Credit Rating Agencies – A Theoretical Review
Dr Archana HN
Associate
Professor
Dept
of Studies & Research in Business Administration
Vijayanagara
Sri Krishnadevaraya University
Jnana Sagara Campus, Vinayak Nagar, Cantonment
Abstract
The paper aims at identifying and studying the theoretical works
that have been done so far in the area of credit rating agencies (CRAs). The
review indicates that the concepts of credit rating services are carved mainly
out of four prominent theories; they are, The Information Asymmetry Theory, The
Theory of Reputation, The Principal Agent Theory and The Theory of Efficient
Markets. This theoretical framework helps us to understand the evolution of
CRAs and its impact on Deficit Spending Units and Surplus Spending Units. It
also helps us to comprehend the present status of CRAs. The CRAs which came
into existence to resolve the information asymmetry got engulfed in the
principal agent problems; and lost their reputation. It is also found that they
have contributed very minimum to the efficiency of the securities markets.
Key
Words: Credit Rating Agencies, Asymmetry
theory, Reputation theory, Principal Agent theory, Efficient Market theory
Introduction
The principal objective of this paper is to create a framework of
theory for the CRAs. The literature survey indicates that the concepts of
credit rating services are carved mainly out of four prominent theories; they
are, The Information Asymmetry Theory, The Theory of Reputation, The Principal
Agent Theory and The Theory of Efficient Markets. CRAs undoubtedly play a significant role in
amassing, fusing and disclosing the information about DSUs and their
instruments, which helps to bridge the information asymmetry between SSUs and
DSUs. However, there are problems associated with disclosure practices of CRAs
which either discloses selectively or maintains confidentiality of information.
Apart from it, the principal agent problems (conflict of interest) are innate
in credit rating industry. This problem is perceived to be more serious and
exacerbating owing to the issuer pay model. A few researchers have suggested
that it is better we move towards investor/subscriber pay model or switch on to
regulatory pay model. In this backdrop, it is intended to review the works
related to all the four theories associated with credit ratings.
Objectives:
INFORMATION
ASYMMETRY THEORY
Information
asymmetry refers to lack of transmission of information between any two parties
in general; and SSUs and DSUs in particular (SEBI Report, 2009). The Seminal
works on information asymmetry are the works of George A Akerlof (1970), Spence
(1973) and Stiglitz (1974), who have won the 2001 Nobel Prize in Economics for
their analysis on markets with asymmetric information. Rothschild and Stiglitz
(1976), Myers and Majluf (1976) and Diamond (1984) analysed the impact of
asymmetric information in insurance markets; Leyland and Pyle (1977) and
Williamson (1987) studied the impact of asymmetric information on credit
rationing. Ramakrishna and Thakor (1984), Diamond (1991), Smith and Walter
(2001) illustrated the prominent role played by financial intermediaries in
minimising the information disparity between different parties. On the one
hand, works of Sylla (2001) and Olegario (2001) show that CRAs as financial
intermediaries play a pivotal role in bridging the information asymmetry, where
as the works of Duan et al., (2012), Frost (2006) and Hunt (2009) criticise
CRAs for revealing biased information (lack transparency) to the investors.
With this, the present section discusses on the works of information asymmetry
and reviews the works on the disclosure practices of Credit Rating Agencies (CRAs).
The
significance of information was highlighted
for the first time by George A Akerlof (1970) in his paper titled “The Market
for Lemons: Quality Uncertainty and Market Mechanism”. He identifies that the
sellers in many markets have better information about the quality of the
product than the buyers. This difference in information is called asymmetry by
him, he terms it as Asymmetric
Information. This asymmetric information creates a gap about the quality of
the product. Buyers who do not have access to information will suspect the
quality of the product. This in turn, will diminish the price that he is
willing to pay for the products, which discourages the sellers of high quality
goods. Akerlof finds that in the presence of asymmetry in information, the good
quality merchandise sellers are driven out of the market, leaving behind only
sellers of poor quality products, which hinders mutually beneficial
transactions and eventually the markets will collapse. This, indicates the
reappearance of Gresham’s Law (the bad money drives out the good). Akerlof
explains the need to distinguish the good quality goods from the bad in
business models and also suggests some counter acting institutions such as
guarantees, brand names, chains/franchisee and licensing to minimise the
information asymmetry problem.
