Can we still rely on credit ratings?

JASLENE BAWA / SANKARSHAN BASU

Within a span of 20 days, both Naresh Takkar, MD and CEO of ICRA (A Moody’s Investor Service), and Rajesh Mokashi, MD and CEO of CARE Ratings, were sent on leave pending individual enquires against them for their alleged involvement in the Infrastructure Leasing & Financial Services (IL&FS) debt securities case. The rating agencies, apparently, deferred plans to downgrade IL&FS group subsidiaries on account of threats from the company’s management to discontinue business with them if unfavourable ratings were assigned.

This implies that the managements of large and powerful institutions can and have influenced rating agencies to obtain desired ratings in the Indian debt market, thereby misleading investors.

ICRA, CARE, India Ratings (a Fitch Group Company) and Brickwork Ratings continued to assign high ratings to IL&FS (with a high financial risk profile), allegedly under the threats from the IL&FS management, and are under scrutiny by the Serious Fraud Investigation Office.

This brings us to the looming question: How reliable are these assigned credit ratings?

Of the total debenture issuances in India, about 50 per cent (value wise) have been rated AAA and another 20 per cent rated AA (see Chart 1); majority of these issuances are by finance companies.

Chart 2 presents the percentage of AAA/AA-rated finance issuances to total AAA/AA-rated issuances between January 2018 and June 2019. AAA-rated issuances reduced temporarily in September 2018, and then between March and May 2019 due to the IL&FS and DHFL default, respectively. Instability in the debt market led to a temporary dip in AA-rated issuances in April 2019, with debt issuances returning to previous levels subsequently.

Mutual incentives

How do companies obtain desired debt ratings and operate the quid pro quo nexus? Companies, banks, and financial institutions (that is, the ‘issuer’) approach rating agencies to assign a rating to their debt instruments for a fee. The rating agency is expected to objectively rate the issuer based on its financial risk profile and performance parameters. If the agency assigns a desired rating, the issuer brings repeat business.

Alternately, if an undesired rating is assigned, the issuer may fire the rating agency and take their business to a competitor, resulting in business loss for the agency. This situation creates an incentivisation structure for both management and analysts at the agency. Dangling repeat business as a carrot, issuers hold sway over the rating agencies, prompting analysts to assign them the desired ratings.

However, if analysts present conclusions that prevent a rating agency’s client from obtaining the desired rating, they are viewed as “impeding deals” and are deemed harmful for the agency’s business. These analysts often face mistreatment in the form of frequent inter-departmental transfer, punitive actions, harassment or even layoff. This brings to light a primary conflict of interest between the issuer company and the rating agency.

Fiduciary duties

This nexus between rating agencies and issuers and the mistreatment of analysts is nothing new. The global financial crisis of 2008 put the US credit rating agencies under intense scrutiny. The “Big Three” — Standard and Poor’s (S&P), Moody’s, and Fitch Ratings — who were supposed to offer reliable information to investors regarding the risk associated with different debt instruments, deluded investors by providing high financial estimates for insolvent organisations and assigned high ratings to very risky mortgage-backed securities in lieu of repeat business.

This led to inquiries, imposition of hefty fines on rating agencies for not abiding by their fiduciary duty towards stakeholders (investors and issuers) and also forced Brian Clarkson, President and Chief Operating Officer of Moody’s, to step down from his post in 2008.

These events teach us that rating agencies should remember their fiduciary duty towards stakeholders. It is their duty to treat issuers and investors fairly, inform them about the rating attributes, limitations, observe transparency with respect to their rating methodologies, policies, decisions etc.

In India, institutional investors (mutual funds, insurance companies, pension funds, etc) holding the savings and retirement funds of the nations’ middle-class rely on the credit ratings for investment decisions and the nexus between issuers and ratings agencies could mislead them.

Here are some steps that can ensure that ratings are objective and protect investor interest:

Independent reviews for modifications to rating methodology should be conducted. If an analyst presents an adverse report on an “issue”, the same should deliberated upon by the rating committee. If the committee overrules the analyst’s view, the same should be mentioned in the rating report stating the analyst’s reservations.

If the agency committee downgrades an issuer, after which the agency representatives interact with the issuer’s management, the rating report should include the details of such meetings.

The rating agency should publish the number of issuers from whom they receive a proposal for rating, how many issuers the rating agency approaches for business, and which get converted (conversion ratio). This will give an indication of the rating agency’s rejection rate and the conversion ratio.

The management compensation at present is divided into a fixed and incentive pay structure, where incentive pay is linked to the short- and long-term company performance objectives. One can consider delinking performance and incentive pay or introduce a cap (the highest amount of incentive to be paid as a ratio of the fixed compensation). Currently, the incentive pay constitutes roughly 30-40 per cent of the total compensation for top executives at a leading Indian rating agency.

Bawa is an Assistant Professor of Finance, FLAME University and Basu is a Professor of Finance, Indian Institute of Management-Bangalore

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