The credit ratings procedure

The credit raters are not to blame as such; they only review the data and aspects of a company presented. It is a consensual process, in that the agencies do not barge in uninvited, nor do they pay surprise visits. The company visited pays for the inspection, or it may have been requested and funded by a party intending on buying a large stake or take-over.
If the firm wishes to hide or misrepresent the truth, then it is difficult for the rating agency to find out the accurate picture. The rating agency may be given a short time of a day or less to make an inspection of the company. More complex inspections can take a bit more time on site. Follow visits may be done in one or two hours some time or years later. Such visits can be rather superficial inspections, depending upon the conditions, but time is tight and the extent of cover-up would be difficult to spot in many cases. So, deep information is unlikely to be revealed where intent of deception remains.
Nevertheless, many unbiased analyses are made by the credit raters where a “favourable assessment cannot be bought”. Rating agencies disagree more often on banks and insurance companies. The strength of a balance sheet in a financial company can be difficult to assess, even after several on-site visits.
Where the subject field is broader, there is likely to be even more room for controversy and disagreement. Sovereign, market, interest rate or currency risk carry a lot of attention. The room for surprise is quite large. The rouble’s dramatic devaluation in 1998 or the Argentinean peso in 2001 reflect how experts can get it wrong.
Yet, banks and financial institutions cannot blame the credit-ratings agencies. This former get-out clause is further closed where the banks themselves choose to gauge their own risk rating under the Basel II AMA (Advanced Measurement Approach) or IRB (Internal Ratings Base) system proposals. Yet, the blame for a bad investment decision cannot reasonably be laid at the door of the raters. Caveat emptor clearly states that caution had to be exercised by the buyer, and no ratings agency forced investors into Argentina or WorldCom.
Frankly, it is not the job of the rating agencies (Moodys, S&P, Fitch) to be the world corporate police officers. All they do is survey past data and monitor news releases or pay a short visit to the companies themselves. The ultimate decision on investing money after the assessment of fundamental enterprise risk rests with the owner of the capital of the person who is mandated to make the choices. The passing the buck:
“I only made the decision because the credit-raters told me it was a good company”, is an insufficient excuse. To say anything less would be cowardice, and chicken capitalism thrives.
Business investment decisions must be made by the investor, resting upon a straightforward train of processes:
1. Formulate business plan.
2. Marry risk appetite to risk offer.
3. Manage reputational risk/due diligence.
4. Risk support/risk monitoring.
Not only is risk appetite directly linked to risk offer, but risk appetite is also covered by regulatory capital. Risk support means that the danger of capital becoming inadequate to cover expected losses automatically signals an alert to the bank. What we have created is a web-based system for warning of banking danger areas.
The spectre for shouldering risk increases under the latest Basel II standards where “higher rated” banking and financial institutions choose to rate their own risk under AMA (Advanced Measurement Approach) or IRB (Internal Ratings Base). This essentially means that the banks will develop their own ratings systems (geared towards showing that they are lower risk banks) and justify their models to the regulators. Naturally, it would be in the banks’ best interests to portray themselves as lower risk to the regulators and the credit-ratings agencies. It is going to be very interesting what sort of assumptions and theories underpin their models.