Spence
(1973) in his paper titled “Job Market Signalling” identifies that individuals
possessing better information about markets make some efforts to improve their
market outcome. He also observes that certain
characteristics such as age, gender, qualification, experience and race act as
signals in transferring information from one party to others and thereby reduce
information asymmetry. In this study, he
also identifies the characteristics or attributes which cannot be altered as ‘Indices’ (Age,
Gender, Race) and the attributes which can be altered as ‘Signals’ (Experience,
Qualification). Both indices and signals together decide the wage schedule. He
also recommends that, sellers (job applicants) of high quality must take
observable measures such as training and pursuing extra qualification that are
costly for low quality sellers to replicate and concludes that potential
employees signal their productive capabilities and reduce information asymmetry
between themselves and the buyer (employer).
Stiglitz (1975) in his work “The theory of
screening, education and the distribution of income” introduces the concept
called ‘screening’ (an instance of
signalling) and defines it as a way of identifying the different qualities of
goods, individuals, brands and other items. Stiglitz opines that the process of
screening can reduce information asymmetry in labour markets. He finds that
without the screening process in the labour markets, the asymmetric information
leads to grouping of all individuals identically irrespective of their
productivity, and receives same wages. Asymmetric information acted as wage tax
for high productive labours and as wage subsidy for less productive labours. He
showed that the screening process identifies the good workers and provides them
the incentive. He also concludes in this work that the process of screening
bestows with both private and public returns. Private return is in the form of
redistribution of wages and social returns are in the form of trade off and job
matching.
Michael Rothschild and Joseph Stiglitz (1976)
extend the process of screening by analysing the Self Selection Mechanism in
their work “Equilibrium in Competitive Insurance Markets: An Essay on the
Economics of Imperfect”. They found and suggested that the information about
the insurance market in general and the details of the transactions in
particular be made known to the parties involved in such transactions. They
also explain how and when less informed individuals can extract information
from better informed individuals in insurance markets. Like signalling, (Spence
explained); screening (through self selection mechanism) also promotes mutually
beneficial transactions.
To put in nut shell, the works of Akerlof, Spence
and Stiglitz point out that there is a need to protect and increase the welfare
of various stakeholders in the market. Based on this, Akerlof (1970) opines
that the Government or the third party intervention is necessary to minimise
the information asymmetry and enhance the functioning of markets.
Leyland and Pyle (1977) explain the role of
financial intermediaries in resolving ex- ante information asymmetry (adverse
selection problem) and Diamond (1984) provides the model of financial
intermediation for ex-post information asymmetry (Moral hazard problem). Both
the works exhibit that financial intermediaries expend resources to produce,
monitor and disclose the information at minimum cost and thereby resolve the
problem of information asymmetry between the borrowers and the lenders.
Diamond
(1991) in his work finds that in the presence of information asymmetry, the
SSUs cannot successfully distinguish the good borrowers from the bad borrowers,
and because of this, the investment decisions made by SSUs become inefficient
(Stiglitz and Weiss, 1981; Myers and Majluf; 1984).
Sylla
(2001) in her work “Historical Primer on Credit Ratings” identifies that the
CRS and the financial press were created to address the problem of information
asymmetry between SSUs and DSUs before the establishment of other channels of
information; CRS and financial press were the only transmitters of information
(Olegario R, 2001); these information transmitters could not mitigate
information asymmetry completely (Deb and Murphy, 2009).
In
this backdrop, CRAs emerged to level the playing field between SSUs and DSUs by
issuing a rating that describes the DSUs and their instruments
creditworthiness, and thereby disclose vital information to the SSUs (Marwan
Elkhoury, 2008).
Smith and Walter (2001)
opine that CRAs perform a valuable function of analysing and assembling
the information into alpha numeric code called rating. They also explain that
the rating provided by CRAs help avoid both Type I error (extending credit when
it must have been rejected) and Type II errors (rejecting the credit when it
was supposed to be lent) in the lending process. They also explain the two
folded role of CRAs – signalling and certification. The signalling role of
rating agencies provides new information or interpretation to the market and
the certification role of CRAs gives the eligibility to a debt issue.
Tang
(2006) examine the effect of information asymmetry on firms credit market
access, financing decisions, and investment policies and suggests that CRAs
help to reduce information asymmetry in credit markets by revealing new
information about firm’s credit quality.
