Graphic: Ajay Negi/Mint
Graphic: Ajay Negi/Mint

Regulating credit rating agencies

The issuers obtaining non-rating services have higher ratings and default rates suggesting conflicts of interest

Credit rating agencies (CRAs) in India generate significant revenue through non-rating activities undertaken by their specialized subsidiaries. On average, about 40% of the total revenue of the rating agency stems from non-rating activities. A recent study by Ramin P. Baghai and Bo Becker, Non-rating revenue and conflicts of interest, provides convincing evidence that such non-rating activities generate significant conflicts of interest with respect to the main service that CRAs provide to the economy—ratings of the issuers. Given the pernicious role of CRAs in the financial crisis of 2008-09, the Securities and Exchange Board of India (Sebi) should take note and appropriately regulate the CRAs to eliminate these conflicts of interest.

Fundamentally, the concerns with the ratings system are related to the conflict of interest generated by the rating agencies’ “issuer-pays" business model. CRAs are mainly paid by the companies whose securities they rate. These companies benefit from favourable (high) ratings on them or their securities. Therefore, the compensation arrangement leads to a conflict of interest. The heart of the problem lies in the flow of money from issuers to raters.

The commercial ties between issuers and raters have two components: first, CRAs perform rating services, usually charging according to a standardized price list; second, agencies perform a variety of non-rating services such as risk consulting, funds research and advisory services. One example of consulting services is a ratings’ assessment service, which encompasses pre-rating analyses as well as assessments of the potential effect of a hypothetical transaction, such as a merger, spin-off, or share repurchase, on an issuer or security credit rating.

Despite maintaining a Chinese wall between advisory services and rating services, rating and non-rating entities have common ownership and top management. Recognizing such conflicts of interest, CARE’s board decided to discontinue its advisory service business and their activities are confined to only credit rating and research activities.

CRAs maintain that while non-rating services do pose conflict of interest challenges, revenues from other services reduce dependence on rating service revenues and thereby enable them to maintain objectivity and independence. However, the evidence does not support their claim of objectivity and independence.

The study employs data on the rating and non-rating activities of all CRAs in India from 2010 to 2015. It finds that a CRA that provides non-rating services to an issuer provides higher ratings (designating lower default risk) to that issuer when compared to the rating provided to the same issuer by other agencies. The authors are extremely careful in controlling for all possible confounding factors. After controlling for various confounding factors, the distribution of ratings of issuers with non-rating services clearly dominates that of issuers without non-rating services. Additionally, the study examines the amount paid for consulting and finds that issuers obtain higher ratings the more (non-rating) revenue they generate for an agency.

The most uncomfortable evidence, which clearly suggests conflicts of interest, comes from comparing the defaults among issuers that pay for non-rating services and issuers that don’t. If higher ratings assigned by agencies to those issuers that pay for non-rating services are warranted, then default frequencies should be similar for firms within a given rating category, whether or not these firms have a non-rating relationship with the rating agency. If such issuers instead are treated more favourably, their ex-post default frequency would be higher than for other issuers with the same rating. The study finds support for the latter case. As the chart shows, within a given rating category, firms that pay for non-rating services have higher one-year default rates than other firms. The fact that issuers that obtain non-rating services have higher ratings but higher default rates clearly points towards significant conflicts of interest despite claims of objectivity and independence by CRAs.

These results likely constitute a conservative estimate of the scope of the agency problem. The authors’ methodology centres on contemporaneous payment flows from non-rating activities. Issuers and CRAs have long-term relationships, and past or future business, rents or cash flows may be as important as those that are contemporaneous. Given the short time series dimension of their data, the study cannot investigate this aspect in great detail. However, the study does find that the association between ratings and non-rating fees holds with a one-year lag as well.

Anecdotal evidence supports such conflicts of interest as well. An internal S&P email from the case United States of America vs McGraw-Hill Companies Inc. highlights this conflict of interest: “I mean come on the study pay you to rate our deals, and the better the rating the more money the study make?!?! What’s up with that? How are you possibly supposed to be impartial????"

Referring to non-rating services, Fitch chief executive officer Robin Monro-Davies stated in 2001 that “(w)e looked at doing it and we saw the potential conflicts. If you guarantee a ‘triple-A’ [rating] to a company, it becomes more difficult to change your mind afterwards".

Sebi should therefore take strong note of the worrying evidence in this study and appropriately regulate the CRAs to eliminate these conflicts of interest. Overlooking this issue may sow the seeds for an Indian version of the destructive role that CRAs played in the financial crisis of 2008-09.

Krishnamurthy Subramanian is associate professor of finance at Indian School of Business and a board member at Bandhan Bank and NIBM. He was a member and director of research of the P.J. Nayak committee.

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