Rating the Raters

All that Paul Krugman says in the NYT is this

It was a system that looked dignified and respectable on the surface. Yet it produced huge conflicts of interest. Issuers of debt — which increasingly meant Wall Street firms selling securities they created by slicing and dicing claims on things like subprime mortgages — could choose among several rating agencies. So they could direct their business to whichever agency was most likely to give a favorable verdict, and threaten to pull business from an agency that tried too hard to do its job.

Right now, it looks quite like the relationship between the film industry and the media which reviews movies every Friday, often amidst allegations that reviewers have been paid off by powerful film producers to give them favourable reviews. But even for something as trivial as that, I never watch a movie without reading at least three different movie critics. I usually watch them anyway – but that doesn’t take away from the fact that I value getting at least three different perspectives on the same product.

Clearly, a free market system for rating agencies to compete in was bound to fail and inflict heavy collateral damage. Ideally, rating agencies should not be making money from the very agencies (whose products) they are supposed to rate, much like say, advertisers, lawyers or consultants – only that a rating job expects a competent and impartial judgment. Not sure then, why Krugman shies away from advocating specific reforms – he merely says that we need ‘a fundamental change in the rater’s incentives’. What he does say, but only at the very end is this (once again, stating the obvious) –

It’s comforting to pretend that the financial crisis was caused by nothing more than honest errors. But it wasn’t; it was, in large part, the result of a corrupt system. And the rating agencies were a big part of that corruption.

Now, even if the raters were being paid by their clients, we should have had systems in place for them to disclose their financial statements to regulators and the general public. Was there no such system in place in the US? Or did everyone just take it for granted that rating agencies would do an impartial and thorough job. Everyone – not just the general public, but also financial institutions that made lending decisions based on these ratings! Krugman calls it corruption. I think there is corruption as well as utter incompetence – of the kind that just cannot be excused as ‘honest errors’.

I have always been curious about microfinance rating. I once asked a friend who works in one of the leading commercial banks in India, about the extent to which they relied on microfinance rating agencies’ ratings when making lending decisions. His bank is among the top five lenders to the microfinance industry in the country and he handled a heavy and growing portfolio. He laughed and said – “about 5%”. Part of the reason could have been that at that time,the microfinance rating industry, although steadily growing, was still a nascent entity and lenders had to watch out, even when they were scrambling for clients. As microfinance institutions start transforming into large financial corporations, float IPOs and are rated by standard credit rating agencies, I hope the mistakes of the big banks are not repeated.


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