The Hindu Business Line : ‘Investors do not have any financial claim over the rating agency’

Even though the issuer pays for the rating exercise, a rating agency has a strong incentive to maintain its independence due to the reputation risk arising out of lax rating standards.

MR N. MUTHURAMAN, DIRECTOR, CRITERIA AND PRODUCT DEVELOPMENT, CRISIL

In the ongoing subprime drama, rating agencies are key players, coming under heavy fire. Serious doubts are being raised, both in the US and elsewhere, whether the rating agencies could have alerted investors and thus averted the massive losses, rather than give good ratings to the subprime mortgage loans. Significantly, Ms Kathleen Corbet, president of Standard & Poor’s, a leading global credit rating company, resigned a few days ago, making way for Mr Deven Sharma.

Just the right time for a zero-base on rating, which is why Business Line interacted with Mr N. Muthuraman , Director, Criteria and Product Development, CRISIL, for answers to a few basic questions about rating.

An engineer and a management graduate from IIM, Bangalore, Mr N. Muthuraman has, over his decade-long stint with CRISIL, handled credit rating assignments across various sectors including automobiles, auto ancillaries, general engineering, chemicals, petrochemicals, shipping, media and FMCG industries.

Excerpts from an email interview:

Why rating? What is credit rating?

The generic term ‘rating’ denotes the opinion of an independent third party, usually by classifying according to a grade or rank. A credit rating ranks debt (usually bonds) into categories such as ‘AAA’, ‘AA’, and ‘A’, according to credit quality. Credit quality is the likelihood that the borrower will pay interest and repay principal on time.

A credit rating is expressed on a simple alphabetic/alphanumeric scale. Investors use credit ratings as a key input in their investment decisions.

Credit ratings also play a crucial role in the development of the capital markets. A credit rating on a bond acts as a reference point on credit quality and enables easy trading of a bond, without each investor having to carry out a detailed credit analysis every time the bond is bought or sold.

What factors/parameters govern the credit rating of a firm? How far into the past and future does the rating exercise travel?

Credit rating aims to assess the likelihood of default on the rated bond. This risk of default is assessed through three main components of risk — business risk, financial risk and management risk.

Business risk assessment is an evaluation of how well a business is run, and whether it will generate stable cash flows over a period of time, including the different phases of economic/business cycles.

Financial risk assessment is an evaluation of how well the business is funded in terms of debt and equity, and whether the cash flows generated are adequate to meet interest and principal payments.

Management risk assesses the competence of the management, its risk appetite, and whether the management has willingness to honour the debt obligations in a timely manner.

Typically, for manufacturing companies, the assessment is based on performance of the company in the preceding five years and the next three years. Even when a rating is assigned to a debt instrument maturing beyond three years, the assessment is usually made only for the next three years. This is because, beyond three years, the visibility is usually poor, and projections could end up being, at best, a mathematical exercise. Instead, rating agencies conduct this assessment on a continuous/periodic basis throughout the life of the instrument, thereby providing investors a medium-term forward-looking assessment on credit quality at all points of time.

Does a rating have to consider up-to-date info about the enterprise? How old is good enough for a rating exercise? Is there a best-before date for the rating?

Typically, ratings are kept either under continuous or periodic surveillance. CRISIL keeps its ratings under continuous surveillance; its ratings are therefore current at all points of time, and take into account all available information to date.

As ratings are under continuous surveillance, there is no specific ‘date of rating exercise’. Most credit ratings in the Indian context are ‘instrument-specific ratings’ and the best-before date is the maturity of the rated instrument.

How expensive can rating be?

Rating fees are part of the ‘agency costs’ for raising any form of capital and are expressed as a fraction of the total amount of the instrument being rated. CRISIL typically charges 0.1 per cent of the rated instrument as initial rating fee, usually subject to a cap. An annual surveillance fee of 0.03 per cent of the outstanding amount is also charged, from the second year till the maturity of the instrument. Rating fees are typically paid by the issuer of the debt.

