Time for a new credit rating lifeline

Credit rating agencies play a significant role in the financial world. They help clear up confusion in the capital market by providing investors and lenders with information so they can make informed decisions about the credit worthiness of debt obligations and financial products.

But they can also be destructive, as evidenced by their role in failing to do anything to stop the financial crisis that exploded in 2008. With the United States experiencing yet another financial crisis and the European Union debt crisis depressing the global economy, there have been calls for greater regulation of credit rating agencies in order to reduce the influence of these agencies.

With the rise of the BRICS (the emerging economies of Brazil, Russia, India, China and South Africa) and other emerging economies and their exposure to government debt in a number of advanced economies, these emerging creditor nations need access to reliable, transparent and independent credit analyses. A new, reliable, independent and influential rating agency is needed. In short, it is time to set up a BRICS credit rating agency.

First, however, let's talk about what these credit rating agencies do. In short, they help lower the cost of seeking information and improve transparency. They usually assign ratings to states, countries, government agencies and corporations in both domestic and foreign markets. Governments and institutional investors often review reports generated by agencies to gain assurance on the debt issuers' ability to meet its capital and interest obligation on its debt.

There are about 72 agencies worldwide, out of which 10 are viewed as Nationally Recognized Statistical Rating Organizations (NRSRO) by the US Securities and Exchange Commission.

The NRSRO status allows these agencies to issue credit ratings in the US. The global credit rating agency sector is dominated by three players: Standard & Poor's, Moody's Investor Service and Fitch Ratings.

The Big Three have come under intense scrutiny in recent years due to their role in the subprime mortgage crisis and the ongoing sovereign debt crises plaguing the EU and the US.

In the build-up to the subprime mortgage crisis, the three agencies failed to outline the risks in subprime mortgage debt products and gave these mortgage-backed securities very high ratings. Global investors, relying on the ratings, invested in these dubious financial products and created a housing bubble. Eventually, when the subprime borrowers began to default on their obligations (and when it was already too late for homeowners and investors and a financial crisis was inevitable) the agencies downgraded the financial products. These downgrades pushed the crash forward in the capital market. In the aftermath of the crisis, these agencies were roundly criticized for their incompetence and their inability to issue accurate ratings.

In the aftermath of the backlash resulting from their role in the subprime crisis, the Big Three became more proactive in ratings of sovereign debt. Previously, the Big Three were silent on the deteriorating fiscal conditions of the more developed markets in the US and Europe. While the Big Three were proactive in downgrading the ratings of fiscally challenged emerging market sovereign debt, they continued to retain the investment grade ratings for large economies such as Europe and the US. Things began to change in December 2009 when Fitch cut Greece's rating from A- to BBB+ with a negative outlook. Within the month, S&P and Moody's also cut Greece's credit rating. In January of this year, Fitch joined S&P and Moody's in downgrading Greece's bonds to junk status.

This year the Big Three have turned their attention to the US, which had never experienced a credit downgrade. On Aug 5, S&P downgraded the US credit rating from AAA to AA+ citing its doubt in the ability of the US Congress and the Obama administration to formulate an effective fiscal consolidation plan that would stabilize the government's debt dynamics.

As a consequence of downgrading the US and European debt ratings and their role in failing to warn investors of bad loans in the subprime mortgage crisis, S&P, Moody's and Fitch are facing an unprecedented backlash from European and American governments.

On both sides of the Atlantic, there have been calls for greater regulation of credit rating agencies in order to reduce the influence of these agencies. The EU is proposing a number of measures to reduce the influence of rating agencies and is advocating the use of two obligatory ratings in addition to the review of the current investor-pay model framework of credit rating agencies. In June, members of the European Parliament recommended that credit rating agencies should be liable in civil law for their ratings. The EU Commissioner for Internal Market and Services Michel Barnier recently suggested banning credit rating agencies from assessing and rating countries that are under the EU-IMF bailout programs. There have also been calls by a number of European political leaders, such as Jean-Claude Juncker and Angela Merkel, for the formation of a European credit ratings agency to rival the Big Three, while the European Parliament has proposed setting up a European credit rating foundation. The European Commission has also suggested forcing credit rating agencies to let countries know about rating changes three days in advance.

The potential clampdown on the rating agency sector is likely to widen the gulf in accurate credit information that passes between BRICS and advanced economies. A number of large emerging economies have sizeable exposure to government and corporate debt in a number of advanced economies. China is the largest holder of US Treasury bonds with an investment of $1.17 trillion. It is indeed time to set up a BRICS credit rating agency.

BRICS should consider forming a credit rating agency to rival the Big Three and the proposed European credit rating agency. Forming a BRICS agency would help address the oligopolistic structure of the credit rating market. It would also act as a counterbalance to the domination of the rating agency market by agencies in developed economies.

The formation of a BRICS agency would be timely. Although there are other rating agencies outside developed markets, their ratings are often discounted by investors, issuers, the media and regulators in developed markets. Dagong Global Credit Rating Company, the Chinese rating agency that lowered the US credit rating relative to China in July of last year, is an example. Investors simply did not pay attention to the rating.

But the BRICS agency would have to be independent and autonomous. This could be a challenge for the BRICS, but for a BRICS agency to be accepted by the international capital market, BRICS would have to work toward this independence.

The agency should be transparent by disclosing the model and statistics it uses in arriving at its ratings.

A major challenge for a BRICS credit rating agency is the likelihood that its ratings will be disregarded. The agency may also not have easy access to debt issuers in developed markets. To overcome this potential obstacle, the organization's agency would need to build clout. Each of the BRICS nations should officially recognize the organization's agency as a rating organization. They could also encourage other emerging markets such as countries in Africa, the Middle East and other oil-producing and Asian economies to recognize the BRICS agency.

The author is a CFA charterholder and a strategist for Diadem Capital Partners Ltd in London. The opinions expressed in the article do not necessarily reflect those of China Daily.