THE paralysis in the credit market has arisen from the failure of that most fundamental tenet of banking: trust.

Reestablishing the trust that investors had in the world’s leading banking centres will not come easily. Institutions’ measures of goodness have been shaken to their foundations.

A key expression of that trust was found in the faith placed on the judgments delivered by the credit-rating agencies. They were trusted commentators on the fundamental credit risk of companies, shares and bonds.

But with the evidence that is now available, it could be argued that those agencies are fundamentally flawed and maybe even dangerous in a global financial system.

First, let’s examine the incentives that drive the behaviour of ratings agencies. Who pays for the agencies’ commentary?

If you were buying a house and wanted to be sure that it was sound, you would pay a surveyor to assess it. You would expect that buyers of bonds and shares in the financial world would pay the credit-ratings agencies to assess the soundness of the instruments they are going to buy. You would be wrong. In the highly paid financial-services world, the organisation selling a credit risk pays for the rating.

Imagine the outcry if a lawyer from whom you sought advice on a contract were to be selected and paid by the other person in the contract, even though it is you whom he is advising. That would be unthinkable.

But it has been perfectly acceptable for an organisation selling billions of dollars of credit risk to select and pay the agency that does the rating - on the basis of which that risk is then sold into the market.

Second, let’s examine the governance of the organisations that deliver the “safety assessment” of financial instruments. Are they accountable to the wider market? No. Are they fully accountable to a financial regulator with strong teeth? Not really. Are they accountable to governments or global financial entities? No, again.

Third, consider the organisations themselves. As a trainee in the finance industry many years ago, it seemed entirely reasonable to me to expect that the people in the agencies who made the analyses on which the ratings were based would be highly specialised actuarial professionals with years of training and that there would be a professional association that certified each individual. It didn’t take long to realise that this was not the case.

At least one highly regarded financial institution has privately complained that the ratings agencies’ analysis of the sub-prime market focused not on the risk of default of the underlying creditor - the homeowner - but on the level of loss in the financial institutions that gave out those mortgages.

This is plausible at one level but fundamentally ignores the true credit risk. In a rising housing market, when the borrower can’t keep up his payments, the mortgage lender can repossess the house and might even make a profit by selling it to someone else. The fact that mortgage defaults are occurring may not be apparent in the financial performance of the originator.

So what’s to be done? Three propositions seem obvious.

First, there should be better regulation. The agencies must have policies and processes to follow when making their assessment of a credit risk. This regulation should ensure that ratings delivered in different markets and in different asset classes should be comparable. Many leading market participants believe that they are not comparable at the moment.

Second, the professionals in the agencies should be required to be accredited, regulated members of a professional body with the same rigours that are applied to accountants, lawyers and doctors.

Third, the market should commission and pay for credit ratings. The fees should be paid by exchanges, perhaps in proportion to the financial values traded on each exchange. This will remove the incentive for agencies to compete on how positive an approach they might take.

Whatever the international complexities, there is a major prize to be gained - global market stability and confidence – through ensuring that ratings do what they say on the tin: that is, be reliable predictors of financial performance and reasonable bases for investment decisions across the market.

Tim Stone is the chairman of KPMG’s Global Infrastructure and Projects Group and an expert nonexecutive member of the board of the European Investment Bank. He writes here in a personal capacity

Times Recommends

• Lies and cover-up at MG Rover exposed by report
• High oil prices push manufacturing costs up
• Primark founder steps down as chief executive