Can rating differ according to who initiates the exercise? Are there ‘tailor-made’ ratings?

Ratings do not differ based on who initiates the exercise. The rating process is independent of the fees charged, and the source of request for the rating.

There are however some classes of ratings that are ‘tailor-made’, such as ratings on asset-backed securities. In such ratings, the target rating sought by the originator can be achieved through appropriate levels of credit enhancement. Needless to say, a higher level of enhancement may be required to achieve a higher rating level.

Is it necessary for the rating agency to be independent?

It is essential for a rating agency to be absolutely independent and free from influence of any external constituent. Credibility of ratings assigned is essential to boost investor confidence in using the ratings. An independent rating agency can assign objective credit ratings, gaining credibility in the process.

A related question that is often raised is the rating agency revenue model. Most credit rating agencies across the world, including CRISIL, use a revenue model where the issuer pays for the credit rating. While the issuer-fee model naturally creates a potential conflict of interest (that could possibly lead to higher than warranted ratings), global experience indicates that the existence of this conflict does not by itself lead to lax rating standards. This is because reputation plays a crucial role in the credit rating discipline.

Although the issuer pays for the rating, the investor uses it. Like any other product or service, the ‘value’ of the rating depends entirely on the perceptions of the user — in this case, the investor. Consequently, issuers ‘buy’ only those ratings that investors find ‘valuable’. Investor perceptions, in turn, are based on the credibility of the past ratings assigned by each rating agency. Lax rating standards by any rating agency would lead to a loss of credibility with investors and an erosion of the ‘value‘ associated with the ratings assigned by that agency. This would reduce issuer demand for ratings from that agency, consequently affecting its revenues.

Thus, even though the issuer pays for the rating exercise, a rating agency has a strong incentive to maintain its independence due to the reputation risk arising out of lax rating standards.

What factors can cause an increase in the demand for rating? And, what, a slump? Does the current wave of M&A (mergers and acquisitions) demand a lot of rating?

Sustained economic growth resulting in significant capital investments will be a prime driver for credit rating. Besides this, an active corporate bond market with participation from banks, mutual funds, insurance companies and retail investors will also lead to significant and sustained demand for credit rating. New regulations that mandate rating also spur demand. For instance, the recent guideline on implementation of Basel II norms has resulted in significant demand for ratings on banks’ loans.

A slump in demand may be due to cheaper alternative sources of funds, which may not need ratings (such as hedge funds, alternative investment markets, etc.), or due to low levels of capital investment during economic downturns.

Recent M&A activity has resulted in increased demand for rating; however, since most of the funds for the M&A are raised in global markets in foreign currency, this has had limited impact on demand for ratings from domestic rating agencies such as CRISIL.

How are ratings validated internally before release? Is the release private or public?

All ratings are assigned by a Rating Committee comprising experts with several years of experience in credit analysis. No individual has any right to assign or promise a rating.

All new ratings assigned as well as subsequent rating actions (such as an upgrade, downgrade or reaffirmation) are released in public through a press release, along with the reasons for the rating/rating action. These are also made available free of cost on CRISIL’s website.

Have there been occasions when, post-release, ratings have been found to be erroneous? If so, what is the action?

There has been no instance of CRISIL having made an erroneous rating release, in its two-decade-long history of credit ratings.

Do ratings come with a warranty or some such assurance as to their effectiveness? Is there any accountability? Or, is it caveat emptor that governs ratings? Can a depositor in a company, for instance, get back to the rating agency when things turn ‘sour‘ despite a good rating?

As mentioned earlier, credit ratings assess the probability of default on debt instruments. Ideally, the highest rating will have lowest probability of default, and the default probability increases as one goes down the rating scale. Thus, it is possible that even a higher rated bond could face default, but this is an extremely unlikely situation. At a portfolio level, the likelihood of default at higher ratings is lower and vice versa. The investor is compensated for potential losses through a higher interest rate for a lower rating.

