Photo: iStock
Photo: iStock

Credit rating: The agency problem

Rating agencies need to work towards reducing information asymmetry between the issuer and investor

Credit rating agencies (CRA) in India suffer from chronic problems in multiple dimensions. They work towards maximizing CRA shareholder value by way of increasing revenues from issuers, while trying to provide independent ratings for the consumption of investors. As that may sound convoluted, let us take a step back and understand why rating agencies have attracted unwanted attention for some time now.

CRAs were set up to provide independent evidence- and research-based opinion on the ability and willingness of the issuer to meet debt service obligations, quintessentially attaching a probability of default to a specific instrument. Evaluating the creditworthiness of an instrument comprises of both qualitative and quantitative assessments, making credit rating far from a straightforward mathematical calculation.

There are four CRAs approved by the Securities and Exchange Board of India (Sebi) in the country. Since all four rating agencies approach the same set of clients, CRAs have little bargaining power in terms of selecting the instrument to rate. Regrettably, on many occasions, the CRA quoting the lowest price or quite shockingly promising an investment-grade rating beforehand wins the mandate. Post receipt of rating fee, the CRA begins the rating process.

Rating analysts conduct comprehensive management discussions, ranging from competition, business expansion, succession plans, to organization structure and much more. A classic example of these meetings is when the management refuses to share critical details. When the issuer decides not to answer some determinant questions, the rating may be principally based on public information.

The rating is reviewed by the rating committee of the CRA. Considering the issuer-pays model, CRAs are cognizant of the impact a rating may have on future business opportunities with the issuer. It is possible, therefore, that a tough decision may be sidestepped.

Once the rating is assigned, we would expect the rating to be published, thereby making creditworthiness of the instrument public. Unfortunately, the system does not permit publishing a rating without the issuer’s consent. In essence, if the rating is not as high as the issuer expects it to be, it can choose to go to another CRA and fish for a better rating. This takes away a lot of freedom from the CRA and puts it in the hands of the issuer. This is the reason why we hardly ever hear of non-investment-grade ratings.

Moving from an issuer-pays model to an investor-pays model doesn’t solve our problems. We may assume unsolicited ratings are free of commercial conflicts of interest. However, considering the bearing a rating would have on the reputation, interest costs and market cap of an entity, extracting information would be a hurdle. Issuers would not disclose the right reasons for declining sales performance or anticipated business problems. All discussions would be reduced to glorifying the entity, only to ensure a high rating. Importantly, CRAs would be unable to meet their operational costs and pay attractive dividends to shareholders.

Continuing with the issuer-pays model, CRAs may contemplate adopting the following best practices:

1. Incorporate predictive modelling techniques: Credit ratings are sticky and reactive, defeating the purpose of facilitating investor decision-making.

2. CRAs should refrain from providing advisory services to the rated companies, even via subsidiaries, as this entails conflict of interest. Sebi may look into this as part of its regulatory practices for protecting investors.

3. Avoid arriving at ratings with limited information, even if it means foregoing that mandate.

4. Disclose underlying assumptions, allowing potential investors to factor inbuilt risk in the final rating.

5. Operate on fixed fee structure, restricting competition to quality and not pricing.

6. Increase objectivity of rating models, thereby reducing subjectivity and cognitive bias.

The regulator, on the other hand, can minimize conflict of interest by:

1. Allowing peer reviews if a competing CRA disagrees with another on a particular rating.

2. Disclose an assigned rating to all registered CRAs, even if it is not published.

3. Build a surveillance policy, imposing stringent monitoring of an outstanding rating.

4. Encourage CRAs to come out with a minimum number of unsolicited ratings of large corporates per year.

5. If CRAs are providing research or advisory services to the rated entities, build governance and policy firewalls; audit the same judiciously.

6. Increase accountability of CRAs to provide better protection to consumers; this one will need intervention by Sebi by affixing some monetary or business implications. For example, restricting a particular CRA from re-rating an entity that defaulted above a threshold for a certain period of time.

CRAs need to work towards reducing information asymmetry between the issuer and investor. They need to strike a balance between business and quality. As Indian capital markets struggle with high-profile defaults and weak balance sheets, CRAs need to voice their opinion without being solely led by their business calculus.

The credit-rating market in India is oligopolistic, with high barriers to entry. CRAs should compete on quality and analytics than mere product pricing. Desperate measures to rate every possible instrument based on superficial research and low analytic rigour is myopic and exposes CRAs to high forward-looking risks for immediate gains.

Gunja Kapoor is an associate fellow at Pahle India Foundation.

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