Rating the Raters

Even since the subprime crisis erupted last year, there has been an extensive debate about the role of credit rating agencies in exacerbating the crisis. Questions have been raised whether the rating agencies ought to have raised the red flag much earlier than they actually did, thereby protecting the interests of investors who placed reliance on their reports.

The debate over rating agencies largely focuses on two key issues. First, there is an utter lack of competition among rating agencies. Worldwide, there are three main rating agencies, Standards & Poor, Moody’s and Fitch, and as far as India is concerned, the two main agencies are CRISIL and ICRA (both of which are affiliated to two of the worldwide agencies). It is alleged that this lack of competition does not incentivise the rating agencies to improve the quality of their ratings practices. Second, there is the issue allegiance. Currently, it is the issuers of securities who remunerate the rating agencies, owing to which, the argument goes, the rating agencies tend to provide more optimistic ratings to issuers so as to help better market and sell their securities. On the other hand, there are proposals for rating agencies to be remunerated by the investors instead, as it is the investors who rely on the rating reports. The debate on these issues continues, although there are increased efforts by governments in various countries to rein in the activities of credit rating agencies through stringent regulation.

In this context, there are two interesting columns. The first by Jaimini Bhagwati in the Business Standard tackles the first issue of competition and suggests the establishment of a public sector rating agencies. He states:

“One of the reasons why CRAs have been found wanting is that S&P and Moody’s are in duopoly in most financial markets and a corrective measure would be to increase the level of competition. Higher competition and a better balance between income maximisation and investors’ interests could be achieved in India by the setting up of a majority government owned CRA. It is high time that benchmarks are set for the credit rating function since it provides critically important inputs for debt and equity issuance and investment activities. A public sector CRA should be conservative in its creditworthiness assessments and provide guidelines for investors on how best to interpret its credit ratings.

To summarise, for CRAs there is a near duopoly situation internationally and in India. The ratings provided by private sector CRAs have been inconsistent with market signals and rating agencies have pushed for higher earnings at the cost of investor interests. Further, it is likely that if this quasi-regulatory function is left exclusively to private sector CRAs, ratings would continue to be governed by profit maximisation considerations. It follows that it is necessary to set up an Indian public sector CRA to increase competition and provide benchmark standards.”

In a separate column in the Hindu Business Line, Roopa Kudva of CRISIL deals with the second issue of who should remunerate the credit rating agencies, in which she defends the present position of the issuers paying for the rating rather than the investors, and also highlights some of the other issues involving the rating industry. She justifies the status quo as follows:

“The complaint against the issuer-pays model — where the entity issuing debt pays for the rating — is that it compromises the quality of analysis and ratings. Some suggest an investor-pays model instead, while others recommend third-party involvement such as a regulator.

Will the investor-pays model work? When a rating is assigned, the investor is generally not known. If investors were to pay for ratings, then only those paying will have access to the ratings. Lenders and the market cannot benefit from the ratings. Today, all the ratings are available to all — including retail investors — free of charge, and are widely disseminated by agency Web sites and the media because the issuers pay for them.

The issuer-pays model also gives rating agencies easy access to company managements, which provide insights into strategy that might otherwise not be widely known, and help the rating agencies evaluate them better. It is hard to imagine this level of information-sharing under an investor-pays model.

The issuer-pays model enables rating agencies to provide a quality and depth of analysis to the market that public-information-based opinions and model-driven approaches cannot.”

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.


  • WIth due respect to your views, I must say the rating agencies in India are very thorough with their processes.

    I’d like to turn the argument on its head. The lower and better-known agencies are .. the better it is … because of less competition at the expense of price and quality … it could happen that a corporate goes to a new agency that gives them a suitable rating .. In fact a few newer agencies that are coming up, are competing at the cost of price and quality … and you make a new agency government controlled .. and see how suffocating it gets for the already tight undeveloped credit market in India

    The current crisis has nothing to do with corporate ratings … it is with more sophisticated structured finance … which is not these people’s forte in India

  • Its interesting to read Michael Lewis/ Thomas Friedman discussing this –

    "‘We always asked the same question,’ says Eisman. ‘Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.’ He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S.& P. couldn’t say; its model for home prices had no ability to accept a negative number. ‘They were just assuming home prices would keep going up,’ Eisman says.”


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