The Monopoly of Credit Rating Agencies

“After Fitch, Moody’s lowers India’s growth forecast” reads a headline in The Hindu on August 25. Who are these agencies? They are credit rating agencies responsible for assessing the creditworthiness of big borrowers – companies and governments. The market for credit rating is dominated by 3 big firms – Standard & Poor, Moody’s and Fitch. Basically, these credit rating agencies sell information about the debtors to the creditors.

How reliable are they? As the regulator of the Indian securities market, Securities and Exchange Board of India (SEBI) writes in its FAQ, ‘A credit rating is a professional opinion given after studying all available information at a particular point of time. Nevertheless, such opinions may prove wrong in the context of subsequent events. There is no contract between an investor and a rating agency and the investor is free to accept or reject the opinion of the agency.’ As a matter of fact, the credit ratings were proven to be completely wrong in the wake of the Great Recession because they grossly misrepresented the risk on the mortgage-backed securities. Joseph Stiglitz is quoted as saying: “I view the rating agencies as one of the key culprits.” And not surprisingly, between 2001 and 2007, the operating margins of Moody’s exceeded 50 per cent, three to four times those of Exxon Mobil Corp., the world’s biggest oil company. Also, as a CFR report states, the “EU governments and ECB policymakers accused the Big Three [S&P, Moody and Fitch] of being overly aggressive in rating eurozone countries’ creditworthiness, exacerbating the financial crisis”.

A financial market mediates between debtors and creditors through the buying and selling of financial instruments with varying risk and liquidity (to meet the different preferences and needs of the market participants). Unlike in a product market, say for tomatoes, it is difficult to assess the ‘value’ (let alone the quality) of a financial instrument. Suffice to note here that different financial theories exist which provide explanations for the ‘value’ of a financial instrument. The creditor needs to know whether the debtor is credit-worthy, i.e., whether the probability of the debtor to default is low. This information need is met by the credit rating agencies, of course, not very satisfactorily. For, they also seem to fall prey to the irrational exuberance characterizing the financial markets. More importantly, as during the Great Recession, evidence points to them as perpetrating a financial crime by aiding and abetting the housing bubble by issuing top ratings to bad mortgage-backed securities.

Global investors obtain information on investment avenues from multiple sources. And in the specific case of India, most of the financial savings are parked in time deposits, Post Office savings and with LIC and not in the stock market. Should a credit rating downgrade worry us? Are we worried because of how the stock market may react? Will it affect capital inflows? Rational investors make informed decisions by examining the macroeconomic situation, the ease of investing and the transparency and stability of macroeconomic policies. For example, any amount of mere rhetoric of ‘Make in India’ will not help – as seen by the exit of Jim Rogers, a global commodities trader and hedge fund manager, from India. As Rogers’ says, “one can’t invest just on hope.”

The argument of this blog post is not that all the assessments by credit rating agencies are incorrect. The argument is rather than we must critically appraise them and contextualize them. For instance, the lowering of Asia’s growth forecasts on account of slowing exports and subdued demand by Moody’s on 8th September 2015 should be a cause for concern. Why are we not focusing on policies which generate domestic demand?

I end with the financial commentator John Kay’s observation on the power of the bond markets in Britain. “So how do bond markets acquire their power to intimidate? Politicians spend too much time talking to people who take a daily interest in the bond market, and come to believe that their obsessions are important. Britain’s economic performance should be judged by benchmarks relating to employment, productivity, growth and innovation, not credit ratings.” This should be the case in India too.