It’s time for rating agencies to step up their game

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Indian credit rating agencies (CRAs) have faced difficult weather conditions in recent years, the combined result of a multitude of economic factors. However, without a doubt, the most damaging notch to their reputation has been the IL&FS debacle, which is still fresh in public memory. Despite glaring systemic vulnerabilities, credit rating agencies got away with small penalties on the assumption that ratings are, after all, a subjective opinion and that an opinion cannot be penalized.

As rating is a regulated activity, survival has never been an issue, but their credibility is indeed at stake. On the one hand, rating agencies are seen as lagging behind. Often, credit rating agencies overlook material issues that affect credit.

There have been cases where they first assigned a higher credit rating and then lowered it over time to a more reasonable level. The market is almost always one step ahead of risk pricing, resulting in higher returns despite the instrument’s high rating; we saw rating downgrades follow later. This defeats the very purpose of an ARC. I have heard that some private banks are strengthening their internal rating mechanisms to reduce their dependence on rating agencies.

The fault lies in the way the activity of the rating agency is structured, since the issuer pays its own rating. The truth is that rating agencies often have limited access to company management. This access suffers even more if the rating is downgraded. This insufficiency necessarily impacts the monitoring revenues of rating agencies.

The debatable question now is: How exactly do credit rating agencies cope with credibility challenges? There seems to have been little action on this front so far. When the subprime loan crisis hit the United States, the Senate blasted credit rating agencies for their slippages that contributed to the crisis.

Credit rating agencies in the United States have taken action and have launched a number of initiatives to move up the value chain, including the separation of the business rating and credit functions, the detachment of the activities of credit rating and non-credit rating, independent review and approval of changes to credit rating methodologies. , taking into account overall credit score performance when deciding the compensation of certain types of employees, organizing exams and training programs for analysts, cleaning and maintaining databases and investing in technology .

However, despite the IL&FS crisis and the ensuing backlash, it appears there is little recognition of rating agencies in India, let alone the action. There was no reassuring communication to investors. In fact, an ARC audit report did not even mention the IL&FS fiasco.

The composition of the boards of credit rating agencies leaves a lot to be desired. Their boards need a holistic representation of seasoned professionals from a variety of industries, not just banking. Bankers provide a key point of view, but it is not fully representative. Links to global agencies are one way to ensure better representation, but a broader representation of a cross-section of the company’s veterans – people familiar with the intricacies and dynamics of the rating business – is a must.

From the perspective of minority investors, the performance and policies of rating agencies are far from inspiring. Their capital allocation is questionable, especially since they have a secure market, light asset activities, strong balance sheets, zero debt, low investment spending, zero claims, high returns on equity and available liquidity. Helped by such bright positives, why don’t they return money to shareholders or reinvest carefully?

All their woes and flaws aside, rating agencies benefit from a strong gulf in terms of barriers to entry and scaling up for any potential competitor. Currently, the business environment is constrained and the credit cycle is down, but things could improve soon. When the pandemic subsides, the economy will get back on track, the private investment cycle will resume, and the corporate bond market will deepen. Measures such as the PLI scheme and an increased ease of doing business are expected to boost capital spending over the next five years. With bank lending expected to double over the next five years, the long-term value proposition of rating agencies appears intact and the game is certainly wide open. But rating agencies need to step up and improve their own ratings, before they start rating others and making the most of business opportunities as they arise.

By pulling up their socks, they will have done a great deal of good not only for their investors but also for the country by ensuring that the economy thrives on a solid footing.

Amar Ambani is Senior President and Head of Research, Institutional Equities, at YES Securities.

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