Who will rate the ratings agencies?

15 May 2016 - 02:00 By Herbert Kawadza

Finally South Africa can breathe relatively easy. Judging by the recent and continuing reports on the topic, the anxiety over a sovereign credit downgrade - arguably occasioned by self-inflicted macroeconomic factors such as government debt, the current account deficit and the budget deficit - had thrown South African policymakers into a state of panic.

This gave rise to a flurry of measures and countermeasures, especially by Finance Minister Pravin Gordhan and his team, to avert the possibility of the economy plummeting to junk status.

That anxiety was explicable. There are profound economic impacts a downgrade might have been associated with, including making sovereign borrowings costly, heightening capital flight and making South Africa an unattractive investment destination.

So powerful and feared are these gatekeepers that countries subjected to credit reviews find themselves in distress. South Africa is an example. It is no wonder the recent announcement that the country would not be downgraded to sub-investment grade was met with celebration in some quarters. Such a response reinforces the clout of ratings agencies.

Because ratings agencies wield enormous power to destabilise an economy, and because a mis-rating can have devastating consequences, one would be forgiven for thinking that such bodies are themselves flawless. In fact, until the global financial crisis, the standing and reliability of ratings agencies were largely unquestioned.

However, a series of inauspicious events have demonstrated that ratings agencies are susceptible to defective ratings. For instance, the financial crisis was preceded by structured securities - all amounting to billions of dollars - which were overrated by ratings agencies and contributed to the financial meltdown.

What seems to have compromised the accuracy of ratings are the industry's structural defects. Specifically, the oligopolistic setup in which, out of about 100 authorised credit ratings agencies worldwide, only a tag team of three - Fitch, S&P Global Ratings (formerly Standard & Poor's) and Moody's - accounts for nearly 80% of the ratings industry.

This means that the ratings industry is highly concentrated and the three have found it difficult to shirk allegations of collusion. The claims are that each of these three private companies tends to make policy decisions taking into account the interests of the other two. This is conceivable, especially in light of events that have demonstrated that each action taken by one of them has a bearing on the sales and profits of the others. For instance, it has been shown that a downgrade, or an upgrade, by one usually influences the other agencies' ratings.

Having exposed some of the entrenched rating models, scales and methodologies as flawed, governments, especially the US, have sought to rein in the largely unfettered activities of these gatekeepers through regulation. This approach has not been well received by the regulatees, who argue that unlike regulation, reputational risk provides a better enforcement tool which fosters the transparency and accountability of their actions.

The fact that they have the potential to wreak havoc on economies requires that they also be put under constant scrutiny

It is argued that credit ratings agencies' profitability is inseparable from their market reputation and that in the peculiar circumstances regulation would not only be redundant but also counterproductive as it might render their activities susceptible to political capture and thus compromise the reliability of their ratings.

As such, much as there has been an attempt at regulating ratings agencies, these moves have been inadequate and largely symbolic. Governments seem to have succumbed to the argument that market forces, not legislation should be left tooffer checks and balances to ratings agencies' operations.

Augmenting these defects is the fact that ratings agencies are paid by issuers whose products they rate. This results in a conflict of interest in that, on one hand, they have to satisfy the issuers' need for higher ratings and, at the same time, they seek to provide accurate information to public investors. This, according to economist Joseph Stiglitz, can be likened to "what college professors know as grade inflation".

It cannot be denied that ratings agencies are a significant public good. They make it easier for capital-market investors to evaluate the creditworthiness of the potential borrowers and at the same time, incentivise policymakers to come up with better strategies.

Nonetheless, the fact that they have the potential to wreak havoc on economies requires that they also be put under constant scrutiny.

This is what most countries, especially emerging economies like South Africa, are not doing. Instead, as recent events have demonstrated, they are often browbeaten into engaging in brinkmanship, aimed at warding off the potential negative reviews.

There is a need to revisit the ratings culture with a view to addressing the complacency arising from the current three firms' oligopoly and allow for investor-friendly ratings agencies or other options to mushroom. This would foster competition, accountability and transparency. Until that is accomplished, credit ratings agencies will continue to be part of the problem and give credence to calls urging policymakers to make their services susceptible to downgrades.".

Kawadza is a lecturer in banking and finance law at the law school of the University of the Witwatersrand