The Hindu Business Line : Credit rating agencies

In India, there are cases where CRAs had suddenly downgraded an issue from a high level to the lowest default category, indicating faulty assessment and/or sloppy monitoring.

R. Viswanathan

Can there be any financial service provider, which is not at all accountable to anybody for its misdeeds?

Can this state of affairs exist even in the highly litigant society of the US?

Yes, dear reader, it is a credit rating agency (CRA). When a CRA commits serious errors of omission and alleged commission, the affected parties cannot hold it answerable. This was amply clear in the recent financial meltdown that had gripped the US and many western nations.

Is there a way of making the CRAs really answerable? Yes.

CRAs appraise the financial health, especially capacity to honour debt obligations of companies and even Governments. People who invest in the debt instruments, such as bonds, debentures, commercial paper etc of these entities rely on the report of CRA and decide to invest or otherwise. Internationally, three leading agencies based in the US straddle the globe in this field. They are Standard & Poors (started in 1860), Moodys (1909) and Fitch (1913). They all have collaboration with and/or ownership stake in three CRAs in India, viz., Crisil, ICRA and Fitch.

Initially started for analysing the financial statements of railroad companies in the US, which resorted to extensive market borrowings, CRAs have, over the years, acquired enormous clout in the financial markets and have wide ranging recognition from regulators the world over. For instance, all bonds issued in US need to be rated by one of the three CRAs. There are at least two more CRAs in the US, but these are not approved by SEC.

Indian scenario

In India, SEBI has recognised only four CRAs, namely Crisil, ICRA, CARE and Fitch, for rating a debenture issue with maturity over 18 months. There are two more CRAs in India, ONICRA and SMERA (a joint venture of SIDBI and banks), but these do not seem to have official recognition. All issues of commercial paper (CP) in India have to be mandatorily rated by one of the top four CRAs and, if an issue does not have a satisfactory rating, the issuer is barred from issuing CP. The recent Basel II norms accord a preferential treatment, in the matter of bank capital requirement, for loan to a borrower which gets high rating from a CRA.

CRAs do an elaborate study of the issuing companies/ Governments and accord ratings ranging from the best (triple A plus) to the lowest (Default or D) depending on their assessment of the issuing company’s ability to honour the debt obligation in time. For its services, it recovers fees from the issuer. Its report is, however, relied upon by the investors. But then, if CRAs make a faulty judgment, the investor cannot hold it responsible. And this has come in for adverse criticism in recent times.

In India, there are cases where CRAs had suddenly downgraded an issue from a high level to the lowest default category, indicating faulty assessment and/or sloppy monitoring. A questionable rating was in respect of debenture issued by a financially weak public sector company, which was guaranteed by Government of India. The issue was given a high investment grade rating by one of the four top CRAs. The issuer defaulted and the Government did not also pay. It is well known in banking circles that the Centre or any State Government rarely, if ever, honours its guarantee obligation to a bank. With this track record, it is moot whether the CRA did perform due diligence before giving the high rating.

Some blunders

In the US also, it is alleged that CRA committed blunders in some major cases. In 1994, Orange County, a very rich municipality in California, went bankrupt due to speculation in derivatives. However, the CRA had given good rating to the County, till the last moment. Enron, an energy major, was accorded investment grade for its debt instruments, till just 4 days before filing for bankruptcy, in 2001. In 2007, one of the major causes of the world wide financial tsunami was sub-prime (totally reckless) lending by major banks in the US and the subsequent parcelling of the loans to banks all over the world. These parcels of sub-prime loans carried, undeservedly, high rating by CRA. In none of these cases, the hapless investor had any recourse against CRA.

While in Orange County and Enron, the incompetence of CRA was suspected, in sub-prime mess, the integrity of CRA also came for questioning. Some experts aver that CRA tends to be biased because it is paid for by the issuer and so might feel obliged to give a better rating than warranted. For this, they suggest that the CRA should be paid by the investors only. This is somewhat impractical. It is reported that CRA did collect fees from investors till 1970, but changed the practice, after the wide use of photo copiers. (The danger was that one investor might get the report for a small fee and share the report with others).

Case of auditing firms

The conflict of interest faced by CRA is prevalent in the audit profession also. Auditors are paid by the management of the companies whereas their report is for the use of shareholders and other stakeholders of companies. There is a neat solution in the audit profession. If an auditing firm commits a serious blunder, it is held financially accountable by the stakeholders. The classic case in recent memory is that of Arthur Anderson, one of the top five auditing firms in the US, which had to shell out huge sums in damages for wrong reporting of Enron’s financial condition. In the process, the audit firm became insolvent. Such financial liability should be enforced on CRAs also for their mistakes.

Indian regulators, the RBI and the SEBI, it is fervently hoped, will take the lead in this regard and fix financial accountability on CRA whether or not the western world takes action.

(The author is a retired deputy managing director, SBI)

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