Stephen
Rousseau (2006) opines that the CRAs eliminate the redundant and
wasteful efforts of investors who individually engage in research activities.
In the absence of the CRAs, investors should have conducted their own research
which would be expensive for investors (Estrella, 2000). Despite the critical
role played by CRAs, all the stakeholders are questioning the ability of CRAs
in assembling and disclosing the information particularly after the default of
issuers (Enron, Lehman Brothers and Kingfisher) and their instruments (MBS, ABS
and CDOs).
Duan
et al (2012) identify that the CRAs are criticised for revealing biased
information to the investors, i.e., CRAs are not transparent and they face
problems in disclosing the information.
DISCLOSURE (Transparency) PRACTICES OF CRAs
Frost (2006) identifies three problems in disclosure
practices. They are CRAs Disclosure Adequacy (CRAs fail to adequately disclose
information about their procedures), Selective Disclosure (they might
selectively disclose information to their subscribers), and Maintaining
Confidentiality (might inadvertently disclose confidential information about
the entities they rate).
Disclosure Adequacy
Hunt (2009) identifies two issues in disclosure adequacy,
namely disclosures related to rating methodology of CRAs and disclosures
related to CRAs performance. The Regulatory bodies such as SEC and SEBI
emphasize that the CRAs should disclose all the information about their ratings
procedures, determinants (criteria) considered while ratings and analytical
methods on their websites. IOSCO (2003) also recommend that CRAs should disclose:-
a) The meaning of each rating category
b) The definition of default
c) The time horizon of CRA for making a rating decision
d) The information about historical default rates and
e) The rating variability over time
The above disclosures
are recommended to promote transparency and enable the markets to assess the
performance of the ratings by drawing comparisons from ratings issued by
different CRAs. SSUs particularly seek
more detailed information about the rationales behind rating decisions and the
information on which the agencies rely (SEC 2003). SEBI has also recommended
that the CRAs should disclose the information pertaining to ratings revision
(upgrade/downgrade) in the standard format as prescribed by it and also
disclose the information about the ratings unaccepted by issuers on their
websites.
Frost (2006) divulges that CRAs have certain advantages
disclosing the information, such as, gaining stronger reputation and
credibility, quality credit ratings and increased market value for the
securities. However, CRAs are worried of the potential costs that they incur
owing to disclosure practices, such as release of proprietary information to
competitors, release of proprietary information to users of credit ratings who
might no longer require the CRA’s services; and increased vulnerability to
litigation. However, disclosure adequacy is not precisely defined. Frost puts
it (disclosure adequacy) as providing sufficient information to comprehend the
information by the investors and precisely use the letters of the alphabets and
the associated commentary of the ratings.
Selective Disclosure
According to SEC (2003) two issues related to selective
disclosures are,
1. The information
pertaining to the rating is made available to subscribers prior to public
issuance of the rating?
2. The extent of the
information about rating is made available only to subscribers and not to
general public.
The works of Kothari et al (2009); Lougee and Marquardt
(2004) conclude that managers disclose information strategically, i.e., they
either withhold bad news or emphasize good news. However, the CRAs state that
the ratings information is disclosed at the same time to both, their
subscribers and the general public.
Maintaining Confidentiality
The SEC’s regulation fair disclosure (Reg FD) makes it
mandatory to the issuers to disclose confidential information to CRAs, provided
that CRAs use that information solely for the purpose of rating. Kliger and
Sarig (2000) state that issuers/DSUs disclose confidential information to CRAs;
this confidential information is used by CRAs only in analysing and assigning a
rating and not to be explicitly disclosed to the general public. The CRAs also
confirm with issuers about the factual information before releasing it to the
general public to protect against any misuse and unauthorized disclosure of non
public information (Frost, 2006). Strauss (2003) says if confidential
information makes a difference in the rating decision, then, that information is
material and should be disclosed to credit rating users/DSUs.