For example, a 3-year ‘AAA’ bond could pay 8 per cent interest, whereas a 3-year ‘A’ bond could pay 9.5 per cent. When held as a portfolio of bonds, the higher interest received on the ‘A’ rated bonds will compensate for default of a few bonds.

Rating agencies can prove the effectiveness of their credit ratings by publishing their default statistics. CRISIL is the first rating agency in India to have published its default rates. Some highlights of CRISIL’s default study are:

No bond rated ‘AAA’ by CRISIL has ever defaulted.

There is a clear inverse correlation between ratings and default rates: the higher the ratings, the lower the default rates, and vice versa.

The study covered over 800 ratings, and spans over 15 years, which is by far the largest sample of ratings in the Indian context.

Investors do not have any financial claim over the rating agency, if they face a default on a rated bond. However, lack of investor confidence in a rating agency could seriously undermine its business, which acts as a strong motivation for the rating agency to assign correct ratings.

In addition, a highly-rated bond would normally go through a downward rating transition before defaulting, and it is therefore in investors’ interest to monitor outstanding CRISIL ratings on their debt investments.

Have ratings been withdrawn in the light of info that came to light subsequently?
CRISIL has a policy of keeping every credit rating under continuous surveillance till the rated instrument is redeemed in full. This policy is designed to keep the investors informed about the credit quality of the rated instrument at all points of time.
Any new information that comes to light may result in a rating action (upgrade, downgrade or reaffirmation) but not a withdrawal.
How can investors take a decision when confronted with varied ratings from different agencies for the same company?
The credibility of the rating agency is the best guide in such instances. The track record of the agency, the transparency of its rating process and criteria, the rationale for the rating assigned, and published default statistics, could serve as a good guide to investors in choosing which rating agency’s ratings to use.
Do companies ‘shop’ around for the best rating?
A brief outline of the process of rating acceptance will help answer this question. Companies choose their rating agency voluntarily; the decision to accept or reject the initial rating vests entirely with the company. However, once the rating is accepted and funds are mobilised, the company cannot have the rating withdrawn before redeeming the rated instrument in full.
As companies have a choice to accept or reject a rating, they can technically ‘shop’ for a higher rating. However, over a period, the investors also understand the relative ‘quality’ of ratings and price accordingly. This annuls the motivation for ‘shopping’ for a higher rating.
Is there a regulation that governs rating? If yes, what are its pluses and minuses? How does it compare with similar regulation elsewhere in the world?
The capital market regulator regulates rating agencies in most regions. In India, the capital markets regulator, the Securities and Exchange Board of India (SEBI), regulates the rating agencies in the country. SEBI laid down an extensive set of regulations for rating agencies in 1999.
Regulation of rating agencies is typically concerned with ensuring that only reputable entities set up rating agencies, and that adequate safeguards are in place to manage the conflicts of interest arising with respect to both the rating agency and its employees. Regulation that is more intensive or intrusive than this has not resulted in any incremental benefits.
Indian regulation preserves the independence of the rating agency and does not interfere with the agency’s opinions. This aspect is identical to the regulation of credit rating agencies by SEC (Securities and Exchange Commission) in the US.
Rating agencies in India also have to be accredited with Reserve Bank of India, before their ratings are used by banks for risk weight purposes under Basel II guidelines. The accreditation is provided based on six broad principles: objectivity, independence, transparency, disclosure levels, resources and credibility.
CRISIL has been accredited by the RBI, making CRISIL ratings eligible for use by banks for risk-weight purposes. This accreditation process is based on the criteria laid out in the Basel II guidelines.
On foreign agencies rating Indian companies, and vice versa. The pros and cons.
Each rating scale has a defined frame of reference and all ratings are relative within this frame of reference. The frame of reference for CRISIL is all debt issued within the country. On the other hand, the frame of reference for a global rating agency such as Standard & Poor’s is all debt issued anywhere in the world. Hence, the rating assigned on the same debt instrument may be widely differing on these two scales.
