As suggestions go, nothing can be more injudicious than the one recommending that credit rating agencies (CRAs) should be rotating, much like auditors.
Proponents of this argue that CRAs could develop cosy relationships with corporates who pay for their services and, therefore, not act in the best interest of other stakeholders. So, the thinking that led to the law mandating rotation of auditors should apply to CRAs.
Equating credit rating with audit is a cardinal flaw.
Also, while auditor rotation has innate advantages, rotation of CRAs can potentially disrupt the market.
The differences first. Audit, the Cambridge Dictionary says, is “to make an official examination of the accounts of a business and produce a report". And credit rating is “a calculation of someone’s ability to pay back money that they have borrowed".
To elaborate further:
■ Auditing involves examining past financial records and auditors can comment on whether debt was serviced on time during the period of audit. However, credit rating represents a forward-looking opinion on the ability to service the debt in future and involves bucketing the credit risk into various rating categories.
■ Auditors undertake an exercise that is based on clearly defined rules and principles. However, a rating is based on credit analysis and is inherently analytical, based on expert judgement.
■ A company is expected to have only one auditor who provides an opinion on the true and fair picture of the accounts; hence the rotation to get an alternative view after a lapse of time.
On the other hand, companies can, and many do have ratings from multiple CRAs. Thus, multiple opinions can be made available if a rating user desires. Last fiscal, 60% of bond issuances by value had ratings from more than one CRA.
Cons far outweigh pros:
Mandatory rotation of CRAs offers no real advantage. If the idea is to ensure diversity of views, that’s already there.
In some cases, regulators have made dual ratings mandatory. The Reserve Bank of India mandates it for those whose total commercial paper issuance in a calendar year is over ₹1,000 crore.
So, why try to fix what ain’t broken?
On to the cons:
One, rotation would absolve credit rating agencies of the responsibility for aggressive ratings of the past. If a credit rating agency is aware that it won’t be required to rate a debt after some time, it can’t be held responsible for steep rating changes that occur after its turn.
Second, CRAs may assign higher ratings and not downgrade on time if they know they would be rotated out. This will lower rating standards.
Third, it would encourage ‘rating shopping’ as issuers will likely switch to the CRA that offers a higher/convenient rating, which would be against investor interest.
Fourth, those who invest based on such ratings will find exiting tough given the endemically low trading volumes. They may thus be forced to hold on to potentially inflated credit opinion.
Fifth, the corporate debt market will have no reliable default/transition data as CRAs will stop assigning ratings after a certain period. This data is critical in any developed debt market, not just to compare CRA performance, but also for benchmarks.
These are reasons why rotation is not followed anywhere in the world for CRAs and other intermediaries. Imagine if a banker is asked to transfer loans after a fixed period, so as to accommodate diversity of credit views!
So, what is the solution?
Clearly, rotation is not a solution. Credit rating agencies need to re-build the confidence of stakeholders by ensuring greater transparency of criteria, tight and timely monitoring of credits, and unshakeable commitment to standards than chasing market share.
Tighter scrutiny of credit rating agencies by investors, regulators and media is critical and credit rating agencies that frequently get their ratings wrong should be penalized. Only then will they step up to the plate.
Raman Uberoi is consultant at Crisil.