REPUTATION THEORY
The
importance of reputation was highlighted for the first time by Shapiro (1983),
in his work “Premiums for High Quality Products as Returns to Reputations”. He
describes that the reputation acts as an important mechanism through which the
businesses gain trust and relationships in the markets. Macey (2010) opines
that reputation is critical in fostering high trust environment for the
business of CRAs, and it plays a far greater role than religion or social
networks. Partnoy (1999) opines that the CRAs survived and prospered
mainly on their ability to build and retain reputation capital. The CEOs of
CRAs in their speeches and reports also highlight the importance of reputation
capital in their business. Standard and Poor’s state that reputation is more
important than revenues. Moody’s claim that reputation is the bread and butter
of their business and they prosper based on their ability to acquire and retain
reputation capital. Reputation forms the core competence of CRAs (Hunt, 2009).
Hemraj (2008), Klien and Leffler (1984), Diamond (1991), Partnoy (1999), Cantor
and Packer (1994), Becker and Milbourn (2011) and Hunt (2009) in their works explain
the radical shift in the focus of CRAs from reputational view to regulatory
view.
Hemraj (2008) having observed the fall of
investment grade rated issuers such as Enron, Worldcom, Paramlat and Lehman
Brothers, insist that the reputation of CRAs should have prevented them from
assigning and retaining investment grade ratings till they became bankrupt.
These defaults show that the CRAs have compromised their integrity in the
ratings, to appease the issuers – their paying customers — by either issuing an
undeservedly high rating or by failing to downgrade the rating on issuers when
circumstances warranted. The works of Coffee (2006); Cox, (2010); Jiang et al,
(2012) also share the same opinion. The opinion about the CRAs favouring
issuers rather than investors was confirmed and they (CRAs) started came under
sharp criticism, when CRAs started rating structured financial instruments such
as MBS, CDO, ABS (Cox, 2010). In a nutshell, the findings of the said
researchers have tarnished the reputation of CRAs completely. It is shocking to
see that, despite the loss of reputation; the CRAs have continued to garner
their business of rating, that made the stakeholders to question the very
reputation theory itself (Govt reform report, 2008).
Partnoy (1999) in his work “The Siskel and Ebert of Financial
Markets?: Two Thumbs Down for the Credit Rating Agencies”, observes that in the
investor pay model the reputation of the CRAs is important. Here, according to
him, the agency’s name, its integrity and its credibility are subject to
inspection by the investment community. Partnoy in his work observes the
following:-
a. The reputational
considerations were very acute when investors paid CRAs for their services, as
they protected the interest of investors.
b. The shift in the
payment model from investors pay to issuers pay have diverted the focus of CRAs
in protecting issuers rather than investors, leading to the demise of
reputation theory in CRAs.
c. The CRAs survived,
despite the loss of reputation, because of the regulatory importance attached
to the ratings. The ratings have been used as a criterion for various acts of
banking, insurance, pension and real estate to name a few.
d. The CRAs have
thrived, profited, and have become exceedingly powerful because they began
selling regulatory licenses. The CRAs are successful not because of their
ability to provide information, but on their legally privileged position which
allows them to sell regulatory licenses to issuers.
Hill’s (2004) observation in his work “Regulating the
Rating Agencies” is not different from Partnoy’s observations. The genuine
demand for CRAs and their services fuelled by market forces is displaced by
ersatz demand fuelled by regulatory requirements leaving very little choice for
investors to decide if they wish to use the ratings. Thus, the issuer pays the
rating fees to purchase not only the credibility with the investment community,
but also the licence from the regulator.
Hunt (2009) in his
work “Credit Rating Agencies and the Worldwide Credit Crisis: The Limits of
Reputation, the Insufficiency of Reform, and a Proposal for Improvement”,
identifies the two main reasons for compromising on the reputation (by the
CRAs), they are: a) high entry barriers (because the CRAs are in the oligopoly
market structure) and b) The benefits of over rating are greater than the costs
of such ratings to CRAs (since, CRAs are not subject to civil or criminal
liability for malfeasance as they fall under limited agency liability).
Similarly, Macey (2010) opines that CRAs would not mind to monetize the value of their
reputations by participating in one-shot frauds as they (CRAs) do not find any
rationale in building strong reputations. Bonewitz
(2010) is of the view that the regulatory component attached to credit rating
gives an incentive to the issuer to purchase untrustworthy ratings even if the
investors do not value them (ratings).
