The reputation and reliability of Credit Rating Agencies (CRAs) have taken a knock since the US sub-prime crisis of September 2008. Their failure to account for weaknesses and even giving high ratings to toxic mortgage-backed securities (MBS) was well exposed during that time.

This was not the first time, though, that lax CRAs triggered a financial crisis; they did so even earlier in 1997 with the South-East Asia currency crisis and, then, in 2001 with the dotcom bubble.

Ham-handedness in dispensing sovereign ratings, bolstering ratings for complex MBS instruments just to serve business interests, triggering wider global recession by downgrading European Union countries, and regulation of the CRA industry are subjects of extensive discussion today.

Origin and Purpose

Credit rating is an opinion on the future ability and legal obligation of the issuer to make timely payments of principal and interest on a specific fixed income security, thereby helping make informed investment decisions.

Moody’s, Standard & Poor’s, and Fitch, which rate the credit worthiness of companies and countries, are the big brothers in the industry of 150 players, cornering 55 per cent of the total business and about 94 per cent of debt ratings. They now have offices in hundreds of countries, thanks to their rapid expansionist tactics. Over the last two decades, European authorities also created a captive market for an essentially US-based industry till the 1980s, through the Capital Requirements Directive under Basel-II, and the liquidity-providing operations of the European Central Bank, even as the US Federal Reserve avoided depending on CRAs for both.

Power and prejudice

As ratings fall for any instrument below the investment grade at ‘BA’ or ‘BB’ or lower, they get categorised as speculative, leading to most of the global investors staying away from them. It affects investment inflows into the country or corporate issuing that particular instrument.

This vantage position of CRAs as setters of investment flow has empowered them as makers or breakers of the fortunes of countries or corporations, enabling them to turn king-makers in one sense and bureaucrats at best in another.

It is said that on the one hand, CRAs do not deal rigorously enough with the companies which pay them, and on the other too aggressively with companies who don't. Thus, in order to have any credibility, companies really need at least one among Moody's, S&P and Fitch — preferably all three — on their side.

Piqued by the way their sovereign ratings have been downgraded by CRAs citing purportedly not very valid reasons, several countries are in the process of bringing global CRAs under their domestic regulatory oversight. Those that have mooted new guidelines include the Euro Zone countries, the UK and South Africa.

In India, these agencies are registered with the Securities and Exchange Board of India (SEBI) and regulated by the Reserve Bank of India (RBI).

Indian Scenario

In the 26 years of their existence, CRAs have spread their tentacles to entity rating, asset and mortgage backed securities, public finance, mutual funds, governance rating, etc., before entering bank loan rating based on Basel-II norms in 2007 and a pro bono service of IPO rating.

Basel-II requirement is not mandatory for the purpose of any instrument rating for financial institutions (FI) and bank advances. However, banks and FI are rating the instrument without giving any direct benefit of rating in terms of rate of interest and charges to the issuer.

Their customers, particularly SMEs, are unable to do the catch up due to lack of this knowledge. A regulatory mandate in this regard would benefit SMEs in gaining knowledge for improving their ratings.

While India had expressed doubts over the rationale adopted by CRAs in sovereign downgrade actions in 2009 itself, the dissenting voices have become louder now, including from the US and several European countries that have been facing ‘rating heat’ of late.

Taking a cue from global trends, Indian companies like Srei Infrastructure Finance (SIFL) and Videocon Industries took a CRA to court citing anomalies in arriving at respective ratings, thereby setting a precedent in imposing a stay order on rating releases. The conclusions from these cases are expected to have far-reaching implications on CRAs in India.

Suggested steps

The time has come for CRAs to improve their own ratings and inspire confidence on their actions among stakeholders like issuers, banks and investors, particularly among the sovereigns.

They must prove that they are competent enough to judge governments and companies by evolving robust internal corporate governance standards, and attracting competent staff. Besides, they have to assume some kind of responsibility and accountability for their actions.

Of the two functions, CRAs undertake – quantifying risk and predicting uncertainty – they are good at the former using mathematical and statistical modelling.

But they frequently fail in the latter, i.e. predicting even events that could have been easily assessed, like the impact of spiralling mortgage loans in the US before the sub-prime crisis.

Above all, they are rating only the instrument and not the company in question. The practice of rating a company in relation to the industry to which it belongs is not being adopted. There is no benchmark for such ratings and as such it is not as scientific as it should be. Rating the company, to reflect an overall perception, should be made mandatory.

Every industry has a different risk profile. But CRAs look at them through the same lens.

Visible anomalies

These anomalies are visible when ratings accorded to large, medium and small industries are studied, which are almost on the same lines in many cases, even though their risk profiles generally differ based on the scale of operations and their ability to withstand uncertainties.

CRAs seem to lack industry specific expertise; rating committees are mostly filled with finance specialists.

Where a CRA is promoted by banks and/or FIs, the parent's customers should be prohibited from being rated by to avoid conflict of interest

Many high rated companies have been defaulting in the short term, suggesting that the companies' risk profiles were not properly assessed. In such a scenario the regulator should fix the accountability of the CRA, including cancelling registration should the need arise.

It is observed that the company is not being given an opportunity to make a presentation before the rating committee before according the rating, with the rationale that the company shall be impressed upon on its weaknesses.

Some members on the rating committees of CRAs have been there for years. Infusion of fresh blood is necessary. This can be done by making it mandatory to change the members every two-three years.

SEBI and RBI, both regulators of CRAs, should impose reasonable restrictions on ratings to ensure their quality and impartiality.

If they ensure that these aspirations of the stakeholders are fulfilled, they will go a long way in improving the investment climate per se, which is languishing for different reasons, besides improving rating quality and investor confidence.

(The author is a former CMD of Corporation Bank. The views are personal.)