Rating credit rating agencies?

Credit rating agencies (CRAs) are once again in line of fire for unfathomed concerns: ratings are obligatorily through financial regulation, the CRAs operate in an oligopoly; there is conflict of interest, because they are paid by the issuers of the securities they rate, not by investors; and they are unaccountable because their ratings are deemed opinions and thus protected as free speech.

In terms of the issuer-fee conflict, we have heard a number of points made in the past by investors and CRA’s responses to them. Investors argue that since the fee does not get generated without a deal, being benevolent at issuance and revisiting the credit after the deal is in the market, makes perfect sense. This evidently creates an ostensible stress in the decision making process. Any rating action/assessments that prevents an issuer from accessing the market such as an unduly harsh opinion or demand (and transparent) set of metrics and forward expectations could imperil the deal, and hence no fee. That action presents additional risks since the CRA can always revisit later after the deal is in the market, describing this act of theirs as "surveillance of credits". CRAs fight hard to establish their “transparencies” by making their rating rational available for subscription and they even sell their rating models obviously with disclaimer!! And they call their ratings free, public good!

The CRAs are obviously in a tough position here. If they move too fast, they get lambasted. If they move slowly, they get lambasted. None of these issues can be comfortably palliated. Switching to an investor-pays system might seem the obvious answer, but it’s highly improbable that enough investors would cough up to make the business viable, CRAs fear this may put them out of business.

Another solution might be for them to be much more transparent about their criteria and expectations that are built into ratings so investors can better assess what the risks are when they rely on the ratings. For example, clear statements of time horizons for achievement of specific metrics, downside target ratios that would prompt a downgrade, expected growth rates for an industry, or any other tangible and quantitative yardstick that would improve the ability of the investor to make a more informed assessment.

More competition should help, but it might just as easily lead to a race to the bottom, as agencies vie to offer the best terms to issuers.

Making CRAs legally liable for their opinions would scare them out of the business.

The most beckoning reform, in theory, would be to end the regulatory dependence on ratings and let investors draw their own conclusions from “expert” opinions and market data, as they do with equity investment.

A more practical approach might be to let the CRAs get on with their house-cleaning while introducing a reform borrowed from the accounting industry: a board, made up of industry types, investors and academics, charged with policing their analytical techniques and governance.
Another reform is in offing! Indian CRAs seem to be moving in the direction of getting their act together. Recently CRISIL launched complexity level classification (simple, complex and highly complex) of capital market instruments reflecting the ease of understanding and analysing the risk elements in these instruments. Complexity levels help the investor determine the degree of sophistication and due diligence required to understanding the risk and factors involved in such instruments. Needless to say a simple financial instrument is nor necessarily less risky than a complex instrument. These complexity levels are being provided free of charge to all users. However, it would have been helpful if they also provided their rational for classifying one instrument as highly complex over complex/simple rather than just providing with the criteria. For example why Real Estate Investment Trusts are classified as highly complex and commodity futures as complex? Further refinements may follow, in all it’s a welcome move by CRA.