Home > Opinion > Views > Opinion | A credit rating moratorium? Don’t shoot the messenger

Imagine being told that all testing and reporting of covid-19 cases should be stopped forthwith because it will create panic in the neighbourhood. The recent call in some quarters for a moratorium on credit ratings is just as skewed in its logic. The refrain is that credit ratings, and changes thereof, must be suspended during the current pandemic and lockdown because publishing their impact on credit profiles will affect debt issuers, corporate groups, lenders and investors, which, in turn, would make the credit profiles of issuers weaker than they currently are.

First of all, it is important for all concerned to understand that a credit-rating report is akin to a pathologist’s verdict. It objectively reflects the current credit profile of companies, using a consistent methodology backed by facts and a cogent rationale. Like a swab test for coronavirus infection, the credit rating process checks the borrower’s financials and business performance for the onset of health challenges and enables stakeholders to take appropriate action in response.

During an epidemic, the right thing to do is to increase the rate of testing and maintain, or even enhance transparency—and not go the other way. The same applies to credit ratings. These enable issuers, investors and lenders to get a handle on the credit health of companies. They are a critical input to lending and interest rate decisions, and thus facilitate the issuance of debt. In the secondary market, ratings facilitate the pricing of securities and act as a lubricant that reduces friction in decisions taken to either buy or sell these.

What would happen if all credit ratings were put on hold? Scepticism will increase if they are believed to be higher than warranted, and cause further risk aversion among investors. Primary and secondary market transactions would show a significant decline, perhaps even come to an abrupt halt. This would result in a dislocation of the debt capital market in the country at a time when it can afford no further disruption. Corporate bond yields would likely spike even for strong issuers. Banks would find themselves under-capitalized for the real credit risk they are carrying. And since the regulatory capital required of banks is linked to their external credit ratings, this will have follow-on ramifications on the broader economy.

Worse, disruptions caused by any such moratorium on credit ratings would intensify once the lockdown ends, because companies will then have to be evaluated afresh, which could spawn a raft of potentially sharper rating changes, which could catch investors on the wrong foot and lead to a general loss of confidence in debt instruments.

Proponents of a moratorium on credit ratings must understand such consequences. They argue—with little data or analyses—that rating actions are “pro-cyclical". That is, too many ratings are upgraded when an economy is doing well, and vice-versa. This is a logical fallacy, because if it were correct, then there should be more upgrades when an economy is—or companies are—not doing well. How bizarre is that?

Sure, it is reasonable to expect credit ratings to demonstrate a broad, through-the-cycle stability. An assessment of the actions of any credit rating agency with a consistent track record will substantiate this. Crisil’s annual upgrade and downgrade rating actions, for example, have moved in a relatively narrow band around 10% and 8%, respectively, in the three business cycles witnessed since 2008. Put another way, only one out of 10 outstanding ratings was upgraded, and even fewer downgraded. Most of Crisil’s ratings since then were reaffirmed.

To be sure, once in a rare while comes a black swan event such as the covid-19 pandemic which no market participant, including rating agencies, investors, regulators or governments, could have divined for the purpose of their forecasts and assessments. Sharper-than-usual changes in share prices, indices, yields, credit ratings, and significant government and regulatory actions are par for such a course because the intensity, spread and duration of a pandemic like covid-19 cannot be foretold.

The so-called pro-cyclicality of ratings, thus, is a non sequitur.

Rated portfolios need close surveillance, more so now, with rating actions predicated on the resilience of business models and strength of balance sheets, especially liquidity. At the same time, another moratorium—on loans, permitted by the Reserve Bank of India—and steps taken by other regulators have proven apposite by providing additional liquidity to companies and averting a default epidemic.

It is also important to distinguish between a default and a rating downgrade. A downgrade by a notch, say from AA to AA-, driven by weakening of a company’s business performance or financial profile, especially liquidity in the current context, only means that on a scale of 1 to 20 (where 1 is the best and 20 indicates default), a company earlier at “3" has now been assessed slightly lower, at “4". This is very different from a rating revision to “D" or default.

A moratorium on rating actions would clearly be an unwarranted remedy that will hurt rather than heal the country’s credit sector. It would also be antithetical to the fiduciary remit of credit rating agencies to ensure the transparency and timeliness of their opinions.

Ashu Suyash is managing director and chief executive officer, CRISIL Ltd

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