George Akerlof, in his Nobel prize autobiography, tells the story of his prize-winning paper on ?The Market for Lemons?. He wrote it as a first-year assistant professor at UC Berkeley, but revised it while visiting the Indian Statistical Institute in Delhi in 1967-68. In an observation which will comfort many an academic who has been similarly treated, he says the paper ?had been rejected two or three times in the course of the year by editors who felt that the issues in the paper were too trivial to merit publication in a serious academic journal?. The ?lemons? in the paper are used cars, and the central point of the analysis is that the inability of potential buyers to discern the quality of individual used cars can lead to a collapse of the market. This insight carries over to numerous other markets. One revision during the Indian sojourn involved adding the example of credit markets in India, which could similarly fail to function properly, if at all.
The market for lemons can be rescued if the information asymmetry can be overcome, for example through certification by independent mechanics. In credit markets, rating agencies play the same role, assessing the quality of borrowers, or rather of the debt they seek to issue. The subprime crisis in the US can be seen in the light of Akerlof?s classic analysis. Credit rating agencies did a poor job of looking under the hood when they rated various debt instruments created from the securitisation of subprime mortgages: they were far too optimistic. Since the mortgage-based securities were spread around various financial institutions, based on the over-optimistic ratings, lenders could not assess the quality of asset portfolios that might hold suspect securities?these could no longer serve as collateral for short-term loans, and the credit crunch began. Since holders of suspect securities included non-US financial institutions, the crisis became global.
While the root causes of the mess included low interest rates and lax regulation (permitting too many mortgage loans that should never have been made), the rating agencies contributed to the problem by failing to assess risks accurately and in an unbiased manner. One might forgive these mistakes on the basis that the financial products being rated were too new, and not well enough understood. However, a lack of good information or understanding about the products ought to lead to more conservative ratings?the mechanic can always say that there are features of the car that he could not assess, and warn the prospective buyer accordingly.
It may be that there is a rating bias caused by the desire to keep markets functioning actively, and ensure ongoing demand for quality assessments. Rating agencies may therefore consider the preferences of borrowers in making their judgments. The conflict of interest is not as stark as that of Wall Street securities analysts in the 1990s, who worked for firms that profited from active stock markets and buoyant IPOs, but ?independent? credit ratings have often failed to play the role they are supposed to.
Put another way, the market for credit ratings is itself imperfect, subject to moral hazard (as opposed to adverse selection, the consequence of the lemons problem). Moral hazard can be mitigated by concerns for reputation, but those are weaker if there are few alternatives. That is precisely the case in the credit ratings industry, where Moody?s and Standard & Poor have a market share of about 80%, while a third, Fitch, has 14%. The three Indian rating agencies have each separately allied with one of these big three to overcome reputational entry barriers in the ratings market.
However, the latest problem of the big international agencies represents an opportunity for the strongest of the Indian agencies. To use a different citric metaphor, this is a chance to make lemonade out of the lemons handed out by the subprime crisis. Essentially, this is a market where two or three firms dominate, without providing top quality. (Think of the US automobile industry before competition from Japan.) Already, Western firms are turning to India for high-quality financial research. For knowledge services, lower costs can lead not only to savings, but also to deeper and better quality analysis. India?s rating agencies, removed from Wall Street, may also be in a position to establish a stronger reputation for independence as well as high quality analysis.
Realising this opportunity, like any other, is not a sure shot, but India?s rating agencies stand as good a chance as Japan?s automobile makers did once upon a time. The strategic intent of those automakers was to take on Detroit, and the Japanese government foresaw the positive spillovers to the rest of the manufacturing sector. India?s policymakers are certainly trying to formulate a strategic intent with respect to the financial sector. Forty years after Akerlof?s first visit, India?s economy is still replete with asymmetries in information, notably in many kinds of financial markets, but also markets for educational and health services. Credit rating in India is in its infancy, but has to develop quickly if the domestic financial sector is truly to become world class. The nature of knowledge services suggests that this domestic development can go hand in hand with becoming a significant force in global finance.
?Nirvikar Singh is professor of Economics at the University of California, Santa Cruz