The Credit Rating Agency Reform Act of 2006 (CRARA)
and the SEC regulations assume that the quality of credit ratings can be
enhanced by making the credit rating industry more competitive. But, the review
of works on competition in CRAs report diametrically opposite views. That is,
on the one hand, Becker and Milbourn
(2010), Malik (2014), and Coffee (2006) show that the competition in CRAs will
reduce their quality and thereby reputation, while, Klein and Leffler (1983) on
the other hand, demonstrates that competition in CRAs will improve the quality
and thereby increase their reputation and accountability.
Competition in Credit Rating Agencies
According to AMF Report (2010), the market structure of
CRAs is oligopolistic, where, the three global CRAs – Standard and Poor’s,
Moody’s Investor Service and Fitch Ratings – together have 94% share of the
global market and the remaining CRAs have only six per cent of the global
market share. The Securities Exchange Commission’s CRA Reforms Act (2006)
intends to promote competition in the credit rating industry by allowing more
CRAs to apply for NRSRO certification (in accordance with the provisions
stipulated in the act). This certification is necessary for the regulatory
purposes in the USA. To get the NRSRO certification, the CRAs should have a)
Adequate staffing, financial resources and organizational structure, b)
Widespread recognition, c) Systematic rating procedures that are designed to
ensure credible and accurate ratings, d) Internal control procedures to prevent
misuse of information, e) A system of disclosing their procedures and
methodologies for assigning ratings and f) Procedures in place to disclose
public specific performance measurement statistics (including historical
downgrades and default rates).
The new entrants in credit rating industry find it thorny
to fulfill the conditions laid down by the act in getting the NRSRO
certification. In this way, the NRSRO certification itself has become a
hindrance to new entrants to compete with the global three CRAs and survive
(Tse, 2008). They (new CRAs) eventually end up as niche agencies (Jean-Marc
Moulin, 2008).
Tse Tin Shing (2008) identifies two barriers for lack of
competition in rating industry, they are, the natural barrier and the
artificial barrier. The natural barrier comes with the CRA’s expertise, the
economies of scale in gathering the information, the network externalities and
the reputation which is already created (Raymond W Daniel, 2005). The
artificial barrier is largely attributed to the increased regulatory importance
attached to ratings in investment mandates (Kyl, 2006).
Becker and Milbourn (2010) in their work on “How did
increased competition affect credit ratings?” observe that the dilution in the
quality of ratings owing to increased competition amongst the rating agencies
(themselves).
Malik (2014) in his research on “Is Competition The Right
Answer? A Case Of Credit Rating Agencies” develops a game theory model to
address the question: would an increase in competition among the CRAs improve
the quality of the ratings? The model concludes that a) Competition in the
credit rating industry is not always healthy (as reputational consideration
decreases among the players competing) and b) The possibility of collusion will
increase among CRAs leading to assigning inflated ratings. Likewise, Coffee
(2010) opines that the impact of increased competition among CRAs is
problematic; as it encourages ratings arbitrage (issuers pressure competing
rating agencies to relax their standards).
Klein and Leffler
(1983) opine that increased competition
can strengthen the CRAs methodologies and their accuracy. While, Camanho, et al
(2012) in their work explain that regulatory initiatives aimed at increasing
competition in the ratings industry may reduce overall welfare, unless new
entrants have a higher reputation.
The majority of works
related to competition in CRAs is of the opinion that the increased competition
dilutes the quality of ratings.
Accountability of CRAs
Jonathan and Stephen (2007) in their work on “Rating
Agencies: Civil Liability Past and Future”, identifies that the rating agencies
lack accountability towards market participants. Despite their erroneous
ratings, they go unpunished (under the pretext – the right of free speech
protection). Subsequently, this right is removed through CRAs Reforms Act in
2006.
PRINCIPAL AGENT THEORY
Daniel
(1996) state that the CRAs act as conduits between the issuers and investors.
The works of Smith and Walter (2003); European Central Bank (2004); Johansson
(2010); Katz (2009); Kerwer (2001) and Iva and Vukasin (2010) explain the
diverging role played by CRAs, that is, they (CRAs) act as agents for both
investors and issuers. Thus, CRAs operate in the opposing interests of two
principals i.e., Issuers and Investors.
Emmenegger
(2006) says that conflicts of interest are typical in principal-agent
relationships as both the parties (issuers and investors) aim on maximizing
their economic benefits, while having different goals. Issuer expects the best
possible rating from CRAs and the investor expects the CRAs to give accurate
ratings, by preparing rating with caution (Jensen and Meckling, 1976).
