The well-observed notion helps us to understand the paradigm shift in the roles of Credit Rating Agencies from diagnosticians to morticians for most of the times correcting the rating after the damage is done.
The credit for this can be given to “Rate shopping”. Well, this puts us to have a sneak peek into what goes behind this shopping. When a firm wants to issue its bonds they need ratings of their debt by a credit rating agency so that people can put up their confidence in the quality of the firm, services provided by them and also to satisfy the risk appetite exposed by them by investing.
All sounds good and in the interest of the investors and people but what has been found out is that companies rarely stick to the agencies which give the honest ratings and are accused to keep on moving to agencies until they find a better rating for their firm. It has been found that Indian credit agencies have a churn of about 35% as compared to the global benchmark of 8% in particular to this behaviour.
In India, though credit rating agencies are registered with SEBI they are regulated by both SEBI and RBI as they rate bank loans which comprise 70% of their business. As per global practice, the rating agencies are limited to rating and research related to credit ratings while all other business is carried out under separate entity with no directors, employee and shareholders from the rating agencies.
With many agencies functioning in India, companies have good number options to choose from and the issuer paid model plays its part well. The option which they get by choosing the agency of their choice is well leveraged by the unscrupulous companies to get the higher rating. Whereas it is no wonder that it leads to the weird race among the credit agencies to be the lenient one when we expect the stringency for the best quality analysis, to fetch the revenue.
CRAs hold a special value for stakeholder like investors, issuers, market intermediaries and securities regulator. the process if we look closely depends majorly on the type of CRA where few relies on the process whereby analysts form assessment based on quantitative and qualitative indicators and then report to rating committee while others focus on the quantitative model. But for some, the process may be proprietary. Nevertheless, the most common approach is to go for the rating committee which helps to initiate, withdraw or change the rating. Once the rating committee decides on rating the analyst informs the issuer of the rating and may provide the draft of the press release so that issuer can review of for the factual verification.
Ratings provided in the public domain is used to determine the nature and the integrals of the loan. Also, higher the credit ratings lower is the rate of interest offered to the organisations. If we look at credit rating agency as a separate domain away from the mainstreams the top five agencies are- CARE, ICRA, India Ratings Brickworks and CRISIL. Well if “Rate shopping” should be blamed or not is completely a personal opinion yet the rating agencies in India suffers from a chronic problem in various aspects. More or less all the agencies approach the same set of clients and so they try to quote the least price or in some cases not so surprisingly promise an investment-grade rating beforehand to win the mandate.
This is one aspect of it while other being the problems like reluctance from issuer side to share details about company management and even if shared the company takes the final call in case of publishing the ratings as the issuer’s consent is must before publishing. While the transparency level is not so healthy in our country the so-called good practices are farfetched idea.
What is at stake?
The economy as a whole is a vicious cycle “what goes in keeps on moving unless we have people who can fly away overnight with money.” Well, this is all like a mysterious story the more you dig in, the more are the portrays.
IL&FS (Infrastructure Leasing and finance services limited) is an Indian infrastructure development and finance company. The blowout at IL&FS was wake up call for lenders and napping rating agencies which assigned triple-A rating and failed to encapsulate stress building up in the company and also had a preconceived notion that support is provided by the shareholders.
IL&FS which brought with itself the terms like “bailout” which reminisced us of the crisis of Satyam computer when the government intervened to take the charge and remove the top management similarly only when the damage was done enough. Though it’s argued upon IL&FS being considered as NBFC as they are more into project funding and core-sector financing while NBFCs have significant retail operations, still IL&FS is being compared to NBFCs. Many NBFCs still suffer the impact of blow-up which has consequently affected numerous other industries including auto. The financial leviathan when disclosed that its outstanding loans amounted to a staggering Rs 91,000 crores, it created a widespread woe among those lending to NBFC (Banks and mutual funds) and also adding to the sluggish nature of the market and general sentiment that economy is not doing so good.
Banks are mostly presumed to shy away from financing auto sector for different reasons. According to the Society for Indian Automobile Manufacturers (SIAM), the NBFC segment currently finances almost 70 per cent of new two-wheelers and 60 per cent of new commercial vehicles in the country. And so, NBFCs are the lenders to auto sectors. But they are going through breakdowns due to liquidity crunch. If we see as a whole NBFCs are the best example of accessibility based positioning from a strategic point of view as it is rightly said reaching the last mile under the concept of bottom-line opportunity. It has touched the lives of people in many ways, your credit score can be as less as 600 still there will be an NBFC willing to fund you. Undoubtedly a few NBFCs have managed to raise money with almost 250 basis point higher than what NBFC paid i.e 9.5 to 10.25%. The whole lapse has affected both sectors as well as consumer in finance, housing or automobile as it said you name it and they are there but this time in terms of damaging.
What is way forward?
SEBI in its continued efforts to improve the functioning of the regulatory framework for rating agencies came up with new guidelines for enhanced disclosures. The guidelines miss out the crux “issuer paid model” or the rate shopping which has always been the point of criticism still it tries to restore the faith in agencies.
The current system of relationship between corporates and CRAs seems to be skewed in the sense that corporates hold maximum power seeing the oligopolistic nature of CRA present in the function.
INC (issuer not cooperating) status can be put to the firm if they refuse to provide relevant information for than six months putting “below investment grade”. This effects the rating agency in the sense that no CRA will be allowed to allot ratings until the current CRA resumes or issues a withdraw rating.
The move which is more of rule-based as the firms are considered in this case to be compliant. puts pressure as it necessitates the firms to provide necessary information to rating agencies on time otherwise which would lead to negative repercussions also switching among the agencies will not as easy as before.
Apart from this, a company’s liquidity position would include parameters such as liquid investments or cash balances, access to unutilized credit lines, liquidity coverage ratio, and adequacy of cash flows for servicing maturing debt obligation are to be considered. Reduction in Incremental spreads is something which investors demand that can be enhanced through the healthier credit system.
What additionally may be considered?
The probability default(PD) gives us an idea about the default rate in relation to the ratings. For example, the PD benchmark for AAA papers shall be zero for 1, 2 and 3-year default rate with a tolerance level of 1 percent, but the investors need to know about the default rate over three to five year from issuance.
Not only this it can be made mandatory for the firms to state the reason for rate withdrawal from the current one is written to SEBI which only if it is considerable can be allowed to switch. This move can be somewhat used to address the issue of “Rate shopping” as everything will be governed and scrutinized.
If we see the scope of scrutiny in the wake of IL&FS fiasco SEBI is planning towards considering the rotation of rating agencies. This would make the appointment of rating agency for two consecutive years as invalid. Besides the shift towards thinking that a fixed tariff in order to compensate rating agency is also a way forward. But sadly these moves rather the implementation are under scrutiny as they still have to face various proposals and meeting to get the green flag.
It was not for the first time that CRAs have missed out impending defaults but a long list of companies including DHFL, ZEE group etc. While India has 70-odd companies that are rated the highest quality, only two companies in the US enjoy this distinction. No company in Germany and the UK enjoys AAA rating. Among emerging countries, China has only 14 AAA-rated entities.
If rating agencies are a guarantee?
The defaults have made investors feel that rating is not a guarantee but simply an opinion which was actually meant to act as a factor on which people can rely or as sacrosanct.
Well, the issue of credit rating agencies is an easy one solve considering the complexity as it is something which even the developed markets have been struggling with. But given the complexity and the risks it entails it makes it more of a compulsion for an attempt to solve if not completely solve.