The recent rash of defaults by highly rated entities has adversely impacted debt holders and also eroded the reputation of credit rating agencies (CRAs). There have been some egregious cases where highly rated bonds were suddenly downgraded to D-grades only after the defaults began, indicating something seriously amiss in the CRAs’ surveillance processes.
Let’s analyse the intrinsic flaws in the prevailing institutional structure of the credit rating industry and look at some measures that could make the system more resilient and reduce inherent conflicts of interest.
The basic objection to the “issuer pays” model is the suspicion that the issuer calls the shots, and therefore, the CRA is likely to subjugate its independent judgment to its commercial interests. The bigger the issuance of debt, the higher the rating fees, and the more this pressure is likely to play out in an undesirable manner. In the event of adverse selection (i.e., a liberal CRA is chosen or a higher than merited rating is issued) and we have a default, it opens several possibilities of moral hazard, tying up financial markets in doubt. Such situations can be avoided through a change in the institutional structure and regulation of CRAs. The much-talked-about alternative, namely the ‘investor pay’ model, has some drawbacks in the sense that large investors could influence ratings assigned by CRAs if their investment positions are adversely affected.
An alternative compensation model for CRAs in the Indian context could be to have all rating fees paid by issuers into a specific fund overseen by the regulator (day-to-day management could be with an independent service provider). The rating fee paid by the issuer is deducted from the funds raised and is credited to a “bond rating fees fund account” overseen by the regulator. The amount so charged to the issue should be split between two CRAs to cover the initial rating fee and annual surveillance fees. Smaller issues could have only one CRA.
The choice of the CRA(s) itself could be decided by a reverse auction process, with the maximum rating fee being the starting point. To avoid situations where one or more CRAs corner most of the ratings through aggressive bidding, a maximum number of awards per CRA may be considered.
Another important measure to be implemented by the regulator would be to stipulate that the CEO of a CRA should not have any say in the process of assigning ratings. The rating process should be under the purview of the CRO, who reports directly to the CRA’s board of directors and not to the CEO. The compensation of the CRO and his/her senior reports should not be linked to the revenues or profits of the CRA. The CEO would be responsible for all operations of the CRA, except the actual ratings issued and the performance evaluation of the senior rating staff.
A CRA may continue to compensate its employees with appropriate incentives, so long as it can be established that its revenues/profits are not fuelled by fees arising from assigning favourable ratings. The compensation (and incentives) of the CRO and the analytical staff must be linked to the accuracy of ratings assigned, as measured by the default statistics analysis of the CRA. This would back-end the performance incentives but would significantly align incentives of all stakeholders.
Another undesirable outcome of the present institutional structure of the credit rating industry is the phenomenon of ‘rating shopping’, where the paying issuer can pressurise a CRA to award favourable ratings on the threat of denying future business. The reform in the remuneration mechanism and the selection of the CRA as suggested above substantially mitigates such adverse outcomes.
To further disincentivise rating shopping, it should be made mandatory that all rating exercises conducted by an issuer (including exercises that are not consummated) should be disclosed by the issuer. There should be no choice for an issuer or a CRA to abort a rating exercise once started (barring force majeure reasons). Incentivising analytical staff differently from the other staff of a CRA will also help in creating an internal check on the incidence of rating shopping.
Along the similar lines of the auditing and legal industries, soliciting business by CRAs from issuers may be stopped and rotation of agencies may also be considered. However, brand-building by CRAs through credit research and knowledge dissemination may be encouraged.
In a regulatory guidance issued on June 13, 2019, SEBI has tightened the outcomes and expectations of ratings issued by CRAs. For instance, CRAs will now be required to disclose the one-year forward probability of default and grade the liquidity position of the issuer in the rating rationale. It is likely that to conform to some of these stipulations, CRAs would have to significantly change their rating processes, including tightening their benchmarks and increasing the efficacy/frequency of surveillance.
In addition, the regulators stipulate an independent audit of the data and analytical process used by CRAs with regard to transition/default analysis.
Role of the board of directors
CRAs generally maintain the position that credit ratings should be the preserve of the rating committee, while the board of directors is responsible for the overall management and governance of the company (without being involved in the rating process).
While this dichotomy is acceptable, the incidence of some erroneous ratings leads to the question if the role of the board should be enhanced to also monitor the appropriateness of the rating processes.
Some issues in this regard are: How should the independence of the rating committee be ensured? What are the issues that could create a potential conflict of interest for a CRA in the issuance of its ratings, and how should they be addressed and disclosed? Should ratings be determined by (the rating committee) through consensus or by a majority? Are there any outstanding ratings that have not been reviewed for more than one quarter?
There could be numerous such issues which possibly need a four-eyes principle between the rating committee and the board, without compromising the confidentiality of issuer-related information or interfering in the analytical process.
Staying in balance
CRAs discharge a critical role in the financial markets – addressing information asymmetry between investors and issuers while ensuring that credit decisions are based on a comprehensive review of risks.
Regulation allows CRAs differential access to confidential information about issuers, so that investors can get a true picture of the credit risks without compromising the confidentiality of the information and in a cost effective manner.
Regulation governing CRAs needs continual review to ensure that the conflicting requirements of market forces, sound analytical judgement, and the viability of rating business are always in balance.
Purkayastha is Director at Clean Energy and Climate Finance Non Profit Institution in India. Rao is CEO, Gopalakrishnan-Deshpande Centre for Innovation & Entrepreneurship, IIT-Madras. Views are personal