Operational Problems of Rating Agencies

Reputation mechanism

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Introduction
It is sufficient to consider even their nature as profit organizations to recognize that there are a series of inconsistencies between the Rating Agencies and the role they are called upon to play. Unfortunately, there are numerous “congenital” errors in the nature of the Agencies, which, especially during periods of economic downturn, have been the subject of strong accusations. Of course, given their relative importance and their much longer history, these considerations relate almost exclusively to the global Agencies. For the reasons we will see, there are doubts as to whether the Rating mechanism works properly. In particular, the Securities and Exchange Commission (SEC), starting from 1975, identified a list of Nationally Recognized Statistical Rating Organizations (NRSRO) which, by preventing the entry of potential competitors, could have generated the problem of regulatory licenses, i.e. a sort of self-referentiality on the part of global Agencies. The second issue concerns the fact that the opinions of the Agencies may be in the nature of prophecies that are carried out by themselves, precisely because of the consequences that the opinion inherent in the Ratings has on the fate of the broadcaster who receives it.

Reputation mechanism
By analyzing a large body of data, the Agencies try to predict what the future prospects of the undertaking will be taking into account its solvency, the economic situation, economic conditions and any other stress factors. The analysis is based on public information, but also on private information, which the broadcaster makes available exclusively to the Agency. This phase of the collection represents a cost for the Agencies; on the other hand, through investment in the collection, they accumulate reputation capital. However, there is a risk that, once the reputation capital is consolidated, the Agencies may be required to reduce their investment in collecting and analyzing information below the optimal level corresponding to a given reputation. On the other hand, whenever the Agencies issue a Rating they put their reputation into question and the prospect of losing it could be a disincentive to underinvestment.

Self-Realization Prophecies
Precisely because of their enormous influence on the conditions under which companies can obtain financing, the decisions of the Agencies can be self-fulfilling. A downgrade of the Rating, for example, will further worsen the situation in which the company finds itself. Of course, this is particularly worrying when the company is in situations of temporary illiquidity which, probably, with the downgrading could turn into an absolute impossibility to obtain new financing to restore the debt.
Therefore, before proceeding with the downgrading, especially if it involves a change from investment grade to non-investment grade, an Agency must assess whether the reasons that would justify it are permanent or only temporary. The Agencies cannot concentrate their attention solely on the state of the business and on information which the judgment should reflect while ignoring the effects which judgment may have on the market. Downgrades and increases in Ratings are operations that refer to the monitoring service. If the Agencies have done a good job in issuing opinions, the same cannot be said for subsequent revisions. Useful examples are Parmalat (2002) and Enron (2001), where downgrades took place when the poor quality of the issuers was already widely known.
Marco Barchetti
Fintech Review

Operational Problems of Rating Agencies
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