Rating agencies and markets

Following the recent downgrade of a prominent company from a high rating to default category, (Indian rating agencies fight trust deficit, 25 October, Mint) questions have been raised about the credibility of Indian credit rating agencies.

The concerns in this specific case are indeed valid. But it is also important to consider a rating agency perspective on these issues. There are three issues at hand. There is a strong case to believe that the problem of assigning incorrect ratings is not widespread and that Indian rating agencies have, on the whole, served markets well. Second, it is important that markets do not paint all rating agencies with the same brush—it is time that investors start differentiating between different rating agencies. Finally, Indian regulations for rating agencies have been proactive, strong and dynamic and even ahead of global regulations. These have been a strong supporting factor for the industry.

Over the past 25 years, India’s credit rating industry has played a pivotal role in raising standards and strengthening the credit culture that prevails in the country. With 20,000 firms rated, India has one of the largest pools of rated companies globally. While some ratings have been questioned, the problem of “wrong” ratings is by no means widespread. The public availability—free of charge—of rating rationales on 20,000 firms has significantly improved transparency in the system. The coverage of smaller companies has brought them to the notice of investors and banks, and enhanced their fund-raising opportunities. As ratings subject companies to public scrutiny, companies are more conscious about financial discipline and timely servicing of their debt. Independent benchmarks provided by ratings help markets price debt more efficiently.

Today, there are six credit rating agencies registered with the Securities and Exchange Board of India (Sebi). There is a strong case for investors not to automatically equate the ratings of all agencies and they need to be aware of the differences between them. For example “AA” ratings of all raters are not equal, since their methodologies and analytical standards differ. As investors are the primary users of ratings, we believe that they are best-placed to make a relative evaluation of Indian rating agencies. The lending and investor community comprises principally of institutional participants who can easily make such an assessment. Most of the information to evaluate agencies can be freely obtained from their websites. Some key factors from this framework are:

• The best report card of a rating agency’s performance is its published default and rating stability rates. Sebi has made this publication mandatory. When investors compare the default and stability rates across Indian agencies, they will see a clear difference. It is, however, important to ensure that the data pertains to the entire history of the rater. If default statistics are published only for selective years of economic upswings, they will provide an inaccurate picture.

• Does the rater recognize defaults on time and downgrade ratings to “D”? Sebi regulations require that rating agencies recognize default in the first instance of missed payment. In actual practice, however, raters set different forbearance limits in their default recognition policy. There are examples of companies that are delaying debt repayments and are referred to corporate debt restructuring cells of banks, but still do not carry a “D” rating from some raters. Crisil does not indulge in this practice.

• Are the criteria used by these agencies aligned towards investor protection? Some examples which reflect investor-oriented criteria include: insisting on liquidity back-up plans for confidence-sensitive instruments such as commercial paper and treating foreign currency convertible bonds as debt and not equity.

• How does the rating agency manage conflicts of interest? Is there a true segregation of business development, criteria development and analytical teams? One can check the rater’s website to see details of key personnel and their responsibilities. This is insightful in making an assessment.

Investors and fund managers should guard against the temptation of using a higher rating on an issuer, irrespective of the answers that the above questions throw up. There is anecdotal evidence from investors that higher ratings provide them with the best of both worlds—the yield of a lower-rated paper with the stamp of a higher rating. But if an “AA” rated paper is priced at the level of a lower rated (say “A+”) paper, investors should be wary, particularly in sectors such as infrastructure, real estate and non-banking financial companies. In the long run, this will damage the interests of investors.

India was one of the first countries globally to have regulations for rating agencies as far back as 1999. The regulations are robust and have helped in building confidence in them. Rating symbols are standardized and strict governance and disclosure standards are imposed. Strong regulations ensured that the Indian raters came out unscathed from the sub-prime crisis. A report of the high-level coordination committee of financial sector regulators commented: “The committee feels that prima facie there is no immediate concern about the operations and activities of credit rating agencies in India even in the context of the recent financial crisis.”

Credibility is the life-blood for a rating agency. The rating industry as a whole needs to keep raising its standards. A slip by one agency can affect the others.

Roopa Kudva is managing director and chief executive officer of Crisil.