RATING AGENCIES HAVE THEIR OWN CONTROVERSIES
INTERNATIONAL credit rating agencies have had their fair share of controversies over the years. They have been at the centre of the major financial crises from the financial markets collapse of New York City in the mid-1970s, the Asian financial crisis of 1997-98, the Enron scandal of 2001, to the 2008 global financial crisis (GFC). All of these cost investors globally billions.
Rating agencies are meant to give comfort about an issuer’s ability to repay debt. Ratings are essential in determining the level of interest rate that a borrower must pay. Inaccurate ratings therefore distort both the prices of debt instruments and the interest rates payable on them. As history has shown, this creates asset bubbles that eventually burst, disrupting the functioning of financial markets.
The three dominant international credit rating agencies – Standard & Poor’s, Moody’s and Fitch – have been accused of many faults including false ratings, flawed methodology, encroaching on government policy, political bias, selective aggression and rating shopping.
These shortcomings originate from their “issuer-pay” business model. The institution being rated pays for the rating which is used by investors. This means that the model has an inherent conflict of interest.
Although this has been evident through various crises, most notably the financial meltdown in 2008, regulatory mechanisms are yet to address this problem. And, despite these known weaknesses, rating agencies are still being referenced in key financial market decisions.
A number of studies have identified the issuer-pay revenue model as a key driver of conflict of interest. Here are four reasons why: The relationship between the rating agencies and the issuers creates pressure for both the lead rating analyst – around which the whole rating process is centred – and the ratings committee to give favourable ratings over time. The second is that rating agencies are bound to be concerned about the sustainability of their revenue sources because they’re profit-driven businesses. They will fight to protect their income at the expense of aggressive or objective ratings that could compromise revenues, although in the long-run will damage their businesses. The third is that the individual employees of a rating agency face no criminal liability. Conflict of interest usually manifests itself through members of the analytical team. Lastly, the credit ratings industry is highly concentrated. Moody’s and S&P together control 80% of the global rating market. Fitch accounts for 15%. The “big three” firms seek to maintain dominance in the industry through discouraging any activities that may lead to a loss in their market share. They are unwilling to allow competition, suggesting that it could instead lead to poor ratings.
Following the 2008 GFC the US, EU, China and South Africa introduced legislation to address the flaws in rating agencies’ operations.
Although strict civil laws are necessary to deter misconduct and encourage compliance, enforcing civil regulations only is both an ineffective and expensive way of curbing conflict of interest. Tighter scrutiny of credit rating agencies by investors, regulators and media is also not effective.
Despite these regulatory responses, rating agencies are still being caught on the wrong side of the law, and there’s the possibility a great deal of wrongdoings go undetected.
In South Africa, the Financial Sector Conduct Authority recently found the Global Credit Ratings agency guilty of failure to avoid a conflict of interest. It fined was R487 000.
Continuing infringement by credit rating firms on rules and analysts’ actions that compromise the independence of their opinions shows there is a major shortfall in the current regulatory mechanism. Mutize is a lecturer at UCT’s Graduate School of Business