Let me explain this with an example:
The debt with highest credit quality within India will be assigned the highest rating of ‘AAA’ by CRISIL (example, debt issued by State Bank of India). However, on a global scale, this may not be comparable to the credit quality of debt issued by, say, GE Capital or Exxon Mobil. Thus, on a global scale, these instruments may be rated ‘BBB’ by S&P.
Investors have to choose which ratings to use, depending on their scale and scope of operations. An Indian mutual fund, with most of its investment options resting within India, should ideally use CRISIL ratings. On the other hand, a global fund manager with the option of investing in several countries could use S&P ratings. Thus, these two rating scales can co-exist and serve the needs of different sets of investors.
On rating announcements and stock price movements. Is there a sync? If yes, how can rating agencies prevent ‘insider trading’?
CRISIL has a strong anti-insider trading policy for all its employees in ratings division. As most of our rated issuers share confidential information including capital expenditure plans, financial forecasts, etc., most of which are price-sensitive, employees in CRISIL’s ratings division cannot trade in securities issued by CRISIL’s rated issuers.
What skills do rating agencies look for in new recruits?
Strong analytical skills, good understanding of basic concepts of financial analysis, experience/interest in tracking some industries, and good communication skills, would make a good rating analyst. CRISIL has a mix of professional accountants, management graduates, and analysts with other relevant qualifications/ experience (including CFA, industry experience, etc.)
Can rating be automated so that one can have real-time rating?
Credit rating involves both qualitative and quantitative assessments, which cannot be modelled into a mathematical exercise. However, the basic framework for a rating can be incorporated into an ‘expert judgment model’ which will help analysts in adopting a structured way to arrive at a rating. Based on several years of experience in credit rating, CRISIL has developed such a model called ‘CRISIL Risk Assessment Model’, which is currently being used by majority of banks in India.
Do SMEs (small and medium enterprises) need rating? Why?
SME rating is a relatively new concept, even globally. CRISIL has launched its SME Ratings in India in 2005 and has assigned over 1000 ratings till date.
Credit rating helps improve access to funding for SMEs, and may also result in savings in interest cost for well-run SMEs. Besides this obvious benefit, other attendant benefits of a rating for SMEs include the following:
Credit rating provides an independent third-party opinion on the strengths and weaknesses of the SME, which the management could use to improve their performance.
A credit rating exercise instils several best practices that are adopted by large corporates (such as financial discipline, quality of Management Information System, assessing future financial performance and planning for the same, timely repayment of all debt obligations, etc.).
Credibility with business partners — customers, suppliers, etc.
Improved visibility.
Are there companies that don’t need rating?
Companies that do not have borrowing programmes may not need a rating.
Does rating make a difference when a company raises money, in India or abroad?
Credit rating has a direct impact on the cost of borrowing for a company. A higher rating would result in lower interest cost and vice versa.
However, a higher rating may also have some indirect costs. In order to maintain a higher rating, the company may have to restrict the amount of debt it takes, to ensure high levels of protection to its debt holders. This may lower the return on equity. Thus, each company has to strike a balance between the two — optimum leverage versus high credit rating.
What is the relevance of country ratings to investors?
Sovereign ratings do not have any direct relevance for domestic investors who invest within the country and use ratings assigned by domestic credit rating agencies.
For trans-national investors, sovereign rating is relevant because most ratings on corporates, banks, etc. in a country would tend to be the same as or lower than the rating on the sovereign. Thus, for instance, the credit rating on People’s Republic of China by S&P (A/Positive) would imply that most banks and corporates in China would tend to be rated in the ‘A’ category or lower.

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‘Investors do not have any financial claim over the rating agency’