Should rating firms be on the hook for banks' books?

A man reads outside the New York Stock Exchange in this June 2009 file photo.

NEW YORK/WASHINGTON (Reuters) - Rating agencies could soon be held responsible for accounting shenanigans at banks and securities firms whose debt they rate, potentially shielding financial institutions from future prosecution.

Changes included under proposed legislation to overhaul U.S. financial regulation could crimp the ability of agencies like Moody's Investors Service, Standard & Poor's and Fitch Ratings to plead innocence when the information provided by the firms turns out to be bogus, legal experts say.

That could have some unintended benefits. For one thing, it would likely make the agencies more cautious about handing out their top AAA rating, a grade they had widely assigned to mortgage securities that later became toxic following the housing sector meltdown.

But analysts contend it would give securities firms, also under fire for their role in triggering the financial crisis, even greater immunity.

The proposed reforms could also restrict the flow of credit to good businesses since rating agencies might reduce the number of companies they rate, making financial risk more opaque.

"This may lead to the restriction of credit to creditworthy issuers," said Linus Wilson, assistant professor of finance at the University of Louisiana in Lafayette.

Ed Sweeney, a spokesman for S&P, said that is a very real prospect.

"Liability provisions as drafted in the Senate and House bills undermine the Private Securities Litigation Reform Act and create a discriminatory pleading standard for credit rating agencies that could hinder debt issuers' access to capital," Sweeney said.

A financial reform bill passed by the House last year sets out a gross negligence standard that would allow investors to sue the credit ratings agencies.

Financial reform legislation now before the Senate would allow investors to obtain financial damages if they can prove that the credit rating agency knowingly or recklessly failed to conduct due diligence on rated securities.

PARSING BLAME

Not that the rating agencies have not made their share of mistakes. The major ratings firms have been criticized for moving slowly on downgrades of troubled sovereign and corporate credits.

They have been criticized for assigning esoteric securities like collateralized debt obligations top AAA ratings, even when they included tranches of risky subprime credits, a practice that contributed to the worst financial meltdown since the Great Depression.

But that does not mean that ultimate responsibility should rest with them. Some observers say that making agencies responsible for the behavior of banks is unfair and instead say the blame should remain at the door of the big accounting firms.

"It's insane to think you can hold a rating agency accountable for poor accounting statements," said John Chrin, global executive in residence at Lehigh University College of Business and Economics, in Bethlehem, Pennsylvania.

Some legal experts fear the impact of restrictive U.S. laws could cause the agencies to pare back their operations in the United States, threatening the country's leading role in global banking.

"If we get this wrong on exposing the credit rating agencies to unlimited liability for not catching misstatements from the issuer and its agents, it may take a very long time before the credit rating agencies feel comfortable to return their main operations back to the United States," said Ford Ladd, an attorney at DiMuroGinsberg in Alexandria, Virginia.

Ratings agencies have found some measure of protection in current legislation, asserting that their views of corporate creditworthiness are forward-looking opinions rather than factual assessments.

Proponents of the proposed reform say letting rating agencies take the rap for questionable accounting practices at the securities firms they rate might have some useful secondary effects. By making the agencies less likely to give high ratings to banks, that could deter banks from borrowing excessively and taking extreme risks.

Yet analysts note there are other, more sensible ways of achieving that goal that do not unduly protect financial institutions from legal action, including more stringent capital and leverage requirements set by regulators.

Moreover, investors themselves should be sufficiently discerning, dismissing ratings they find unreliable.

"To the extent that a rating agency is doing shoddy ratings, investors won't want ratings from those firms and they will go out of business," Chrin said.

(Editing by Leslie Adler)

(For more business news on Reuters Money visit www.reutersmoney.in)