By Ravi Kant

Edited by Nidhi Singh, Junior Editor, The Indian Economist

The information available with credit-rating agencies plays an important role in determining the credit rating for the issuer. And it is this ‘information’ which creates a credibility risk for these agencies, and could create the biggest impediment for business. The different types of information related problems encountered by these rating agencies are –

Information Asymmetry–

It is a situation in which one party in a transaction has more or superior information compared to the other(s). Although the rating agencies are expected to remove the fog of ‘asymmetric information’, many a time they also fall prey to this problem. If the company which they are rating, undertake fraudulent activities which these agencies are unaware of and said activities are revealed by the media, then the rating agency will have to suffer the resultant skepticism about their credibility. In laymen’s terms, the financial statements of the companies received by these rating agencies for the purpose of credit rating are already audited. The company very well knows that their financial statements are fraudulent and the auditing done by their auditing firm is just for namesake. Hence, when the ratings of this fraudulent company are published to the media by rating agencies and if something happens on the contrary, it is the rating agencies which have bear the maximum brunt of the market.

Adverse Selection –

It occurs when the potential borrowers who are the most likely to produce an undesirable outcome – i.e. the bad credit risks – are the ones who most actively seek out a loan and are thus most likely to be selected. In other words, adverse selection is a phenomenon wherein the seller is confronted with the probability of loss due to risk not factored in at the time of sale. This occurs in the event of an asymmetrical flow of information between the seller and the buyer.The adverse selection problem comes in the rating industry from the fact that risky borrowers (risk-weighted at 150%) with downgraded ratings will require more capital to give to the banks, that needs to be set aside to guard against the risk of defaulting, and therefore that particular company will bear higher costs of borrowing from it. So when a rating agency gives ratings on the basis of asymmetric information, the problem of adverse selection rises as the banks fails to maintain the right amount of capital with itself and charge appropriate interest rates to the borrower.

Agency Problem –

It is a conflict of interest inherent in any relationship where one party is expected to act in another’s best interests. Many a time, companies ask for favorable ratings from these agencies for their projects and if they do not do so, they lose their market share as they do not receive any fee for the rating. Hence, rating agencies are tempted to act in the interest of firms, as giving ‘junk ratings’ to companies will lead to a lower probability of doing business once again with the same agency. So, such practices create a wave of skepticism for all the players of the credit rating industry and doubts about the ethics of doing their business. Injecting more competition in the industry will further aggravate this problem as this will tempt agencies to protect their market share by indulging in such activities.

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Ravi Kant has pursued Economics Honors from Ramjas College, University of Delhi. He loves watching Art Cinemas of bollywood and research in the area of Economics, English Literature, Strategy and history. He wants to be an eminent Consultant in the area of Economics and Strategy. Presently he is doing his MBA in Finance from Institute of Management Technology (IMT), Hyderabad.

Posted by The Indian Economist | For the Curious Mind