Who Watches the Watchmen?

The Big Three: Standard and Poor’s, Moody’s Investors Service and Fitch Ratings are the gold standard in rating financial instruments. Any instrument without a rating from at least one of the Big Three, as they are known, is not taken seriously. Together they control about 95% of the ratings market share; Fitch at 15% and the other two roughly equal at 40%, in essence making it an oligopoly. More investors rely on ratings provided by these firms rather than performing their own due diligence, giving them the power to move markets. The Big Four: KPMG, Deloitte, Pricewaterhouse Coopers and Ernst and Young are the four largest accounting services firms in the world. This industry, though not an oligopoly, occupies a place of great importance as they audit most of the world’s premier firms and are different from the ratings agency by the virtue of information that is available to them. The individual investor cannot obtain accounting records to verify it himself, and has no other option than to rely on the accounting firm. What do these two groups of companies have in common?  Apart from the scams of course, they have a conflict of interest with their clients. The ratings agency and the auditing firms are paid for their services by the very firms they appraise. If this is the case, what prevents them from being benevolent in their action, with the ratings agency being generous or the auditing firm turning a blind eye to discrepancies? Absolutely nothing. Till date, the scams from the big four or the big X - since they were 8 at one point and through mergers and acquisitions eventually became the Big 5, have been the largest in the world, commensurate with their size. It was one such scam that took Arthur Anderson, one of the Big 5, out of business. Closer home, PwC was banned from operating in India for two years for their involvement in the Satyam Computers Scam.

It is the same case with the Big 3, if a firm feels S&P rated their instrument lower than the firm’s expectations, they simply go to Moody’s. If S&P’s and Moody’s rating differ quite significantly, then they approach Fitch, and it has been so for decades, if not a century. Since a firm might end up going to the competition, the ratings agency might give a generous rating affecting the whole market as to some investors, ratings are canon.

Apart from the conflict of interest, the rating agencies also wield a huge sway over market movement and there have been instances where they have been aggressive with firms that crossed them. One such instance is when Moody began to foray into European markets and wrote to firms saying they intend to rate these firms and they are welcome to participate in the process, and if they didn’t, Moody claimed to have enough information to do it anyway. In effect, Moody’s had made an offer that can’t be refused. This was thinly veiled blackmail. Another instance involving Moody’s was in mid-1998 when it approached Hannover Re, a German insurance firm offering to rate it. Hannover politely declined as it had been rated by S&P and one other firm. Few months later, Moody’s released an unsolicited rating of AA2, one notch lower than S&P’s. But in the following 5 years, Moody’s continued to downgrade Hannover Re all the while trying to sell its rating service, until in March 2003 when it had pegged the firm as junk, which sparked a drop in the market value of the company by 10% without the release of any new information, simply because Hannover wouldn’t pay. Post-2008, ratings agencies were also criticized for giving AAA rating to many contracts that failed.

Although marred with scams and scandals, this system has been the only one in use. Government regulators have tried to keep a check on accounting firms but have lapsed occasionally. In the case of ratings agencies, they are the government. S&P and Moody’s are officially endorsed by the US government. If this is the case, what is to prevent another scam?

There should be an overhaul of the system, so that there is a double blind in the process. Instead of the firms paying for auditing services or rating, they should instead pay a sort of tax to the government which then should outsource the process to another entity, preferably in secret. This will reduce the conflict of interest as the government can arbitrarily choose any firm with the capability to complete the task and will be employed only as long as they are extremely stringent. This however, creates a new problem, will these firms start lobbying for contracts? But if not the government, who else?

The whole problem is recursively a case of who can be the vigilant and incorruptible guardian. Or in better words, “Quis custodiet ipsos custodes” – “Who watches the watchmen?”

- Sai Kumar M