinced CRAs to extract their rents from the issuers who couldn’t do without them, as the University of San Diego Law School’s Frank Partnoy has suggested. Can’t that be rolled back?
It’s not so easy to turn back the clock. The Internet today amplifies the tech problem, but that’s hardly the only one. By now—in contrast to the 1970s when US bond markets weren’t developed—ratings’ real utility has come to exist in the secondary bond market, where traders quickly buy and sell securities; not necessarily the primary one, where investors subscribe to issuances after considerable thought. India, which wants to develop its bond market, can’t neglect this angle.
What’s more, moving to investor-pays doesn’t exactly relieve the business of its conflicts of interest. A subscriber can swing a rating, too: A lower rating translates into a lower price for the bond and thus a higher yield, both to his benefit.
So perhaps we should start resigning ourselves to the fact that—as Winston Churchill said of democracy—issuer-pays is the worst model, except all the others. Of course, that doesn’t mean we resign ourselves to this model’s specific flaws. All it means is that we stop hollering for radical changes when piecemeal ones could do the trick.
First, Sebi must not erect unreasonable entry barriers. A regulator-enforced oligopoly in the US market meant no competition, and no challenge to, say, S&P’s faults. While this is a business where the importance of reputations probably keeps the market naturally small, Sebi shouldn’t make it unnaturally smaller.
Second, given international norms such as the Basel banking ones now suggest ratings for even loans, regulators should be mindful of unnecessarily giving CRAs more opportunities to sell their “licences”. For that’s what ratings amount to if regulators start asking for them.
Third, Sebi—and other regulators too—should contemplate how they can better monitor CRAs. Historically, regulators worldwide have seen CRAs as harmless as financial newspapers, simply expressing opinions. Yet, with regulatory mandates, CRAs are surely gatekeepers of the financial system (if not sometimes “gate openers” as they’ve become in the US). It’s then time for regulators to sink their teeth into judging culture and ethics of individual firms. Giving transparency mandates may not be enough.
If that means Sebi has to keep a closer watch on what ratings committees at CRAs are up to, so be it. It’s such micro adjustments, rather than macro overhauls, that will keep the system honest.
Abheek Bhattacharya is assistant editor, Views, Mint.
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