One obvious flaw with the system is that no one has incentive to strictly check the credit worthiness of a borrower. You will be given fee to bring a customer and not to reject one. Right from the broker who brings the customer to the loan approval body, the cracks start. This percolates to the bottom of securitization process and to the rating agencies. Ultimately the risk that is transferred to buyer of the security is offset by one more abetting product Collateral Debt Obligation (Insurance for security).
Understanding the dire importance and different operational motive of rating agencies, it is suggested that the government should regulate them differently. Current norms say that a loan above 5Cr needs a credit rating from a authorized agency. The figure 5 crs might have arrived after many long brain storming sessions, but one reason for such a figure might be the sky rocketing fee charged by rating agencies.
To my little understanding, a rating agency, if gives bad rating to more and more customers, lose them in a long run though they might get an edge on the credibility side. They try to strike a balance between the both. For the same reason, there should not be any competition among rating agencies. In fact they should not be a profit making bodies.
Some regulatory body like RBI, SEBI or IRDA should come up to erase the faulty lines developed by the principal agency problem between the systems.
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