Potential Risks in the Credit Rating Industry

By Ravi Kant

The controversies have always surrounded the Credit Rating Agencies. This industry has always been subject to criticisms not among the common masses but also among eminent and respected people and Economists. There were many situations in which these Credit Rating Agencies failed to predict. One of them was Enron Bankruptcy. This episode took place in November 2001 where Enron declared the largest corporate bankruptcy in American Economic History. It was attributed as the biggest audit failure. This led Congress furious on the rating agency and asked how they could not recognize the Enron’s weakened financial statements. The other controversy which they got entangled with was WorldCom Crisis which even surpassed the fraudulent activities which took place in Enron crisis. Alas! In this Crisis as well, the Credit Rating Agencies encountered huge criticisms because the agencies failed to timely downgrade WorldCom’s credit rating despite indications of a deteriorating financial conditions. And the much talked about Controversy about Credit Rating Agencies was Lehman Brother’s Crisis. In an Article published by The Guardian (13 Sept 2013), it wrote “Until six days before Lehman Brothers collapsed five years ago, the ratings agency Standard & Poor’s maintained the firm’s investment-grade rating of “A”. Moody’s waited even longer, downgrading Lehman one business day before it collapsed. How could reputable ratings agencies – and investment banks – misjudge things so badly?’’

Given all the controversies which Credit Rating Agencies encounters, this leads us to a proposition that the Credit Rating Industry possesses strong risks which if not taken care of can severely impact the business of these Agencies. The potential risks which Credit Rating Agencies encounters are discussed below.

Credibility Risk –

The Credibility of these Credit Rating Agencies is always at stake. Most of the eminent Journalist, Politicians and Economist are of the view that it is rating agencies who bear a formidable responsibility for boosting the financial problems. All of them have formed a view about all Credit Rating Agencies that they all are powerful, mysterious, ignorant, corrupt and unregulated. The Guardian wrote on Monday, 17 December 2012, “When the banking blog asks insiders who they blame for the financial crisis, most say: the Rating Agencies. It was the rating agencies which assigned the super-safe AAA ratings to complex financial instruments. When these blew up, the agencies accepted no responsibility, claiming that they had merely been expressing “opinions”. What I believe that even if the Credit Rating Agency are for giving “opinions”, those opinions matters a lot to the investors. These “opinions’’ should be responsible enough which establishes the credibility in the market. If the Rating Agency keeps on stating “opinions” without proper rigorous analysis, soon they will accumulate huge amount of Credibility deficits with themselves. Let’s not forget the fact that it is Rating Agencies who have most crucial and confidential data and information about any Company and not the General public investors in the market. They are the only entity who could clear the fog of asymmetric information. Already Rating Agencies are finding it difficult to reduce the trust deficits post-controversies in this Industry, but if any such controversies again arise in the market, once again in the future, they might have to tolerate the ire of the market plus the Regulators might think about alternative to Credit Rating Agency if they keep failing in their duties. The Rating Agency needs to understand this fact that every time they cannot escape the situation by saying “we are there for opinions”. By doing this, they are adding more risks to their business model which might collapse any time. Even Professor Jayati Ghosh, Centre for Economic Studies and Planning, Jawaharlal Nehru University opines that, “…these agencies blandly declared that they could not be held responsible since they were only offering “opinions”. But these “opinions” have huge influence on markets.” If they do not safeguard themselves from this risk, then each mouth around the World would say like Prof. Jayati Ghosh, “So why should we bother about the “opinions” of these external credit rating agencies

Risk of Uncertainty –

The risk of uncertainty is very much there in the Credit Rating Industry. Many times, a Company whose ratings has been published in the Media by the Credit Rating Agency encounters a risk of revision of ratings when they all of a sudden discovers that the Management of the Company is changed overnight due to some unavoidable reasons of the Company or change in the government policy that might impact the business of the Company. Such kinds of uncertainty create a risk of executing the business of Credit Ratings by these Credit Rating Agencies. Many times there is a risk of non-availability of relevant and reliable information that act as an impediment to decision making process of these Credit Rating Agencies. This is one of the biggest risk which these Credit Rating Agency encounters. The financial statements which these Credit Rating Agencies receive from the Companies are audited. But we have also seen cases that in-spite of having audited financial statements, Credit Rating Agencies still got caught in the cobwebs of controversies. Therefore, it is recommended that the Credit Rating Agency should give it a thought of having its own auditing team that might help them to take better decision while giving ratings to that Company and avoid any kind of controversy.

Switching Risk –

The risk of switching to any other brand of Credit Rating Agency is called the Switching Risks. So Credit Rating Agency might encounter this risk because most of the Companies get themselves rated for the sake of rating as RBI has made it mandatory to get rated by any one of the recognized External Credit Rating Agency if the loans are above INR 5-10 Crores.

Competitive Risk –

This is a risk which these Credit Rating Agencies find it tedious to safeguard itself from. Bo Becker & Todd Milbourn (2010) believes that there is a negative relationship between competition and quality which is also econometrically robust. There research strongly suggests that increasing competition in the Credit Rating Industry will invite the risk of impairing the reputational mechanism that seemingly underlies the provision of good quality ratings. Hence, more number of players in this industry will cause diminishing marginal returns in the industry that might automatically reduce the quality of ratings.

Hence given the above risks, these Credit Rating Agencies must develop strategies to safeguard themselves from these potential risks.

References –

• Bo Becker, Todd Milbourn (2010), “How did increased competition affect credit ratings?” Working Paper 09-051, Harvard Business School.
• http://www.theguardian.com/business/2013/sep/13/lehman-brothers-was-capitalism-to-blame

 Ravi Kant holds Economics Honors degree from Ramjas College, University of Delhi. He likes researching in the areas of Economics, Strategy, Politics, English Literature and Social Issues. Besides that he loves watching Parallel and offbeat Cinemas of Bollywood. He aspires to be a well-known and an eminent Consultant in the area of Economics and Strategy. Presently he is doing his MBA from Institute of Management Technology (IMT), Hyderabad.