By: Jameel Ahmad | FXTM

We are all subjected to tests and scorecards as we go through life, literally within seconds of being born we are given the Apgar test to establish our physical condition. As we progress up the age scale, we are scored on academic, athletic and professional levels. Tests and scorecards are useful tools to get a benchmark of standards and expectations of performance and ability. Similarly, the institutions we create to turn the wheels of commerce, are not immune to the rigors of testing, and in order to keep them competitive and accountable, they have to face an enormous amounts of scrutiny from various regulatory and compliance bodies. Perhaps the most deserving of these checks and balances are Governments, especially when they borrow money from other organizations, such as the World Bank and the International Monetary Fund.

There are three main agencies that run health checks on Sovereign debt and the debt that exchanges hands between large financial institutions and corporations. They are Moody’s, Standard and Poor’s and Fitch. The outcome of the scorecards have an enormous impact on the prospects of the institution that has been rated, so they wield a lot of influence.

The credit risk of a country or institution is assessed in much the same way as an individual would be, if they were applying for a loan, i.e. income, stability, prospects and past behaviour are scrutinized. If the country being evaluated has fiscal or political challenges, its rating is lowered. The end result is that investors may require higher returns to offset the risk. This is never good news because a high debt repayment burden, impacts cash flow and long term growth.

South Africa has recently had to endure a downgrade by all three agencies within months of each other, but they are not alone, all G7 countries have experienced downgrades of their financial institutions and or Governments in the last 7 years. The most recent countries affected by downgrades, are Canada and Australia, who have weakening credit conditions- due to surge in household debt

Ratings Agencies came about in the mid 1800’s to help investors get insights into the finances of canals and rail roads that were being constructed. There are actually many ratings agencies but the big three make up approximately 95% of the ratings industry. Moody’s Investors Service and Standard & Poor’s (S&P) together control 80% of the global market, and Fitch Ratings controls a further 15%.

The reason the big three are the “go to” agencies is largely because of their track record and their standing with the U.S. Securities and Exchange Commission (SEC).

In 1975, the SEC acknowledged their status under the Nationally Recognized Statistical Rating Organizations (NRSRO) banner. An endorsement from an NRSRO means countries and financial institutions wishing to issue bonds can do so efficiently, knowing that the official rating can be trusted. However, this comes with a caveat, the bigger agencies do not charge for information, they get their fees from the institutions that want to be rated. In theory, there could be conflict because there is an incentive to “please” the body that asks for the rating”. However this is unlikely because the reputation of the agency is based on the accuracy of the ratings, inaccurate ratings would canabalise their business.

Even heavy hitters like the big three make mistakes or perhaps get caught in the hype of strong market sentiment. The credit crisis in 2007 is a good example of this. When mortgage-backed securities were booming –they were given excellent ratings, even though the products were actually worthless. When this fact was exposed to the markets, it triggered one of the worst financial meltdowns in recent history.

Incorrect ratings, as we saw from the 2007 credit crunch, have the ability to destabilise a country and it is for this reason that the European Parliament set up a watchdog called The European Securities and Markets Authority and they have been tasked with making sure that agencies conform to a set of protocols that form a firewall between them and the markets. The rules state that agencies can now only issue ratings on a country three times in a year and they have to wait until markets have closed before they release their reports. Comments and ratings from agencies have a direct and profound impact on currencies, economies and markets, so it is vital that their reports and findings are accurate and well researched. When a county is downgraded for its sovereign debt, you will almost always see it play out in the currency and stock markets, so getting the rating wrong is not an option

The EU watchdog set up to monitor credit ratings agencies in the wake of the 2008 financial crisis has established good foundations, but significant risks remain to be addressed, according to a new report from the European Court of Auditors.

So the regulators need to be regulated too. While the Auditors highlighted some flaws in the watchdog, it has significantly helped to ensure the ratings agencies operate within acceptable boundaries and that their reporting standards are uniform and accurate.

Ratings agencies will continue to provide us with a litmus test on the health of nations and companies for some time. There have been suggestions to take the responsibility of ratings out of private hands and to get all nations to contribute to a central fund that allows a body like the UN to manage the ratings. There is certainly merit in not allowing private entities to make these massive decisions and in a world that has gone a little stir crazy on the political front, anything is possible.