Photo: iStockphoto
Photo: iStockphoto

Loyalty dilemma of auditors and rating agencies

Regulatory oversight focuses on customer protection and also minority investor protection

Every time I visit the Decathlon sports chain, a sports goods multi-national, I realize that there is no one selling products there. There have been instances when the salesperson actually advised me to buy something cheaper than what I was looking at. The salesperson was doing what I would call “right selling". Having come from the financial services industry, where product selling (many times mis-selling) is the focus, it’s quite a refreshing change. 

Typically, any business has three stakeholders—the customer, the employee and the shareholder or owner. Regulatory oversight focuses on customer protection and also minority investor protection. Some non-fund based businesses in financial services, such as investment banks, rating companies, distributors and the chartered accountant (CA) community, in general, have what I call the loyalty dilemma. Investment bank’s loyalty is still tilted in favour of the issuer with adequate disclosure of past performance. Distributors clearly have to be loyal to the investor rather than the manufacturer (a mutual fund or an insurance company). The slow shift to “investor pays" has started with the direct option nudge from the Securities and Exchange Board of India (Sebi).

Chartered accountants: The CA community has come under lens in recent times with a large number of financial frauds going undetected. The government has recently set up the National Financial Reporting Authority (NFRA) to regulate this community. CAs are supposed to give a true and fair picture of the company they audit, especially for the benefit of the minority shareholder. However, they get appointed by the company management (read majority shareholder) and are expected to earn fees from the management as also question the management. Is there a possibility of minority shareholders appointing the CAs? A case in point is Sebi auditors on mutual funds, who get compensated by Sebi. Perhaps one can also consider a technology-led platform of the regulator on which CAs can bid for the assignment with a transparent selection process, giving due weightage to the size of the company being audited, the size of the audit firm, fees charged, etc. This would perhaps do away with the whole process of fierce marketing for the audit mandates, which itself leads to a conflict. A debate on this is necessary. 

Rating agencies: The cost of funding for issuers has a direct relation with credit rating. While the loyalty of the rating agency has to lie with the investor rather than the issuer, the “issuer pays" model has led to the “rating shopping" phenomenon. Moreover, rating companies also have non-rating earning streams that often come from the same issuers, increasing the conflict. In fact, non-rating revenue of many rating agencies is significantly higher than rating revenue. The non-rating services (or consultancy services) offered to issuers include risk management consulting, debt restructuring consulting, regulatory advice and monitoring services. In fact, in the developed markets, we have seen ratings assessment services, which encompass pre-rating analysis, which helps the issuer get a better rating. 

A recent research paper—Non Rating Revenue and Conflict of Interest—by Baghai & Becker of Stockholm School of Economics, part of the NSE-NYU Stern School of Business Initiative for the study of Indian capital markets, studies the relationship between issuers and raters in India and examines whether these commercial ties are correlated with differential ratings treatment. This study was possible as Indian rating agencies need to disclose the compensation arrangements with the issuers of debt securities. The paper finds that rating agencies rate securities issued by companies that also hire them for non-rating services, 0.3 notches higher (than agencies that are not paid for such services by the issuer). The paper also finds that, within rating categories, default rates are higher for firms that have paid for non-rating services. This suggests that the better rating that such firms receive does not reflect lower credit risk. 

More importantly, one needs to address fiercely competitive marketing by rating agencies, which leads to this conflict. The “issuer pays" model has to be done away with the regulator stepping in with an innovative technological platform and a transparent process based on which rating agencies can bid for the rating assignment uploaded by the issuer in a transparent manner. 

Technology-led initiatives in future should address these conflicts. Self-regulation is not necessarily the way ahead.

Sandesh Kirkire is IMC Pravinchandra V Gandhi Chair in banking and finance, Jamnalal Bajaj Institute of Management Studies. Views are personal

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