Opinion | Don’t malign CRAs based just on some instances
India has had proactive CRA regulations that have served it well. Today, we need more enforcement, not more regulations
The recent downgrade of Infrastructure Leasing & Financial Services Ltd (IL&FS) has led to criticism of the role of credit rating agencies (CRAs), specifically the conflicts in their “issuer pays” revenue model and their non-ratings businesses.
This is an attempt to provide counterpoints for consideration.
The first argument is that CRAs should not be in any business other than ratings because revenue from common clients can influence their judgement and rating calls. Such a contention would hold water only if a CRA does not have strong firewalls and has common teams for all businesses. But if there are appropriate governance structures and firewalls, additional income streams actually improve the CRA’s ability to assign correct ratings because it then can’t be swayed by the lure or loss of rating fees. A CRA with only rating fees for revenue will find downgrading a few of its largest clients and losing potential business a big challenge.
In India, Crisil Ltd and Icra Ltd have substantial non-rating revenues and the performance of their ratings is telling: they show the lowest default rates in the industry and yields on instruments they rated are closest to benchmarks. They also had the least number of cases going to the National Company Law Tribunal (NCLT) that had “investment grade” a year prior to default.
Some also question the “issuer pays” model followed by CRAs—where the entity issuing debt pays for the rating—saying it evokes conflicts and compromises on analysis. They contend “investor pays” and “government/regulator/stock exchange pays” are viable alternatives. While these models have their advantages and disadvantages, “issuer pays” is simply the best because of its ability to provide quality ratings to all at the lowest cost. Not surprisingly, this is the model followed across the world. “Issuer pays” affords CRAs access to company managements, which improves the quality of ratings. It helps provide ratings and updates to all stakeholders—investors, regulators, intermediaries and media—at zero cost, and gives access to all clients. Sceptics who say this model results in higher-than-warranted ratings should note that out of the 35,000-odd ratings outstanding today, 70% are in the “speculative grade”. And in last fiscal alone, about 2,500 ratings were downgraded. Clearly, CRAs have not shied away from their remit. Under the “investor pays” model, only those who pay get to know the rating. So if an issuance has to be rated at the behest of multiple investors, there would be a cost ramification. The conflict in “investor pays” would be about assigning lower-than-warranted ratings because it would help investors get better yields, and about avoiding downgrades that mark down investor holdings. Also, access to management will be limited, which can impact the quality of ratings.
The “government/regulator/stock exchange pays” model potentially obviates the perceived fee conflict and can make public all ratings for free, but it raises the question of moral hazard because ratings may seem sovereign-backed. Also, will it be the best use of public money when both issuers and investors can easily pay? Another drawback is that with business assured, there would be little incentive for CRAs to improve their standards.
Some also suggest rotating CRAs—just the way it’s done in auditing—saying that would reduce conflicts. That’s incorrect because auditing looks at the past and rating, the future. Asking a CRA to look at the future and then absolving it of responsibility in three to five years by asking another CRA to take over would evoke conflict because the former would tend to give higher-than-warranted rating knowing it won’t have to defend that for long. This will increase rating shopping. Past experience shows one of the main reasons issuers change CRAs is to get higher ratings. No surprises, therefore, that the “issuer pays” model is preferred across the world.
The IL&FS downgrades also triggered debate about the efficacy of CRAs and the utility of ratings. Sure, all CRAs need to take note of such sharp credit cliffs and the learnings it presents to improve their processes and methodologies.
CRAs have played a critical role in the development of the domestic debt market, spawning efficiencies and stability by providing comparable, transparent and forward-looking metrics for decision-making. They have enabled independent benchmarks for pricing debt, ushered in a culture of financial discipline, helped allocate capital efficiently by pricing risk appropriately, and supported financial innovation. CRAs have also brought in the international standard of “one day, one rupee default” and helped remove information asymmetry by ensuring over 35,000 ratings and their analyses are available publicly for free.
So what next?
For CRAs: CRAs need to introspect and strengthen their rating criteria, methodologies, processes and oversights. Conflicts, if any, need to be addressed to reassure stakeholders on the ratings process.
For regulators: India has had proactive CRA regulations since 1999 and these have served the market well. The raft of changes introduced over the past two years has ensured greater transparency, accountability and oversight than ever before. Today, we need more enforcement, not more regulations. That would mean vigorously questioning ill-managed conflicts, and analyzing if any CRA is regularly showing steep changes in ratings.
For investors: Investors have to look beyond the rating symbol and scrutinise the CRA behind it. The temptation to shop for a higher rating, but factoring in the risk in the pricing, needs to be avoided because it is faux comfort. Investors need to distinguish between CRAs using yardsticks such as default and transition rates, intensity of rating changes, ability to flag distressed assets, etc. For, not all ratings are equal.
Make no mistake, the IL&FS episode has learnings for all, but to malign the CRA ecosystem, which has served the market well for over 30 years, just based on that instance would be unfair.
Raman Uberoi is a senior adviser with Crisil
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