Rating agencies are meant to give comfort about an issuer’s ability to repay debt. Ratings are essential in determining the level of interest rate that a borrower must pay. Inaccurate ratings, therefore, distort both the prices of debt instruments and the interest rates payable on them. As history has shown, this creates asset bubbles that eventually burst, disrupting the functioning of financial markets.
The three dominant international credit rating agencies – Standard & Poor’s, Moody’s and Fitch – have been accused of many faults including:
These shortcomings originate from their ‘issuer-pays’ business model. The institution being rated pays for the rating which is used by investors. This means that the model has an inherent conflict of interest.
Although this has been evident through various crises – most notably the financial meltdown in 2008 – regulatory mechanisms are yet to address this problem. And, despite these known weaknesses, rating agencies are still being referenced in key financial market decisions.
Why current regulations aren’t working
A number of studies have identified the issuer-pay revenue model as a key driver of conflict of interest. Here are four reasons why I think the current attempts to regulate rating agencies will not address conflict of interest.
The first big problem is the relationship between the rating agencies and the issuers. This relationship naturally creates pressure for both the lead rating analyst – around which the whole rating process is centred – and the rating committee to give favourable ratings over time.
This is how the process works: after an issuer contracts a rating agency, the rating agency assigns an analytical team (lead and support analysts) to gather information about the entity from different sources they deem credible. The analytical team makes recommendations to a rating committee, convened by the lead analyst. The lead analyst also determines the size and composition of the rating committee based on the size and the complexity of the credit analysis.
The second problem is that rating agencies are bound to be concerned about the sustainability of their revenue sources because they’re profit-driven businesses. They will fight to protect their income at the expense of aggressive or objective ratings that could compromise revenues, although in the long run will damage their businesses.
The third problem is that the individual employees of a rating agency face no criminal liability. Conflict of interest usually manifests itself through members of the analytical team.
Lastly, the credit rating industry is highly concentrated. Moody’s Investors Service and Standard & Poor’s together control 80% of the global rating market. Fitch Ratings accounts for a further 15%. The ‘big three’ credit rating firms seek to maintain dominance in the industry through discouraging any activities that may lead to a loss in their market share. They are unwilling to allow competition, suggesting that it could lead to poor ratings.
Following the 2008 Global Financial crisis the US, European Union, China and South Africa introduced legislation to address the flaws in rating agencies’ operations.
Although strict civil laws are necessary to deter misconduct and encourage compliance, enforcing civil regulations only is both an ineffective and expensive way of curbing conflict of interest. Tighter scrutiny of credit rating agencies by investors, regulators and the media is also not effective.
Despite these regulatory responses, rating agencies are still being caught on the wrong side of the law. Recent cases are proof of this. But there’s still the possibility that a lot of wrongdoings go undetected.
Earlier this year the European Securities and Markets Authority fined the Fitch group of companies in France, Spain and the United Kingdom a total of €5 132 000 for failing to maintain independence and avoiding conflict of interest. Fitch UK, Fitch France and Fitch Spain issued ratings on Casino Guichard-Perrachon, Fondation Nationale des Sciences Politiques, and Renault. This was despite the fact that they knew one of their shareholders – which indirectly owned 20% shares in each of the Fitch group companies – was also a board member of the rated companies.
In 2018, China suspended licences held by Dagong Global Credit Rating, one of China’s biggest agencies. Dagong was found guilty of submitting false information to regulators and charging borrowers very high fees, actions that regulators said compromised the rating agency’s independence.
In South Africa, the Financial Sector Conduct Authority recently found the Global Credit Rating Agency guilty of failure to avoid a conflict of interest. The agency was fined an administrative penalty of R487 000. The CEO of the GCR undertook to an issuer, whose credit rating had expired, that the GCR would issue a credit rating. This was contrary to the rules that required the CEO to act separately from the agency’s rating analysis team.
At the time of undertaking, the issuer was the process of procuring the services of a rating agency, a process in which global agency was one of the bidders.
A shortfall in the regulatory mechanism
The continuing infringement by credit rating firms on rules and analysts’ actions that compromise the independence of their opinions shows there is a major shortfall in the current regulatory mechanism.
Although problematic, abandoning the ‘issuer-pays’ business model is not the solution and will push some rating agencies out of business.
The only solution is to criminalise rating misconduct such as breaching conflict of interest. The strict monitoring, scrutiny and penalising of credit rating firms alone will not be enough to deter bad behaviour. Individuals responsible for breach of conflict of interest rules should face criminal prosecution. If this does not happen, analysts will not hesitate to take chances.
