Just picture this situation: A senior ratings professional in a credit-rating company is asked to leave on grounds of non-performance, even though the real reason is that the person is not flexible with ratings. The decision is a human resources one, and hence no one can complain. The board says it is an internal issue with no room for debate. Hence a strong message is sent down the line for analysts to comply. Such a situation is not inconceivable, though rare, and points us to the broader issue of business management and ethical ratings.
The credit-rating business is unique because it has no skin in the game. For a bank, if money is not lent properly, an asset turning bad will haunt it later on. But an incorrect decision by a rating agency can’t be contested because it is only an ‘opinion’ and there is no recourse. Human error is always possible. Credit rating agencies (CRAs) talk of reputation risk. But then all agencies have some defaults to their names and the standard business practice is for some agencies to showcase to clients the failures of others, so all the beans are spilled.
Curiously, all large investors like mutual funds, insurers and pension funds are supposed to do their research before investing in debt instruments. It is unfortunate that they do not do so, and this was exposed during the recent non-banking financial company (NBFC) crisis, when they pointed fingers at CRAs. Even for private debt placement, which does not require a rating, ratings are often demanded by potential investors.
India has seven CRAs, of which three are big, two medium and two relatively small. The size of the cake is not growing and there is competitive pricing. One way to get ahead is to be flexible in ratings to build scale. The curious thing about the business is that in reality, AA (-) or AA or AA (+) ratings are actually almost the same, signalling a low probability of default. Hence, if the most reputed agency gives a AA (-) rating, another one can take a chance and give AA or AA+ knowing that a default possibility is remote. This is rational economics.
The advantage of a notched-up rating is that it keeps everyone happy. It is a win-win all around. Investors can invest in highly-rated paper as per their guidelines, banks save on capital, borrowers pay lower interest and the CRA gets its revenue. Often, companies move from one CRA to another when it comes to annual surveillance, a time when higher ratings are offered.
Mass defaults happen probably once in 10 or 15 years. Hence, ratings generally stand the test of time and agencies use the cumulative default ratio to show that they have done well. But the trick is to just expand the denominator and this explains the rush for public sector unit (PSU) ratings, which are all AAA as they never default. This helps lower that default ratio. Recall that some PSUs paid just a rupee to get debt of over ₹10,000 crore rated! This is one reasons why revenue growth for CRAs is not commensurate with the volume of debt they rate.
How can one address perverse incentives in this business? The problem is that CRAs tend to get listed to unlock value for shareholders. Once listed, they have to give relentlessly high returns, which is not possible. Some CRAs with an exclusive rating business have had net profit margins of over 50%, rarely seen in other fields. The CRA business thrives on ‘rent’, as debt issuers simply have to get their debt rated. Bank loans above a threshold have to get a rating under Reserve Bank of India rules, while the Securities and Exchange Board of India mandates ratings for public issues and investors insist on ratings for private placements.
If CRAs were not listed, then their quest for profit would not exist. They ought to be treated as financial-service infrastructure and should ideally not be listed to avoid those temptations.
The other problem with CRAs is that some of them have consulting or advisory services lodged in subsidiaries. This should ideally not be permitted because of an inherent conflict of interest. The financial crisis of 2007-08 had its genesis in CRAs giving the same clients advisory services as well as debt ratings. This is not directly permitted by regulation, but subsidiaries can earn good fees for services provided to a client which also gets a rating from their parent. Often, the work is done by the CRA but accounted for by a subsidiary. If the client relationship is worth good money, its rating can get flexible. As it may be hard to compel CRAs to sell off their subsidiaries, a rule can insist that the same client cannot be offered both services.
Since a credit rating is a powerful tool for investment decisions, integrity is critical. Plain profit motivation, though, can encourage compromises in a thin market. The ramifications of debt defaults have reverberated through the country in recent years. As CRAs face no punitive measures for their failures, we need to go back to the basics.
Arguably, an incorrect decision could be a genuine error, just as a notch-up can be an exception rather than a rule. One approach can be for the regulator to allot business. But then the market can blame the regulator for its choice of CRA in case of a failure. Alternatively, as suggested above, ratings and other subsidiary-provided services should be strictly separated. Another idea is that ratings should no longer be mandatory, which could make the market more discerning. Further, external rating committees should be made mandatory, especially if the debt being rated is above a threshold of say ₹500 crore, to ensure fair play. With three CRAs already listed, all this is worthy of consideration.
No comments:
Post a Comment