The Hindu Business Line : Credits and debits of credit rating

IT IS heart-warming news that CRISIL is the first rating agency in the country to publish extensive rating criteria for better transparency and disclosure. It is hoped that other agencies will follow suit. It would be relevant at this juncture to take a look at credit rating agencies and their functioning in general.

Credit rating agencies have a vital task to provide an objective and impartial opinion through their ratings on the ability of the issuer of debt to make timely payment of interest and principal in full. These ratings provide the investors with reasonably reliable information for them to make right decisions, notwithstanding the denial that these are not meant for individual investors for their investment decisions.

But the ground realities are that most investors are guided by these ratings, as they neither have the time nor information to critically analyse as these agencies do. For this purpose, high standard of practices through development of standards are essential and the rating agencies amongst them may develop a voluntary code of conduct reflecting the best practices to be followed.

It should be possible to have a standardised ratings system amongst the different agencies. It is quite possible for the issuers to object the idea of standardisation. Nevertheless, these agencies can perhaps co-operate with each other and share the information amongst them to improve the rating practices and standards. This will inject an element of common understanding. This will allow different debt instruments to be rated by the same standard and provide investors with reliable information for them to make right decisions.

They should, however, maintain and improve their credibility and reputation by avoiding conflict of interests, if any, in the decision-making processes with opportunity for the issuers to react beforehand to proposed ratings wherever permissible. This will result in better transparency and objectivity in the rating process

Of the two factors needed for a debt rating, the agencies rely for quantitative analysis on audited financial accounts without however verifying them in detail independently. They assume the correctness of disclosure in the financial accounts for working out the key financial ratios for operationalisaton of quantitative factors. The reliability and accuracy of these ratios are, therefore, as good or bad as the figures relied upon. This is a major drawback with which the rating agencies will have to live with.

The Government and the Institute of Chartered Accountants of India (ICAI) should take responsibility for a greater level of financial disclosure and transparency as also the enforcement of accounting standards. Else, the credibility of ratings will suffer for no fault of the rating agencies.

The accounting scams elsewhere in the recent past had exposed the failures of chartered accountants and other agencies in ensuring transparency and proper compilation of data, which resulted in the ratings to turn wrong. It would not perhaps be a bad idea if the rating agencies make public such assumptions made by using these figures that have gone foul by subsequent revelations. This will surely put the statutory auditors concerned, the companies involved and the company law department on the defensive.

In addition, these rating agencies embrace other qualitative inputs that may perforce inject some element of subjectivism with its concomitant limitations. What is needed ultimately to judge the efficacy of these ratings is a subsequent comparison of the actual with the assigned ratings, indicating the percentage of success or failure in forecasting.

This will, among other things, reveal the extent to which these agencies relied upon their subjective assessments and how good they were. Such a review of their performance should be made mandatory for some percentage of ratings each year and the results be made public from time to time. The extent and frequency of down-gradation should be an index of the quality of ratings and the information relied upon.

While on the subject, it would be interesting to know whether there exists now a common methodology amongst the various agencies and whether the quantitative parameters applied in rating a debt instrument are the same and even the areas for qualitative factors are uniform, though the judgment may vary from one another.

If there is such a uniform methodology in bond rating, wide variations in the ratings of the same instrument by different agencies should be minimal. Investors should, however, keep in mind that the agencies make after all human judgments based on qualitative and quantitative analysis to the best extent possible and the ratings serve the limited purpose of a guide and no more. Contrarily, the agencies should constantly endeavour towards an improved methodology to rating with reasonable accuracy and be focussed more on the needs of the investors than the requirements of issuers.

CRISIL and ICRA have associated themselves with foreign agencies of standing such as S&P and Moody's. This should help in upgrading their technology, perspective and exposure. Through such associations they may get involved in rating foreign companies also, besides getting their own rating methodologies upgraded and their operational skills honed. All the stakeholders would have no dispute that rating agencies should be independent providers of objective and accurate credit analysis with no control whatsoever from outside.

The need for independent high quality rating agencies is an essential component for the development of bond markets. This should not, however, preclude an independent and impartial review of some percentage of ratings each year by an external agency well acquainted with the system and appointed by the Central Government. Their report, finalised after discussions with the agencies concerned, should be made public.

It is not known whether SEBI or any other body is, at present, doing such a review. An independent audit of the working of CRAs may not be amiss especially in the context of the weighty role they play in the debt market through their ratings. This is considered essential in the context of the important role these agencies are playing. Who should do it and how it should be done is best left to SEBI. The findings should, however, be made public.

The consolidation of rating agencies advocated by some is not desirable. In fact, the acute competition among the three or four agencies to garner more business is welcome as they would be constantly alert to the need for efficient rating and their reputation. More the agencies, the higher the competition and better will be the quality of ratings. The existing agencies have been promoted by developmental financial institutions to facilitate the development of the debt market in the country. There can be no bar as in developed countries for private agencies also to set up similar institutions as a part of their developmental role. Large industrial groups outside the public sector who have an unsullied reputation for fair business methods can float rating agencies attracting high credibility for their ratings. It may perhaps be not wise or even desirable to vest in the existing rating agencies, the task of rating all specialised and complex areas such as corporate governance. There can be a specialised agency for this area, as it requires a different mindset and skill. It would not be wise to put all the eggs in one basket.

It is time a mechanism is evolved whereby those credit rating agencies that meet consistently high standards of success in giving credible and reliable ratings are given a seal of quality by SEBI or an international body somewhat akin to ISO accreditation for quality standards. Besides helping investors and issuers as a guide, it would serve as an incentive for other credit rating agencies to improve their practices to recognised standards.

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