Think Twice Before Taking Credit Rating Agency Public

The credit-rating business is unique because it has no skin at all. For a bank, if the money is not lent properly, the perishable asset will haunt it later. But the wrong decision of a rating agency cannot be opposed as it is only an ‘opinion’ and has no recourse. Human error is always possible. Credit rating agencies (CRAs) talk about reputation risk. But then there are some omissions in the names of all agencies and standard business practice for some agencies is to display the failures of others to clients, so all the beans are shattered.

All big investors like mutual funds, insurance companies and pension funds should do their research before investing in debt instruments. It is unfortunate that they do not do so, and this was recently exposed during the Non-Banking Financial Company (NBFC) crisis, when they pointed the finger at the CRA. Even for private debt placements, which do not require ratings, ratings are often sought by potential investors.

There are seven CRAs in India, of which three are large, two medium and two relatively small. Cake size is not increasing and there is competitive pricing. One way forward is to be flexible in ratings to build a scale. The curious thing about the business is that, in fact, AA(-) or AA or AA(+) ratings are actually almost identical, indicating a low probability of default. So, if the most reputable agency gives an AA(-) rating, one can take a second chance and give AA or AA+, knowing that the probability of a default is remote. This is rational economics.

The advantage of a notch-up rating is that it keeps everyone happy. It is a win-win all around. Investors can invest in higher-rated paper as per their guidelines, banks save on capital, borrowers pay less interest and CRA gets its revenue. When it comes to annual monitoring, companies often move from one CRA to another, a time when higher ratings are offered.

Mass defaults probably happen once in 10 or 15 years. Therefore, ratings usually stand the test of time and agencies use cumulative default ratios to show that they have performed well. But the trick is to just expand the denominator and that explains the rush to public sector unit (PSU) ratings, which are all AAA because they never default. It helps to reduce that default ratio. Recall that some PSUs paid only Re 1 to get more loans 10,000 crore rating! This is one of the reasons why the revenue growth for CRAs is not commensurate with the amount of loans they have given.

How can one address the perverse incentives in this business? The problem is that CRAs get listed to unlock value for shareholders. Once listed, they have to consistently deliver high returns, which is not possible. Some CRAs with specific ratings business have had net profit margins in excess of 50%, which is rarely seen in other sectors. The CRA business thrives on ‘renting’, as loan issuers only have to appraise their loans. Bank loans above a threshold have to be rated under RBI regulations, while the Securities and Exchange Board of India mandates ratings for public issues and investors insist on ratings for private placements.

If CRAs were not listed, their quest for benefits would not exist. They should be treated as financial-services infrastructure and ideally not listed to avoid those temptations.

The other problem with CRAs is that some of them have consultancy or advisory services in subsidiaries. This should ideally not be allowed because of the inherent conflict of interest. The 2007–08 financial crisis had its origins in CRAs, which provided advisory services as well as credit ratings to similar clients. This is not directly permitted by regulation, but subsidiaries can earn good fees for the services they provide to clients, which also get ratings from their parents. Often, the work is done by the CRA but accounted for by a subsidiary. If the customer relationship is worth good money, its rating can be flexible. Since it can be difficult to force a CRA to sell its subsidiaries, a rule may emphasize that both services cannot be offered to the same customer.

Since credit rating is a powerful tool for investment decisions, integrity is important. Plain profit motivation, however, can encourage settlement in a thin market. The effects of loan defaults have reverberated across the country in recent years. Since CRAs do not face punitive measures for their failures, we need to go back to basics.

Arguably, a wrong decision can be a genuine error, just as a notch can be an exception rather than a rule. One approach could be to allocate business to the regulator. But then the market can blame the regulator for the choice of CRA in case of failure. Alternatively, as suggested above, ratings and other ancillary-provided services should be strictly separated. Another consideration is that ratings should no longer be mandatory, which may make the market more prudent. In addition, external rating committees should be made mandatory, especially if the valuation of the loan is above the threshold. 500 crore, to ensure fair play. With the three CRAs already listed, it’s all worth considering.

These are personal views of the author.

Madan Sabnavis is Chief Economist, Bank of Baroda, and author of ‘Hits and Mrs: The Indian Banking Story’.