In the aftermath of global financial meltdown, the credibility of virtually all the renowned rating agencies has come under question. A conflict of interest arises from their revenues, which are a function of the number and the frequency of instruments/entities being rated at their will.
Since, Pakistan hosts just two rating agencies, the problems are not just limited to vested interests of the agency and the entity but also on the quality of rating agencies.
A number of entity & instrument ratings revised downwards by over 6 notches or more, in the span of five quarters (Jul08 - Sep09) demand the attention of the regulator to reflect on the standard and procedures adopted by rating agencies and address the conflict of interest.
The credibility of procedure and that of the staff employed by rating agencies is depicted from the fact that State Bank conducts an independent confidential rating process for commercial banks despite the fact that all banks are ought to be rated by two agencies - PACRA and JCR-VIS - working in Pakistan.
SBP rates banks by using its own rigorous Capital Asset Management Earning Liquidity and Systems (Camels) control method that takes months to complete and are shared only with the management of the respective bank. This process is deployed to safeguard the depositors money and not the interest of investors.
Likewise, since the Securities Exchange Commission of Pakistan (SECP) relies only on rating agencies to evaluate the companies and/or their instruments, protection of the interests of public at large, to have unbiased and thorough credit assessment of all these entities and instruments, remains much wanting.
Case in point: First Dawood Investment Bank, which, along with its TFC, is rated at BB whereas news reports suggest that the company is in default. Interestingly, banks have to have 100 percent risk weight against its assets of a company or entity below BB(-), however, they may use their own credit assessment for un-rated entity.
Moreover, if a company that solicits to be rated and gets the feel of getting poorer rating may refrain from being rated. In such a case, banks can potentially collude with that company and leave it unrated and assign better credit assessment to apply lesser risk weight to its assets. In this way, banks have an incentive to under capitalize. This defeats the purpose of central banks minimum capital regulation for commercial banks to safeguard their depositors.
In order to discourage this practice, the regulator (SECP) should facilitate the law of unsolicited rating i.e. a rating agency which volunteers to rate an entity/ instrument shall be provided with the same information as being provided in the case of solicited.
In 2004, the law allowed a rating agency to conduct unsolicited rating but the information provided to it is at the behest of the entity being rated. Lately, in the US there is a debate on law of providing similar information to solicited and unsolicited rating agencies.
If the information and its flow is same in both solicited and unsolicited cases, it will deter any entity to collude with a rating agency as the competitor rating agency can simultaneously come out with its own rating. This will help a long way to protect the financial system from any systemic failures.
There is an alternate solution, to the likes of SBP, SECP who should conduct rating themselves. But, then, that may hurt the free market mechanism. Hence, to foster competition while ensuring quality, regulator should pull up its socks, and design and monitor the standards & procedures for domestic rating agencies operating on the basis of best international practices.