Wednesday, October 21, 2009

The future for rating agencies

Since the start of the global economic downturn considerable emphasis has been placed on the roles and responsibilities of various stakeholders. One group in particular that has had its share of the spotlight is credit rating agencies (CRAs).

There has been a significant amount of discussion in the media around the role of CRAs. The value of credit ratings has been widely questioned as have the perceived weaknesses in their processes (including not downgrading companies promptly enough) and the potential for regulatory reform. It is this last point which is particularly interesting.

There is no doubt that CRAs fulfil an essential role in the global capital markets. The ongoing role of CRAs is to instil confidence and integrity to our capital markets, the current challenge facing the industry is to restore the confidence, value and role of all participants in the marketplace.

There is a hurdle though, relating to conflicts of interest – real and perceived – which significantly diminish the value of their work. Ratings were perceived, at times, to contain bias (poorer quality) because of the financial incentives and future revenue rewards. Yet how do we respond globally to those perceptions?

We have seen the International Organisation of Securities Commissions (IOSCO) announce that it would update the Code of Conduct (and that has now been done) to provide more detail on minimum standards for regulating the activity of CRAs. And in Australia, CRAs will be required to hold an AFS licence and full details of this regime will emerge soon. But will this be enough?

It is interesting to compare this approach with what occurred with the global audit profession in the last couple of years.

After the collapses of Enron, Worldcom and HIH Insurance there was a global push to change the perceptions around the independence of auditors. Auditors were seen to be ‘too close’ to their clients at the potential detriment of users of their audit reports. In the United States we saw SOX reform and in Australia CLERP9 as two types of responses. We also witnessed the change in ethical standards and the increase in the requirements for auditors to fulfil, and the introduction of auditor oversight regimes (PCAOB in the US and ASIC in Australia) which independently examined the policies and practices of auditors regarding independence and quality. These were fundamental changes for auditors.

Perhaps most importantly of all, we observed that auditors recognised that they had to change perceptions. They could see they had to respond. They invested heavily in additional resources and systems to deal with new requirements, and as a result much has changed.

So when I compare what has happened with auditors, I can only sense that there will be much more to come with the CRAs. It is important there is balance in regulatory responses and public policy settings. It is also very important that the CRAs recognise the challenge of changing perceptions. There are some interesting times ahead.