South Africa’s economy is in dire straits. Unemployment has reached a 15-year high of 27.6%. And in the first quarter of this year GDP growth dropped by 3.2%. That’s the biggest quarterly drop in a decade.
Considered in conjunction with the country’s dismal education outcomes, which the IMF found are perpetuating inequality and contributing to the country’s low economic growth, and the possibility of a rating downgrade, the outlook isn’t auspicious.
Academics and political leaders have long warned that a combination of high youth unemployment, poor educational outcomes, and high inequality levels will eventually explode into large-scale social disorder. There has indeed been a steady rise in the number of protests. The country is now classified as a fragile state by Corruption Watch.
However, the recent elections provide two interesting pointers. The first was the extremely low voter turnout of just 49%. The second was a near doubling of the Economic Freedom Fighters’ (EFF) share of the vote, from 6.4% in the 2014 poll to 10.8% in 2019. Taken together, these factors suggest that South Africa’s vulnerable citizens are frustrated with the established political parties. However, they are not as yet widely attracted to the potential re-distributive policies of populists.
This raises a question. If South Africa’s political and socioeconomic stability is so fractured, how has the country managed to defuse the ‘ticking time-bomb’ for so long?
According to economists Daron Acemoglu and James Robinson, the democratic system attempts to balance two forces. The revolutionary redistributive pressure of the citizens on the one side, against the repressive power of the elites on the other. But high levels of inequality interfere with democratic consolidation and make revolutionary change more attractive. For self-preservation reasons, elites must stomach high tax rates, or land and capital redistribution.
In the first decade of democracy in South Africa, the country followed a path of financial and trade liberalisation as it re-engaged with the global economy. The relatively strong economic performance then enabled the government to placate the formerly disenfranchised through redistributive policies. The key ones were black economic empowerment and social grants. This was underpinned by an effective tax system.
Unfortunately, the ability to balance the insider-outsider economy with social support was then significantly rocked by two major disruptions. The first was the global financial crisis. The second was the misrule of President Jacob Zuma.
Over the next decade, state capture and crony capitalism, coupled with economic decline, weakened the middle class and entrenched meritocracy. In turn, this raised pressure for greater re-distributive policies, both among factions of the ANC and eventually with the emergence of the EFF. The dire state of private sector investment and growth meant that the increased redistributive pressure was initially alleviated by public sector employment creation. This grew from 2.2 million in 2008 to 2.7 million by the end of 2014.
But in recent years, as the corrosive effects of corruption took hold, economic decay has become entrenched. This has resulted in declining tax revenues and spiralling state-owned enterprise debt. Political factionalism and policy paralysis have also increased.
Consequently, the government no longer has the financial wherewithal to fund the dysfunctional and indebted state-owned enterprises. These enterprises have been associated with the failed developmental state ideology. Weakened government finances have also made it difficult to provide social support via public sector employment.
As a result, the African National Congress (ANC) has increasingly turned to desperate policy debates such as expropriation of land without compensation, prescribed assets, off-shore income taxes, and changing the mandate of the South African Reserve Bank to print more money.
To make matters worse, the global economy is experiencing instability associated with trade wars and populism. South Africa’s economy will therefore likely continue to perform worse than the slowing global economy.
Tough choice ahead
If the country is to survive its current crisis, the government will need to undertake two difficult tasks simultaneously. It will need to:
refocus on resuscitating inclusive growth by supporting the informal economy and removing red tape for small, medium and micro-sized enterprises,
allow the private sector to invest in state-owned enterprises, and
facilitate the move away from a fossil-fuel based mining economy.
At the same time, the government will also have to free up budgetary resources by reducing the size of the bloated public sector and withstanding trade union wage demands.
If the inclusion of left-leaning ministers in the new cabinet and the recent contradictory policy statements from ANC leaders are a precursor to continued fractional government paralysis, then the country can expect even more economic instability and policy stagnation ahead.
Eventually, this will lead to significant socio-political stress as the private sector disengages and disinvests. The public sector will collapse under its own weight, and disenfranchised citizens will clutch at populist straw men.
Given the dysfunctional state of the ANC alliance and the over-arching quest for ‘unity’, it is apparent that President Cyril Ramaphosa must make a choice between saving the ANC alliance or saving the country. He can’t save both. Let’s hope he chooses wisely.