Sinclair (2005) in his work on “The New Masters of
Capital: American Bond Rating Agencies and the Politics of Creditworthiness”
believes that in the issuer pay revenue model, there is an incentive for
cooperation between the issuers and the CRAs. This cooperation encourages the
CRAs to issue inflated ratings, creating the conflict of interest between CRAs
and investors (Kotecha and Ryan, 2011). The practice of charging fees based on
the size of offerings also make CRAs more vulnerable to the pressure exerted by
issuers (Stephen Rousseau, 2006).
Hill (2004) in his work on “Regulating the rating
agencies” explains that the CRAs have begun to provide a large variety of
ancillary services such as advisory, research and consulting. The issuers might
subscribe to such ancillary services assuming that their failure to do so may
have an impact on the rating. This creates conflict of interest between issuers
and CRAs. However, SEBI has instructed the CRAs (in India) to separate their
rating business from other ancillary businesses,
Rousseau (2006) describes that CRAs are compensated
primarily by issuers (for rating/grading services) and secondly by investors
(as CRAs continue to offer subscriptions about informational services).
Therefore, there also exists conflict of interest between CRAs, Issuers and
Investors. If controlling measures are inadequate, the agent (CRAs) has no
obligations to consider the interest of the principal (Neubaumer, 2010).
Conflict of Interest (Issuer Pay model)
According to Cantor and Packer (1999) the transformation
in the revenue model, that is, from investors pay to issuers pay, has created
significant conflict of interest between issuers and CRAs. In the issuer-pay
model, the CRAs are sensitive to the needs and desires of their paying
clients—the issuers (Timothy E Lynch, 2009). As private and profit oriented
enterprises, CRAs have a desire and an obligation to maximize the profits to
their shareholders. Unfortunately, the interests of issuers (to receive high
ratings) seldom align with the needs of investors (to receive reliable rating
information). However, the interests of issuers and CRAs necessarily coalesce,
which propels the CRAs to make more money by providing their paying
customers—issuers—with higher ratings. This alignment of CRAs and issuers occurs
at the expense of the investing public. Therefore, Partnoy (1999) state that
the current model (i.e., issuer pay model) of the CRAs is built upon
fundamental and blatant conflict of interest.
On the one hand, the Wall street report (2012), the works
of Covitz and Harrison (2003) and Roopa Kudva (2010) support issuer pay model
and assert that CRAs have implemented adequate measures to prevent or eliminate
the perceived conflicts of interest. On the other hand, the Senate Report
(2006), The Wall Street Hearings (2010), and the works of Becker and Milbourn
(2011); Alp (2013); Baghai et al., (2014); Dimitrov et al., (2015), and Baghai
and Becker (2015) affirm that the CRAs have failed to operate objectively.
According to former employees of Moody’s and SandP, top
priority is given to market share, revenues, and investment bankers opinions
than to the ratings given by the CRAs. (US Senate Report, 2006). Rich Blake
(2010) observes that the investment banks have hired former employees of CRAs
(who possessed knowledge to structure the deals) to influence for better
ratings. Becker and Milbourn (2011) in their work on “How did increased
competition affect credit ratings?” express that issuers are directly important
to the CRAs because of the fee/income they generate, and therefore the ratings
provided by CRAs cannot be free from bias. The internal e-mails showed that
managers of the CRAs were willing to adjust the rating criteria to enhance
their market share (Wall Street Hearing, 2010).
The CRAs started providing ancillary businesses such as
risk management and consulting, advisory services, business process solutions,
and other related services to complement their core ratings business. The DSUs
might subscribe for these services out of fear that their failure to do so
might have an impact on the rating (Partnoy, 1999)
The CRAs have time and again argued that issuing
objective and credible ratings are important for them, and they would not put
their reputation at risk to appease a particular issuer. The CRAs also state
that they have a number of policies and procedures including substantial
firewalls in place that separate the ratings business from the influence of
ancillary businesses. CRAs say, to ensure the independence and objectivity in
the ratings process, the rating analysts do not participate in the marketing of
ancillary services. Added to this, the CRAs assert that the rating analyst
compensation is merit-based (i.e., based on the demonstrated accuracy of their
ratings), and is not dependent on the level of fees paid by issuers. However,
it is not clear if such organisational measures can resolve conflicts of
interest (SEC Report, 2003). Amadou (2009), Coffee (2006) and Jiang et al.,
(2012) feels that the investor pay business model is better and suggests that
we should go back to investor/subscriber pay model or regulatory pay model.
