Rating agencies are back in focus

Rating agencies continue to make news, for all the wrong reasons. Over the past few days, there have been three illustrations of how decisions of rating agencies have contributed towards their declining credibility.

Just before the market close on Thursday last week, the Standard & Poor’s (S&P) erroneously sent out an e-mail suggesting that it had lowered the rating on France’s sovereign debt. The mail shook the markets and forced up French bond yields,

"In a statement, S&P attributed the message to "a technical error" and affirmed that the rating was unchanged. But the yield for France’s 10-year benchmark bond jumped more than a quarter point, to 3.48 percent, and the spread between French and German bonds of that duration reached 1.7 percentage points, a euro-era record... The erroneous S.&P. message went out shortly before 4 p.m. Paris time, and the correction was issued almost two hours later, after most European markets had closed."

Simultaneously, in India, Moody's Investors Service revised its outlook for India's banking system to negative from stable. It attributed the downgrade to increasingly challenging operating environment that will adversely affect asset quality, capitalisation, and profitability of Indian banks; high inflation; monetary tightening and rising interest rates; and the crowding out effect of government's massive borrowing program.

Just a day after the Moody's downgrade, S&P went the opposite direction and upgraded the sector from group '6' to group '5', the same as the other similar economies. Its argument

"Dependence on stable bank deposits due to an extensive branch network and limited dependence on external borrowing made India's banking system low-risk on system-wide funding... In our view, banking regulations in India are in line with international standards and the regulator ( RBI) has a moderately successful track record".

So what do we make of these contrasting ratings signals? Do investors and financial market actors go by the fact that since S&P is larger entity, its ratings should be given greater credence? In this context, The Gold Standard has an excellent post where it compares the Moody's decision on India's banking sector with that on China's similarly troubled banking sector. He wrote,

"The price India has paid for its relative transparency on its problems is a negative outlook. The more opaque it is, the higher the rating. That is why these agencies gave AAA ratings to CDOs, CDO-squared and to CDOs on CDOs...

Its giant neighbour to the North has an entirely State dominated banking system and an economy with even greater financial repression. It systematically under-counts and under-reports its bad debts. Those who dare to raise their voice are forced to withdraw their reports.

Banks have large exposure to local governments who are dependent on land banks sales for their revenues. Banks have exposure to developers who want the prices of land banks to decline. Their apartment prices are dropping and transactions are plunging. So, we have no idea of the true health of Chinese banks or, for that matter, the whole economy. We will never have one. Yet, on November 8th, Moody’s reaffirmed its ‘stable’ outlook for Chinese banks."

It is hard not to be baffled by the clear inconsistency in these rating decisions. In fact, during the ongoing European debt crisis, on several occasions ratings downgrade decisions by one or the other of the three big rating agencies have triggered market downslides. There is a strong and credible enough view that the decisions of ratings agencies could contribute towards turning a liquidity crunch into a solvency crisis. It is therefore no surprise that a growing number of opinion makers hold the view that the ratings agencies hold disproportionate power, whose exercise has, as numerous events of the past four years have shown, been questionable.