Do credit ratings really reveal all?

Credit rating reports are not the staple of information that people consume on a regular basis. Though it would be unfair to expect of the narrative the engrossing appeal of a John Grisham novel, it must be admitted that they rank low in the scale on the attribute of grabbing readers’ attention. Even the hardened professional investor/banker would simply gloss over much of the stuff once he has gleaned the fact that the instrument is rated at a level above the ‘investment’ grade. Which is all the more reason why regulatory attention must be focused on some minimum standards of disclosure in discussing the rationale for a particular credit rating of an instrument of debt or a loan.

Granted that there can be no standardised format for what a credit rating report should contain. Equally, what the rating agency chooses to put out by way of a rationale ought not to be left entirely to the discretion of the rating agency, either. Between excessive regulatory zeal that seeks to impose a one-size-fits-all kind of standardised format and a benign neglect that currently passes for a regulatory framework, there must exist a middle ground for the informational content of such reports.

Take, for instance, a look at what a rating agency had to say recently on a company in the infrastructure space. The report starts off by saying that in arriving at the ratings, the agency had combined the business and financial risk profiles of the company and its subsidiaries, X, Y, Z, etc, and then goes on to describe the collective entity as a “Group”. Up to this point, the rating agency scores a perfect ten for the informational value of its report on the credit risk in the debt instrument of that company. After all, credit risk is impacted adversely by the financial situation not just of the company whose instrument is the subject matter of a rating assessment but that of its associate and subsidiary companies as well. Before we commend the agency for its 360 degree view of ‘risk’, what follows thereafter is a source of deep disappointment. This is what it had to say.

“For 2014-15 (refers to financial year, April 1 to March 31), the company on a standalone basis, reported a profit after tax (PAT) of Rs. 1.1 billion on a total operating income of Rs. 83.0 billion, against a PAT of Rs.405 million on a total operating income of Rs. 61.2 billion for 2013-14. For the three months ended June 30, 2015, again, on a standalone basis, it reported a PAT of Rs. 412 million on a total operating income of Rs. 17.3 billion, against a loss of Rs. 30 million on a total operating income of Rs. 15.0 billion for the corresponding period of the previous year.”

Having started by saying that it has taken into account operations of all the Group entities, why does the rating agency now fight shy of revealing what the consolidated picture of its financials looks like? Is it because the consolidated numbers do not present a flattering picture of the Group? What lends added credence to entertaining such doubts is what the report had to say in the subsequent paragraph. It says that the ‘agency’ has withdrawn its bank loan ratings.

This is not all. The report goes on to say that the ‘agency’ has withdrawn its ratings on the company’s bank loan facilities following the expiry of the 180-day notice period. By way of added explanation the ‘agency’ goes on to say that it placed these bank loan ratings on what it termed as “Notice of Withdrawal” at the company's request. Up to this point, the disclaimer could not have been more lucid. But what follows thereafter is bound to leave the reader completely perplexed. It says, “The rating withdrawal is in line with...policy on withdrawal of ratings on bank loan facilities.”

What is an investor-reader of the report supposed to make out from the above sentence? It is clear that once the client says that it no longer needs the services of a rating agency, there is nothing much left for it to do. If on the other hand, it was a case where the rating agency opted out after a refusal by the company to provide some additional information on its operations, that would be a critical piece of information on the safety of investment in the rated instrument. The ‘agency’ hasn't helped the cause of the general public and investors in particular by resorting to such equivocation.

None of this would matter if the rating industry is a highly competitive one where the discipline of the market forces can be expected to sustain operational performance to the standards of the highest order. Unfortunately, after more than three decades of operations in the country, the credit rating industry is still characterised by an oligopolistic market structure with just four to five players rating debt instruments running into trillions of rupees.

The phenomenon per se is an anachronism as credit rating at its core is a knowledge industry. History tells us that a knowledge industry is a well contested market with low entry barriers. Think of the software industry or the auditing profession where service providers are numerous and span the whole spectrum of the value creation process from the very small to the behemoths.

The contrast with the auditing industry which offers a ‘True and Fair View’ assessment of financial affairs is particularly stark. It is a highly fragmented market with roughly 1,15,000 audit professionals giving a professional opinion on companies that are just as many if not more than the entities seeking a credit rating of their borrowing facilities or debt instruments.

On the face of it, the two professional services may appear to be qualitatively different. But at a subliminal level, both serve a common purpose, namely, enabling stakeholders to take informed decisions that have a bearing on their financial fortunes. Yet, the auditors are subjected to a far greater degree of regulatory oversight that goes beyond the standard format of certification. They are required to specifically comment on such aspects as whether the company has adequate internal control systems to safeguard its assets; whether there is any permanent diminution in the value of assets that warrants a restatement of values at a discount to the historical costs of acquisition; and so on.

On the other hand, credit risk opinions are not subject to any extra-nationally imposed standards on the contours of disclosure of a rating rationale. Moreover, the banking sector is currently going through a stressful period with a huge amount of loans and debt instruments locked up as non-performing assets or restructured so as to cleanse them of their initial character as non-performing ones. Many of them have been subjected to an external credit rating assessment. This is as good a time as any to introspect on the nature of regulatory oversight and performance standards governing credit risk assessments.

COMMENT NOW