Who should pay for credit rating?

Who should pay for rating – investors or issuers? In the aftermath of the GFC this has become a point of serious debate. Credit Rating Agencies (CRAs) maintain that their internal systems and procedures are adequate to take care of any conflict of interest between their marketing (get more business) and rating functions. Others are not so sure. Many seem to be thinking that an investor-pays-model will be better. CRAs are quick to point out that an investor-pays-model too will give rise to pressures for favourable (better) ratings as any down-gradation will force the investors to take a hit on their profits. I think we need to be more imaginative about the model and we also need to be clear about the role and functions of a rating agency.

Credit ratings started as investment recommendations, paid for by the investors. Only after the Second War the issuer-pays-model really took off. This model permitted CRAs to recruit an array of professionally qualified analysts, streamlined the rating process & methodology and to some extent it took the mystique away from the business of rating. In practice an issuer asks beforehand what the likely rating of their next issue is. CRAs play demure but hint at what could be done to improve rating. (Often they have made special teams that work closely with their marketing wings to educate the issuers on structuring (read rating) of unusual instruments.) GFC, many insinuate, came from the failure of CRAs. I make no such insinuation. I assert it. They had / have a fiduciary role and they failed. I have posted about it earlier too, see here.

Rating is essentially a call on the probability of default. In the market place the investors and traders in debt papers continuously assess this default probability. The interactions between credit ratings and market prices of debts have been a hotbed of empirical research. These researches have yielded many, some very valuable, insights. A less celebrated insight is that credit rating is essentially a commodity; the brand of a rating does not give the reassurance of superior quality. A triple A rating by one agency does not give any more information than an equivalent rating by another agency .

It clearly implies that rating process should be amenable to be worked out by a set of mechanical procedures. Personal perceptions of analysts, unless their stories can be articulated in numbers, will remain “gut feelings” and would / should find no place in the rating process. This in turn implies that an issue would get the same rating, no matter which CRA is mandated. This, however, is only partially supported by evidence. In quite a few cases (I would say in statistically significant number of cases) of issues rated by multiple agencies we have divergent ratings awarded by different agencies.

This phenomenon deserves a much closer follow up by the investors, academics and regulators than what it has received. Two agencies, one giving say AA and the other AA-, cannot be both correct. It is a facile argument that rating process cannot be reduced to an arithmetical exercise. It must be, else it will remain an opaque mumbo jumbo. Regular surveillance of ratings being given by different CRAs by the market watchdog would ensure the arithmetic (and the objectivity emanating from there).

Once a transparent and really objective rating process, independent of the agency (i.e. of the subject actually doing the rating), is assured it would smoothen the way for uniformity in rating fee and make it possible to introduce a third party between the issuer and the rater. A model which I am suggesting here is of the issuer-pays stable but does not allow the issuer to choose the CRA.

A firm desirous of making an issue should approach the regulator, who would select an agency based on random drawing from a pool of rating agencies and assign to the issuer. This model will make the burgeoning marketing wings of the CRAs redundant. More importantly this model will retain the user pays feature (and thereby free availability of rating to all potential investors – large and small), but will not allow a nexus to develop between the issuer and the rating agency.

I also feel that whenever a new product is to be introduced, the product must be first approved by the regulators, who would also approve, jointly with the rating agencies and the academia the rating methodology for such products and make the methodology public. While approving the product the regulators would ensure safety and added benefits. There is little point in introducing a new product, however safe it is, if it brings no benefits other than those available from existing products. And there are many points against introducing a new product with several new features unless it is safe – safe for the investor and for the financial system.

Rating agencies should be recognised as a semi regulatory organisation rather than as a purely commercial organisation committed to increasing the shareholders’ value. I am aware that it may appear strange, even silly, to people who have been weaned on the American mainstream thinking that public sector cannot do anything right and that private sector cannot do anything wrong. I am also aware that the sketchy model I am suggesting may have / give rise to other problems. But I am sure it deserves a serious consideration / scrutiny.