The need for scientific rigour

Written by YRK Reddy | Updated: Sep 1 2007, 03:46am hrs
The bashing of credit rating agencies appears to have acquired the status of a ritual coinciding with systemic crisis. It happened in the light of the Asian financial crisis and later in the context of the Enron scam. The typical issues raised are on conflicts of interests, lack of transparency, underserved fees, and that they create barriers that give them oligopolistic status. These accusations have resurfaced now, as reflected in comments by several US senators in the context of the subprime mortgage crisis in the US. Rating agencies have been held responsible for promoting predatory lending in an atmosphere of poor oversight and regulation. They have been called gate openers among gatekeepers.

To an academic, the problem appears to be that they have been using unscientific processes that are made to look robust by using mathematical models and computer simulations. It is an old illusionary trick. Since the mid 1990s, financial institutions have begun to use various mechanisms to transfer their credit risks, particularly to insurance companies and pension funds which remain more opaque than others. Thus, it is no wonder that while Enron collapsed, its financiers did not take the same knock the risk had been passed on. With new and esoteric financial products getting invented and patented, the risk is getting farther and farther from its primary source.

The longer the chain, the more complex it gets, and less transparent and indeed less meaningful. In the end, the values may indeed be more than the underlying assets. This is happening exactly at a time when globalisation demands a credible rating market, and when even regulators are being led (hopefully not nose-led) by such assessments. As The Economist had ominously commented as far back as in November 2002, The agencies traditional role of rating debt securities has been stretched to cover a growing list of exotic instruments dreamt up by investment banks, including collateralized debt obligations, which are a way of taking a bundle of credit risks and slicing them into layers that carry different levels of risk.

Rating agencies will be loath to admit that they are out of touch with reality on assumptions of risks, prices, defaults, recovery rates, recovery periods and so on, with these new products. They just do not have the datathe rating products would fail tests of validity and reliability.

This was evident in the manner in which even a less risky service such as corporate governance rating was introduced, flaunted, and later withdrawn in some markets because of poor validity. Currently, there is no system by which sufficient scientific rigour can be ensured for the processes adopted by credit rating agencies in an increasingly choppy environment.

The Technical Committee of the International Organization of Securities Commissions had issued a Code of Conduct Fundamentals for Credit Rating Agencies. It calls for measures to improve the quality and integrity of the rating processindependence and avoidance of conflicts of interest; responsibilities to investors and issuers; disclosure of the Code of Conduct and communication with market participants. The first, indeed, would be more important than the rest. It calls upon agencies to use rating methodologies that are rigorous, systematic, and, where possible result in ratings that can be subjected to some form of objective validation based on historical experience. Some of the new services being rendered evidently fail this fundamental. But then, credit rating agencies have also enjoyed a governance system where they are immune to civil and criminal liability and malfeasance. The conditions overall appear to encourage moral hazard to worrisome extents.

Rating agencies play an important role in regular debt. It is the complex structures, of which greedy intermediaries are so fond, that pose worries. We need scientific rigour and higher transparency, plus greater accountability, before things go seriously wrong.