3:16 pm - Saturday January 21, 5397

‘Fair play’ by credit rating agencies is the need of the hour

In the recently held G20 deliberations, there was a call for ending what is called mechanistic reliance on credit rating agencies and encouraging transparency and competition among them.

The debate on credit rating agencies is increasingly becoming louder and louder. Just to remind, it all started with the recent financial market crises.

Let us recall chronologically the developments so that one can form an opinion on the need for rating requirements and if required, what additional safeguards we need to install to protect the interests of markets in general and investors in particular.

The triggering event for the financial market crises was the higher than expected defaults on US subprime mortgage loans which were packed with favourable credit ratings.

The follow up Dodd Frank Reform and Consumer Protection Act required new rules concerning application and disclosure of credit rating methodologies, conflicts of interest with respect to sales and marketing practices, fines and penalties besides other prescriptions.

As if it were ‘knee jerk’ reaction / response our ratings agencies have suddenly become ‘holier’ in that they have started bombarding the market place with their rather overenthusiastic rating exercises every now and then.

Recently one of the said rating agencies downgraded 15 of the world’s largest banks at one go. It is reported these banks may find it harder to borrow money and also if they still do, they may have to shelve out more towards cost of such borrowing.

When the markets are already clueless and overburdened with all negative developments, such rating downgrades tend to distort the market place with wide fluctuations.

Best practices frame work for credit rating agencies

Credit rating agencies are supposed to provide independent reports on the credit worthiness of a range of institutions, governments, and public bodies, international and domestic active companies. They produce reports and analysis supporting their rating of credit worthiness.

The rating agencies compete for business from those institutions which require rating services. The institutions which are rated pay for the services of the rating agencies. Credit-rating agencies are typically subject to little formal regulation or oversight in most countries.

However, the furore over Enron, Dotcom, Subprime Crisis and other debacles has led to calls for regulatory changes in rating industry. Regulatory issues are always extremely complex and interdependent. Understanding regulatory issues in extreme detail is a pre-requisite not only for anticipating risks and opportunities but also for building mutually beneficial relationships, based on trust and transparency with regulators.

To handle such developing regulatory prescription, credit rating agencies could evolve a code of conducts or best practices framework for their business and strictly follow them. Such best practices will enable the rating agencies to perform better in any kind of regulatory regime.

The rating agencies depend on the integrity and good faith of the management of the rated companies to disclose all material information to them. The rating agencies normally do not disclose the criteria, models and methodologies they employ to determine their rating. They protect this vital information as their trade secrets. The methodologies employed by the rating agencies are claimed to be their intellectual property. The financial market participants arrive at their decision to invest or divest relying upon the ratings awarded by the rating agencies.

The rating agencies are mostly commercial organizations. Their independence, integrity and successful on track record are very important to their success. They should always be ‘truthful, trustworthy and taint-free”. Surely the above desired best practices would enable them to demonstrate that they are in compliance with any possible regulatory prescriptions.

In addition, the regulators could also consider setting up separate monitoring mechanism and impose penalties and fines in case of wrong doings by these rating agencies.

Recently Financial Services Authority reported that Britain’s four largest banks may face more questions over their sale of interest rate hedges to small business customers leading to possible settlement of customer claims.

Yet another instance of wrong doing was brought to the open by the regulators in the form of mis-selling of payment protection insurance plans by some leading banks.

The Libor fixing scandal is being probed by the regulators and already one major bank has been fined.

The money laundering probe by US regulators is the latest and one major global bank across the Atlantic has been hauled and fined heavily.

The market is expecting similar monitoring and treatment of credit rating agencies and regulatory interventions when required.

PS: for a sample list of such best practices for credit rating institutions, one may browse through the post “Best practices frame work for credit rating agencies” appearing elsewhere in this website.

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