Analysts then, credit rating agencies now, who next?

The two latest major bouts of irrational exuberance of our times, the dot com stocks and the real estate bubbles, owed their sustenance in no small measure to the failure of stock analysts and credit rating agencies respectively. Institutions which were suposed to provide objective assistance and advise in guiding investors, had failed collectively. The malaise was retrospectively traced back in both cases to moral hazard related market failures.

Hitherto it was thought that the major conflict of interest within a Bank was between equity analysts, who offered advise about stocks, and investment bankers, who were keen on selling those stocks. But, The Economist quotes a new study, "Sociopolitical Dynamics in Relations Between Top Managers and Security Analysts", by James Westphal and Micheal Clement, which focuses on conflicting interests in relationships between stock analysts and owners of the companies they cover.

The study covers thousands of analysts and executives of companies they cover, over two years. It finds that two-thirds of analysts admitted receiving favors from the firms they cover. Some of the questionable favors include - selectively sharing information to some analysts, putting an analyst in touch with executives at other firms, offering membership to private clubs etc. The study also found clear evidence of analysts responding bitterly to favors withheld by downgrading those stocks.

The sub-prime mortgage crisis has thrown light on another critical conflict of interest - that between credit rating agencies and the securities they rate. The rating agencies are paid by the same Financial Institutions (FI) that sell the rated securities. In fact, the rating agencies are not paid if the FI does not like the rating and even when they pay, the payment is made after the securities are sold.

What is the solution? How can we align the incentives of analysts and rating agencies with those of investors, instead of the company owners or investment bankers or securities issuers?

Following the dotcom bubble, the SEC intervened by separating the stock analysis function from the investment banking function. A solution along similar lines would involve having independent credit rating function, with securities issuing FI prohibited from paying the rating agencies. The investors, both individual and institutional, have to pay the rating agencies for accessing the ratings information.

The aforementioned two are not the only moral hazard generating activities. There is significant scope of moral hazard in the work of engineering consultants, given the interlocking and often direct relationship between them and construction contractors. Design and DPR preparation and Project execution are two independent processes, with separate bidding processes. There is the real danger of having Detailed Project Reports (DPRs) and even Master Plans, doctored to suit the requirements of specific engineering construction contractors.

This practice or trend is common in infrastructure sector projects. There are many infrastructure firms who openly flaunt their expertise in design and construction. There have also been numerous instances of the successful bidder for project development having a stake in the consultant who designed and prepared the DPR.

One way to avoid this moral hazard is by encouraging tendering processes like Engineering rocurement and Construction (EPC) in Project execution. But the more sustainable and effective manner is to strictly separate the functions of designing and execution. If some action is not taken to have more oversight on this, we will certainly have badly designed white elephants, designed not to meet infrastructure objectives but to boost the bottomlines of infrastructure companies!