Brickwork is just a brick in the cracked wall of ratings business

The regulator had earlier imposed penalties on Brickwork Ratings for delays in recognition of the default of non-convertible debentures issued by Bhushan Steel, even after disclosure of default. SEBI had also penalised it for its failure to downgrade debentures issued by Gayatri Projects. In addition, the order lists other lapses, such as not listing material information on press releases. It highlights conflicts of interest, such as the same individuals being part of the credit rating division and the business development division.

While Brickwork may have been egregious in the number of lapses it committed, there is a wider issue that goes beyond the immediate case pertaining to one rating agency. For there's an inherent problem with the credit rating business model, and this is a global issue. The subprime crisis of 2007-08 which turned US mortgage defaults into a global financial problem was a consequence of these unresolved conflicts of interest.

You might also like

Adani in talks with global investors to raise $10bn 

Why Indian music apps are a let-down: 4 charts 

GST profiteers return ₹500 crore to customers 

Why banks are buying more g-secs than they have to  

Credit rating agencies play a critical role as “gatekeepers to financial markets" (as the SEBI order states). Banks, pension & provident funds, mutual funds and other institutional lenders have mandates which bar them from investing in debt, unless it is rated at, or above, a certain level. Even with unsecured debt, the rate of interest charged varies inversely with the rating of the borrower. Secured debt (debentures and bonds) must be rated prior to being issued, and that rating requires regular review.

Agencies also offer other consulting services. One common example is “ratings assessment services", involving an analysis of the entity pre-rating, as well as assessments of the potential effect of balance-sheet impacting transactions, like mergers, spin-offs and share repurchases. Agencies are also often consulted on issues related to risk management, debt restructuring, deleveraging strategy, regulatory compliance, etc.

Ratings themselves are assigned on the basis of information made available to the team. But while these decisions are taken on the basis of well-known variables (such as balance sheet ratios, estimates of free cash flows and revenues, business models and growth projections), ratings are, in the final analysis, subjective. Quite frequently, the members of a credit rating team will differ on interpretations, and the rating assigned is that agreed upon by a majority of the team. Moreover, the business performance of the borrower has to be subsequently monitored for material changes.

One big problem is the payment structure: it is the borrower (debt issuer) who pays for the rating and that creates an incentive for the agency to assign attractive ratings. Somewhat counter-intuitively, competing agencies can actually make these conflicts of interest worse; an issuer can shop around for the agency offering the highest rating.

A second conflict arises when a rating agency is offering other services to an entity it is also rating. There too, incentive exists to bump up the rating. One way to mitigate this is to put up internal “Chinese Walls" between different divisions of the agency. If the same individuals are part of the credit rating team and also part of other business development teams (as in Brickwork), this obviously becomes even more of a problem.

Agencies therefore have to tread a very narrow line in adhering to best practices in governance and ethics. This means rigorous systems and processes must be put in place. In practice, this often does not happen. In the IL&FS debacle for example, the group had the highest possible ratings till the day it defaulted. Similar delays hurt investors in Jet Airways, Zee Group and Dewan Housing.

While there has been academic debate about moving to a model where lenders pay the agency, this has not happened in practice, even after the subprime crisis. Studies such as one by Ramin P. Baghai and Bo Becker (Conflicts of Interest and the Provision of Consulting Services by Rating Agencies: Indian Evidence) also claim corporates that consult with agencies for “other services" consistently receive better ratings. It can, of course, be argued that the consultants have helped improve processes.

SEBI has tried to put more checks and balances in place. “Sharp Rating Actions" meaning three-notch changes in consecutive rating periods must now be highlighted, and non-cooperating issuers (which are not sharing relevant information in timely fashion) must be flagged. These are useful steps. But it could be argued that the current rating agency business model continues to have inherent conflicts of interest.

Elsewhere in Mint

In Opinion, Manu Joseph explains why bosses like office so much. Nitin Pai argues why Elon Musk's "everything app" must be resisted. Rajrishi Singhal finds a common link between loan haircuts and freebies. Long Story asks: can a regulation for EV makers become a road bump?