Role of Rating Agencies
Credit Rating Agencies (CRAs) assess the creditworthiness of a company. They assign ratings (AAA, AA, BBB) which tell investors "How likely is this company to repay its debt?"
Function in Governance
1. Independent Monitor
They act as a third eye. Since retail investors cannot visit the factory or interview the CFO, they rely on the Agency's report.
- Reduces Information Asymmetry.
2. Signal of Governance Quality
A high rating (AAA) usually implies strong governance (transparent accounts, stable management). A sudden downgrade often flags governance issues (e.g., hiding debt).
3. Disciplining Mechanism
Companies are terrified of downgrades. A downgrade raises their interest cost.
- This fear forces management to behave responsibly to maintain their rating.
Failures of Rating Agencies
- Conflict of Interest: The "Issuer-Pays" model. The company being rated pays the agency. This creates a temptation to give a good rating to keep the client.
- 2008 Crisis: Agencies gave AAA ratings to junk mortgage bonds (CDOs) because they earned huge fees.
- IL&FS Crisis (India): CRAs maintained high ratings on IL&FS right until it defaulted.
Note
Gatekeepers: Along with Auditors, CRAs are considered "Market Gatekeepers". When they fail (as in Enron or IL&FS), the governance system collapses.
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