Credit rating agencies are in the spotlight for all the wrong reasons, again. When Infrastructure Leasing and Financial Services Ltd (IL&FS) and related entities defaulted on debt obligations last month, the agencies that rated its debt quickly downgraded them from high investment grade ratings (AA+ in some cases) to default/junk ratings.
A number of mutual funds were caught off guard, too. According to data collated by Value Research, at least 10 mutual fund schemes had an exposure of over 7% to IL&FS debt.
Not that they can blame the credit rating agencies entirely. Yields for IL&FS paper were significantly higher than other AA+ rated debt.
Clearly, for institutional investors, the high investment grade ratings weren’t worth the paper they were written on. The fact that many of them still took large positions in IL&FS points to yield chasing, with the high ratings providing merely a garb of a low-risk investment strategy.
Perhaps, one can say, the mutual fund industry has got the credit rating agencies it deserves.
But all of this begs the question: What purpose do credit rating agencies serve? If market-determined spreads on corporate debt paper are far better at predicting defaults than rating agencies, why should the market dole out generous fees to a handful of rating firms?
Crisil Ltd, for instance, has alone earned nearly ₹ 500 crore in revenues from rating services in the past 12 months at a high profit margin of 35%.
It has done so with disclaimers that say its rating is only an opinion expressed in good faith, and that it is “not a substitute for the skill, judgement and experience of the user making investment decisions".
Other rating agencies have similar disclaimers.
Ironically, the reason they get away is regulators such as the Securities and Exchange Board of India (Sebi) encourage, and even mandate, the use of their ratings.
Regulators, then, are at the heart of the problem related to credit rating agencies.
Lawrence J. White, professor of economics at New York University’s Stern School of Business, suggests in a paper published in the Journal of Economic Perspectives that regulators should shift the weight of so-called safety judgements on debt instruments to regulated institutions such as mutual funds.
Of course, this would be done with oversight by regulators; but institutions would have the freedom to choose on how it evaluates the risks of its bond holdings.
The key here is good regulatory oversight. After all, if chasing high yields has been a weakness for the mutual fund industry, it may not take much for them to find someone to provide a favourable rating and hide risks.
White’s suggestion is one among other proposals that seek to deal with the glaring conflict of interest in the ‘issuer pays’ model, where an issuer of debt securities also pays for the credit rating. In a phenomenon called rating shopping, issuers choose the agency that gives them the most favourable rating, short-changing investors in the process.
But critics of the alternative—the ‘investor pays’ model—say that it leaves room for some market participants to free-ride on services paid for and obtained by others. Perhaps, a form of an ‘investor pays’ model can be considered by Sebi, where the rating fee is borne by all investors who subscribe to a debt issuance, in proportion to the size of their bids.
Another model proposed to prevent rating shopping came from White’s colleagues Viral Acharya and Matthew Richardson. In their book soon after the 2008 financial crisis, Restoring Financial Stability: How to Repair a Failed System, they suggested regulators create a centralized clearing platform for rating agencies.
While issuers still pay the rating fee, the centralized clearing platform would assign a rating firm for an issue using its discretion.
Acharya and Richardson argued that this takes care of both the free-riding problem of the ‘investor pays’ model, and the rating shopping problem of the ‘issuer pays’ model.
Despite the number of suggestions that came to fix the rating agencies problem after the global financial crisis, the sad truth is that nothing much has changed.
IL&FS’ jump to default and the losses in mutual fund schemes should cause Sebi to wake up and smell the coffee. If Sebi wants the market to rely on credit ratings, the least it can do is heavily penalize firms that didn’t do enough to warn investors of credit risks.