It has been four years now since the 2008 financial crisis, where credit rating agencies (CRAs) were culpable. The subprime crisis dealt a huge blow to the reputation of rating agencies. Having rated subprime assets as AAA, these agencies had literally shaken the confidence of investors across the globe. They played a central role in the US housing bubble and the subsequent collapse. And the worst part is that nothing has changed since then.
The conflict of interest in the business model of rating agencies continues to remain. This helps them earn millions in fees from the 'issuers' they rate. Having high ratings from the holy trinity of rating agencies, (S&P, Moody's and Fitch) means a bigger market and lower prices for your debt. So these agencies are able to charge issuers for the privilege of having their debt rated. This is a win-win situation for credit rating agencies even if their calls sometimes go horribly wrong, which happened during the crisis. This situation can't continue for much longer, especially according to European lawmakers.
In early 2013, European Union lawmakers are set to vote through a third package of regulations covering CRAs operating in Europe. These agencies will now have to register, meet corporate governance standards and accept supervisory oversight. If agencies issue erroneous or grossly negligent reports they can be held responsible and even sued. But, the true test will come from whether policy makers can reduce reliance on external ratings and encourage financial institutions to do their own internal rating work. The impending Basel III rules may prove important in this matter. In India, the Reserve Bank of India (RBI) has also sent out a circular on the "internal rating based" approach for measuring credit risk which some banks may follow shortly.
In India, CARE Ratings was the third agency to list on the bourses recently, much after CRISIL and ICRA. We believe that regulatory oversight and supervision is necessary for CRAs, especially since investors put so much faith into these gradings. While more scrutiny into their operations may somewhat normalize returns for investors in these agencies, we believe that this will be beneficial in the long run and may prevent another financial crisis in the future.