Is It Time To Evaluate Rating Agencies?

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It is reported that the number of companies refusing 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% in fiscal 2018 to 47% in fiscal 20, according to Bloomberg. This implies that 53 percent of ratings given by agencies are based on inadequate information and are therefore unreliable.

This is an alarming situation that requires drastic corrective action. The use of credit facilities based on the credit rating and the refusal to part with information for subsequent follow-ups creates the suspicion that all is not well with these companies. But this situation did not arise suddenly; it is necessary to do a thorough study of the operation of credit rating agencies in India to understand why.

There are a number of major credit rating agencies in India such as CRISIL, ICRA, CARE, SMERA, Fitch India and Brickwork Ratings which are registered with the Securities and Exchange Board of India. Internationally, there are rating agencies such as Standard and Poor, Moody’s, Fitch, DBRS, etc. Banks and investors depend on the ratings of these agencies when considering lending or investing in rated companies.

Rating agencies collect information about financial flexibility and turnover values ​​and analyze them to reach a conclusion. Rating agencies assess risks and find measures to overcome them and improve the image of the company.

Ratings provide a measure of the creditworthiness of these companies and how well they will meet their future financial obligations. They help investors see the risks and, therefore, secure the interest in the investment. The higher the credit score, the lower the interest rate offered to the organization.

The failure of an appropriate assessment by the rating agency is not uncommon.

A recent example is the case of defaults by Infrastructure Leasing and Financial Services Ltd. Rating agencies failed to issue timely red flags ahead of the group’s problems. The failure of IL & FS caused sharp declines in the Indian stock and bond markets.

The root of the problem

The company issuing the debt instrument or benefiting from a bank loan selects the rating agency and pays for its services. This invariably leads the agency to give a favorable rating. There is therefore a conflict of interest in the rating process. The issuer pays the rating agency while the investor defers to 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 qualified as the result of their complicity during the analysis and provision of ratings.

Then there are the companies that are willing, at the time of the initial issuance of credit instruments, to provide full details to the rating agency. Subsequently, they are less enthusiastic, either because of the deterioration of their financial situation or for other reasons. As such, there is little the regulator can do, although the market may punish these issuers in the future. Banks may charge only higher interest, but businesses that won’t pay off their debts might not care much about such a criminal 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 financial results. When ratings are only revised periodically, they tend to become less reliable.

Correction course

Whenever the issuer does not cooperate, the credit rating agency has been instructed to provide the rating with a comment stating “The issuer did not cooperate; on the basis of the best information available ”. Similar disclosures should be made when there is a material change in ratings, or when agencies fall behind in identifying risks.

SEBI, for its part, has issued standards to improve disclosures by credit rating agencies, requiring them to provide information on whether the rating takes into account the support of a parent company, group or of a government; or is awaiting an injection of funds for timely debt service, among other things.

However, we need to think about an alternative to the current credit rating system. There may be a separate rating agency, such as a statutory body, with adequate powers to itself assess other rating agencies. As an immediate measure, as the audit of banks is approved by the RBI, rating contracts can also be awarded by the SEBI among the rating agencies. Rating agencies should be accountable to SEBI and investors.

The writer is a retired banker

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