Time to rate credit rating agencies?

It is reported that the number of companies who refuse to share information with credit rating agencies has increased sharply. The percentage of companies that fall into the ‘non-cooperating’ category has more than doubled from 22 per cent in FY18 to 47 per cent in FY20, according to Bloomberg . This implies that 53 per cent of the ratings given by the agencies are based on inadequate information, and are hence unreliable.

This is an alarming situation that needs some drastic remedial measures. Availing credit facilities based on credit rating and refusing to part with information for subsequent follow-ups creates suspicion that all is not well with such companies. But this situation has not come up suddenly; there is a need to make a thorough study of the functioning of credit rating agencies in India to understand why.

There are a number of major credit rating agencies in India like CRISIL, ICRA, CARE, SMERA, Fitch India and Brickwork Ratings, which are registered with Securities and Exchange Board of India. At the international level there are rating agencies like Standard and Poor, Moody’s, Fitch, DBRS etc. Banks and investors depend on ratings by these agencies while cosidering lending to or investing in the rated companies.

The rating agencies collect information about financial flexibility and turnover values and analyse it to reach a conclusion. Rating agencies evaluate risks and find measures to overcome them and enhance the corporate image.

The ratings provide a measurement of these companies’ solvency and how they will fulfill their future financial obligations. They help investors see the risks, and therefore, set the interest for the investment. Higher the credit rating, lower is the rate of interest offered to the organisation.

Failure of proper assessment by credit rating agency is not uncommon.

A recent example is the case of debt defaults by Infrastructure Leasing and Financial Services Ltd. The rating agencies failed to raise timely red flags ahead of the group’s troubles. IL&FS’s failure triggered sharp declines in the Indian stock and debt markets.

The root of the problem

The company issuing the debt instrument or availing bank credit selects the rating agency, and pays to avail its services. This invariably induces the agency to provide a favourable rating. There is, therefore, a conflict of interest in the rating process. The issuer pays the rating agency whereas the investor relies on it.

Ideally, the rating agency should report to and be paid by the investor. The compromise or penalty paid by foreign rating agencies can be termed as a result of their complicity while analysing and providing the ratings.

Then there are companies who are eager, at the time of original issue of credit instruments, to provide all details to the rating agency. Subsequently, they are appear less enthusiastic, either on account of deterioration in their financials or other reasons. As such, the regulator cannot do much, though the market may punish such issuers in future. Banks may only charge higher interest, but the companies who are not going to service debts may not bother much about such penal action.

There is also a fundamental problem with the rating system itself, as it is based on the past and there is no guarantee for future financials. When ratings are only revised, periodically, they tend to become more unreliable.

Correcting course

Whenever the issuer does not cooperate, the credit rating agency has been directed to provide the grade with a comment saying ‘Issuer did not co-operate; based on best available information’. Similar disclosures must be made when there is a sharp change in ratings, or when the agenices fall behind the curve in identifying risks.

SEBI has, on its part, issued norms for enhancing disclosures by credit rating agencies, asking them to furnish information on whether the rating is factoring in support from a parent, group or government; or is with an expectation of infusion of funds towards timely debt servicing, among others.

We must, however, think about an alternative to the present system of credit rating. tThere can be a separate rating agency, like a statutory body, with adequate powers to rate the other ratings agencies itselfFailure by any agency to provide necessary input or giving the wrong input may even lead to its closure. As an immediate measure, like banks’ auditing is approved by the RBI, rating contracts can also be assigned by SEBI among rating agencies. The CRAs should be accountable to SEBI and investors.

The writer is a retired banker

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