Photo: AFP
Photo: AFP

The economics of rating agencies

Whether the ongoing efforts to reform them will yield results or not will only be seen when the next crisis hits

Two recent events have focused attention on the role and influence of credit rating agencies in India.

A few weeks ago, rating agency Moody’s intervention in the debate on growing polarization in the country stoked a political firestorm after its analytics arm warned that Prime Minister Narendra Modi risks losing his domestic and global credibility if he is unable to rein in colleagues making provocative statements against minorities and stoking ethnic tension. An outcry followed, but Moody’s stood by the report, saying it was the view of Moody’s Analytics, and not of its credit ratings division.

The second event involved the $121 million debt default of Amtek Auto Ltd. The default has hit the portfolios of large institutional investors such as JP Morgan Asset Management, which was left holding unsaleable assets. The event highlighted a growing risk for bond market investors; rating agencies often react late, if at all, to growing credit risks.

Indeed, one of the biggest lessons of the global financial crash of 2008 was the vulnerability of ratings systems, which failed to deliver any warning on the growing risks of the complex portfolios that were being rated until it was too late, and then their actions fuelled panic.

Despite their contribution to the financial crisis, rating agencies remain vital cogs of the global financial architecture. It is, therefore, important to understand what they do, and the forces that drive their functioning.

To put it simply, rating agencies rate borrowers—private and public—who want to raise capital in the market. Although there are exceptions to the rule, normally private players seek these ratings while sovereign ratings are unsolicited. When solicited, the fees for providing ratings can run into millions of dollars.

What explains this business? A 1981 paper by Joseph Stiglitz and Andrew Weiss provides the basic economic framework defining the raison d’être of credit rating agencies.

Stiglitz and Weiss argue that the credit market does not work like a textbook case of a competitive market where demand and supply conditions determine the equilibrium price (rate on interest in this case) at which demand equals supply. The difference arises because sellers of credit (like banks) have to make an assessment about both the ability and intent of the borrower (companies or governments) to repay their loan.

Charging a higher interest rate might drive away potentially good borrowers, who would not be willing to pay interest rates beyond a point, and channel credit to sub-prime borrowers with riskier projects or dubious intentions (with a higher probability of default). The aggregate effect of such a phenomenon can be a fall in a lender’s profits, resulting from a reliance on demand-supply mechanism.

The authors conclude that lenders try to solve this problem by rationing the number of loans given rather than increasing interest rates or setting the loan amount.

In case of sovereign governments, the problem facing a lender would be more complicated, given the immunity they enjoy in matters of defaulting on debt payments. As debt instruments become more complex, the problems of information asymmetry magnify.

It is these problems that credit rating agencies ostensibly sought to address. They were supposed to be neutral assessors of credit worthiness of such borrowers, and help the lenders identify the good, bad and the ugly.

The first credit rating agency was founded by John Moody in the US in 1909. By the 1920s, credit rating agencies covered almost all of the US bond market. With an increase in the mobility of finance capital, they have expanded their influence across the world. But the business remains extremely concentrated and can be considered an oligopoly. Three firms—Standard and Poor’s (S&P), Moody’s and Fitch—control more than 95% of the market for credit rating agencies.

Although they still enjoy a roaring business, the reputation of credit rating agencies has been severely dented after the global financial crisis. Almost every report on the crisis by different agencies criticized the role of rating agencies.

“We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction," said the 2011 report of the National Commission on the Causes of Financial and Economic Crisis in the US. “The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms."

The observations highlight how rating agencies can pose a systemic risk to the economy. They have the potential to add a pro-cyclical bias to the existing macroeconomic environment. Good ratings during the boom phase can sustain the crest and thus inflate the magnitude of the eventual bust, while adverse ratings during a rough phase can increase borrowing costs, thus making a recovery even more difficult.

A 2009 National Bureau of Economic Research (NBER) paper by Harvard economists Efraim Benmelech and Jennifer Dlugosz looked into the changes in ratings for different kinds of financial products before and during the financial crisis. The authors show that downgrades of structured finance securities increased sharply during the slowdown.

The clout of rating agencies in financial markets can create a situation where even sovereign finances suffer heavily on account of capital flight induced by sudden changes in ratings. Stiglitz had highlighted this aspect in a 1999 paper co-authored with G. Ferri and L.G. Liu, written in the backdrop of the East Asian crisis.

What explains the failures of rating agencies?

First, there is the question of the methodology used to arrive at these ratings. It is not an easy task to take into account all possible factors that might affect the overall economic environment impacting the future yields on a loan or investment.

Taking too many variables into account may make predictions difficult, while taking too few variables may mean missing out on important information. Getting the right balance is difficult.

Secondly, there is some evidence to suggest credit rating agencies may often give more weight to their subjective judgement than what macroeconomic fundamentals tend to suggest. In a 2013 New York Times column, Paul Krugman argued that an S&P downgrade of France was in contrast with the International Monetary Fund’s projections, which showed the French economy to be doing much better.

The issue has been underlined by many other economists as well. When it comes to sovereign ratings, rating agencies do not have any additional knowledge of government finances, in contrast to their role in issuing solicited ratings, when their inferences are drawn on the basis of confidential information shared by the rating seeker.

Finally, there is an inherent conflict of interest in the ratings business as these agencies depend on payments by those they are rating. Under such a business model, rating agencies may be tempted to be lenient, and more competition among rating agencies can exacerbate rather than curtail this problem.

This relates to the problem of “rating shopping", which refers to the practice of approaching different agencies and then using the most favourable rating to raise capital.

The conflict of interest problem facing rating agencies cannot be attributed solely to malfeasance though. In a paper published in the Elsevier Encyclopaedia of Financial Globalization, Ulrich Schroeter argues that the conflict of interest arises from the nature of the ratings industry.

The ratings industry is a case of investor-driven natural oligopoly. A proliferation of credit rating agencies would defeat the very purpose of disseminating complex information to a world of investors in simple terms (ratings), and hence such efforts would not have traction in the market. An oligopolistic market structure reduces the fear of losing market share for existing credit rating agencies.

Also, since ratings provided by credit rating agencies are to be considered as indicative in nature in the sense that they merely reflect the view of these agencies, they also enjoy liberties akin to press freedom in many countries including the US. This makes regulation difficult.

A similar logic is also used against bringing these agencies under the ambit of liability claims. Also, such liability claims can be unlimited given the public availability of ratings.

Given the lack of adequate accountability mechanisms for rating agencies, the tying of bank capital requirement to credit ratings under international Basel II banking norms has been criticized by many on this count, including by this year’s Trade and Development report of the UN Conference on Trade and Development (UNCTAD).

The UNCTAD report calls for designing an alternative approach to credit assessment which “should avoid repeating the same kinds of mistakes that led CRAs to underestimate risks". The report also notes ongoing efforts in the US (through the Dodd-Frank Act) and Europe (through information disclosure requirements and regulation of fees) to reform the functioning of rating agencies.

The UNCTAD report argues that despite their chequered track record, rating agencies are still relevant for the financial sector. Whether the ongoing efforts to reform them yield results or not is a question that can only be answered when the next crisis hits us.

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