Egan Jones rating agency and CCR rating agency follow investor pay model.
EFFICIENT MARKET THEORY
Fama (1970) in his article on “Efficient Capital Markets: A Review of
Theory and Empirical Work” (with
three underlying assumptions for efficiency – First, investors are rational;
Second, if they are not rational, their random trades will be cancelled; and
the last, all arbitrage opportunities will be used) opines that in efficient
markets, the prices reflect all the available information.
Jensen (1978) states that in an efficient market, it is
impossible to make economic profits by trading on the basis of available
information. The efficient-market hypothesis (EMH) asserts that financial
markets may be efficient in weak or semi strong or strong form. If the markets
are strongly efficient, one cannot consistently gain returns in excess of
average market returns as the price of shares reflects all relevant
information. If the markets are semi-strong in efficiency, the publicly
available information like the credit rating changes (upgrades/downgrade)
should be reflected in the firms’ current market prices. In semi-strong-form of
efficiency, it is implied that share prices adjust to publicly available new
information very quickly and no excess returns can be earned by trading on that
information (Malkiel, 1989; Ogden, et.
al., 2003). Credit rating
announcements (either upgrade or downgrade) are used to examine the information
content of ratings and it is found that credit rating changes, most of the
times, do not contain any new information which influences the stock prices
(Weinstein, 1977; Wakeman, 1978; and Pinches and Singleton,1978). This may be
because of the inaccurate and incompetent ratings.
Diligence and Competence of CRAs
Timothy E Lynch (2009) in his work on “Deeply
Persistently Conflicted: Credit Rating Agencies in the Current Regulatory
Environment” categorises inaccurate ratings to be a result of (i) poor due
diligence or lack of research resources (inadequate research
skills/financial/managerial resources), (ii) lack of analytical resources or
(iii) good faith mistakes (Arthur R. Pinto, 2006).
Frost (2006) explains that CRAs fail to ask
probing questions to the management/issuer and do not ensure the accuracy and
adequacy of financial, analytical, and managerial resources provided by them
(issuers) unlike accountants and auditors. They do not always use sound risk
models; in short, CRAs do not always take the steps necessary to ensure that
they issue credible and accurate ratings. The failure of Enron in 2001 is a
clear example of CRAs being too lax in conducting due diligence and failed to
audit the information provided by issuers.
Partnoy (1999) is of the opinion that the CRAs failed to
invest adequate time and energy in evaluating the corporation’s
creditworthiness and hence retained investment grade rating on Enron until four
days before it filed for bankruptcy.
SEC report shows that the CRAs apparently ignored the
warning signs, and failed in assessing the firms accounting irregularities and
overly complex financing structures. In this background, Frost (2006)
identifies two important issues related to diligence, they are, the first,
there is a gap in the way the CRAs understand their role, duties and
expectations of the regulators and the users. i.e., CRAs deem that their duty
is to ensure the accuracy of the released ratings based on the information
provided by the issuers and not to ensure the accuracy of the financial
statements and other issuer related information. Secondly, even if the CRAs suspect the
information provided by issuers and probe further, they (CRAs) do not have the
competence to carry out due diligence, as they lack the expertise and
experience when compared to auditors. Hence, the problem here is to find the
answer for the question - Does the duty of the CRAs include the duty of an
auditor too?
Conclusion
This theoretical framework is developed with the works pertaining
to four prominent theories on credit rating services, viz., Information
asymmetry theory and the disclosure practices of CRAs, Reputation theory of
CRAs and CRAs accountability and competition, Principal agent theory and the
perceived conflict of interest of CRAs and efficient market theory and the
diligence of CRAs. This theoretical
framework helps us to understand the evolution of CRAs and its impact on DSUs
and SSUs. It also helps us to comprehend the present status of CRAs. The CRAs
which came into existence to resolve the information asymmetry got engulfed in
the principal agent problems; and lost their reputation. It is also found that
they have contributed very minimum to the efficiency of the securities markets.
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