Rating the raters

Each crisis leads to incremental improvement of the institutional structure of the global financial system. The "sub-prime crisis" may generate important reforms in the role and functioning of credit rating agencies, which have come under attack for overly generous ratings that misled the market. On the one hand, it is always easy for investors to complain about losing trades. However, genuine mistakes do appear to have been made by credit rating agencies, who under-estimated the correlations between defaults by households, under-estimated the effect of higher interest rates on defaults, and under-estimated the consequences of default upon home prices and thus further defaults.

Such genuine mistakes can be understood when they come from an impartial analyst. But they look particularly shocking in the context of the close nexus implicit in the rating agencies working jointly with financial firms in structuring products, and getting paid handsomely for this work. When the sub-prime market grew from $120 billion in 2001 to $600 billion in 2006, the rating agencies profited handsomely. The behaviour of a paid analyst who is a party to the launch of a product is inherently different from the behaviour of an impartial analyst who is a bystander.

The European Union says it plans to examine the agencies' roles, and investigate possible conflicts of interest between the agencies and the issuers of mortgage bonds. In Washington, Representative Barney Frank, the chairman of the House financial services committee, is planning hearings in October to examine the same issue.

The first key reform that is now being discussed is to roll back to the pre-1970 situation, when credit rating agencies performed the job of being independent research companies who sold subscription services based on their true merits, and never took payments from the firms that they rated. The second key reform that is being proposed is the removal of credit rating agencies from the regulatory treatment of institutional investors.

The appeal of these proposals is that they would convert credit rating agencies into genuine information and research companies, working at a healthy distance from financial transactions. A rating agency would rate a bond in the hope that investors would like to pay for the subscription service. Institutional investors would judge credit rating agencies alongside other information and research vendors, all of which offer comparable information and research services. In such a world, credit rating agencies would have to pass the market test, instead of being government-supported gatekeepers.

These reforms are particularly pertinent in India, where it is now practically impossible to do a primary issue of a bond without the involvement of a credit rating agency. Fees to credit rating agencies have become akin to a tax. Infosys has zero debt, and its first Rs 1,000 crore bond issue should surely face a good market in a rational world without any credit rating. It is better to trust the processes of the competitive and speculative market, rather than trying to install a set of government-supported profit-making gatekeepers.

Recent Sebi proposals involve mission-creep, from bond issuance to equity issuance. It is proposed that initial public offers (IPOs) should be "graded". All these criticisms apply equally here. If a credit rating agency (or any research firm) has something useful to say about an upcoming IPO, it should pass the market test of being able to sell a subscription service to investors.