N. Balakrishnan says rating agencies failed to warn the world about the 2008 global financial meltdown and, therefore, we should not take them too seriously

Virginity and credibility are one-off affairs. Once you have lost either one you can never gain it back. The US rating agencies such as Moody's lost their credibility when they failed to spot one of the biggest financial meltdowns the world has ever seen in 2008, and they are never going to get it back. The government can ignore the recent downgrading of the "outlook" for Hong Kong by Moody's, safe in the knowledge that the SAR's administration knows better than the US rating agency what is good for Hong Kong.

The Hong Kong government will do well to carry on with its own "risk management", which has a sterling record of success from 1985 to now and which has endured the Asian financial crisis of 1997 and the global financial crisis of 2008 better than most of its neighbors. There is no question that the SAR government, whatever its other shortcomings are, is a better manager of finance than many other governments, including the US government, and a better regulator too. Its financial history of the past 20 years provides ample proof of that.

It is not just that Moody's and the other "global" (read US) rating agencies made mistakes in the past. Worse, they do not seem to have learnt from the mistakes of the past and are still making the same ones now. You do not have to take my word for this. The Securities and Exchange Commission of the US came out with a damning report on these rating agencies just a couple of days after Christmas last year. It provides many details on how these agencies are still engaged in the same "conflict of interest" practices that lead them to issue misleading reports and to put a more optimistic spin on the customers who pay them to rate them.

For those who are inclined to read these sorts of reports, the full report is here: https://www.sec.gov/ocr/reportspubs/special-studies/nrsro-summary-report-2015.pdf.

The problem with the rating agencies is a fundamental one in that the methodology is almost designed to generate a "conflict of interest". The client approaches a rating agency and the client company pays for the rating to be done. In theory, of course, the rating agency can take your money and then still say the financial instrument you are trying to sell is junk. But in practice this is not how it works.

We saw an example of how it works shown in the movie The Big Short, which won an Oscar for its screenplay. One scene depicts a fund manager who spots enormous errors by a rating agency in giving one of the highest grades, AAA, to a flawed and almost junk financial instrument being marketed as a triple-A investment grade instrument good for pension funds.

The fund manager thinks that the rating agencies might have made a mistake in giving a triple-A rating to such an instrument and sets up a meeting with a senior executive of a major rating agency. On hearing out the fund manager pointing out the error, the rating agency chief says that she cannot do anything about the error. This is because if her agency is reluctant to give a good rating, the client will "just go across the street" and buy a good rating! In other words, you can "buy" a good rating!

Common sense tells us that you should not allow yourself to be flattered by those who have a vested interest in flattering you. Such compliments are worthless.

Unfortunately, the rating agencies still carry a lot of weight in the world, since the big funds such as pension funds, sovereign wealth funds and others are bound by contracts to trust the ratings of these agencies with completely flawed methodologies and invest accordingly. So an AAA rating from these agencies means that the big boys will buy your paper, whereas if you get a poor rating the big funds will not touch you.

The people who manage these funds may know better from real-life experience but their hands are tied by the contracts. This is yet another example of why the international financial system, founded by the US just after the end of World War II, seriously needs reforming.

In the meantime, all the Hong Kong government can do is to carry on with the good work in financial matters that it is doing, and wait for most of the world to wake up to the distorted, even manipulative, methodology the major "rating agencies" use in arriving at their skewed findings.

(HK Edition 04/13/2016 page10)