Credit Ratings: Need For New Regulation Or Tighter Supervision?

The collapse of the once AAA-rated Infrastructure Leasing and Financial Services, a prolific issuer of debt securities, brought the focus back on credit rating agencies. Just like at the time of the global financial crisis, questions are being raised about the effectiveness of credit rating agencies in alerting the system and investors of risks lurking beneath the surface. The questions extend to the business model of these rating agencies, where conflicts of interest can crop-up between business interests and credit analysis functions.

The Parliamentary Standing Committee on Finance, in a report titled “Strengthening the Credit Rating Framework in the country”, suggested tighter supervision of rating agencies and perhaps even a change in regulations.

The panel noted:

• Securities and Exchange Board of India and Reserve Bank of India should review their regulations “comprehensively” and should be proactive in ensuring strict enforcement of regulations.
• Fresh evaluation of credit rating framework should be undertaken to restore public confidence in rating agencies.
• Alternative models like investors or regulator paying to rate issuances of a company instead of an “issuer pays model” should be considered.
• Mandatory rotation of rating agencies should be considered.

Assessing Rating Agency Performance

Most agree that rating agencies have some tough questions to answer. For instance, in the case of IL&FS, ratings didn't capture the stress building up in the group and also assumed a level of support from the shareholders, which was not forthcoming when the funding was needed.

It was presumed that a lot of the IL&FS subsidiaries will get supported by the parent and that moved up the ratings of subsidiaries but didn't pull down the rating of the parent, explained Amit Tandon, co-founder and managing director of proxy advisory firm IiAS. This created an idea that everything was okay, which it wasn't, he added.

Rating agencies, however, argue that these costly one-off mistakes must be weighed against their broader performance. They also argue that a distinction must be made between the performance of different agencies.

This performance is captured in the default and transition ratings put out by each agency. The former gives an idea of the percentage of defaults from each rating category. The latter is a reflection of the rate at which ratings move from one category to another.

Data available from each of the agencies shows that there is considerable divergence in these metrics across agencies, particularly in lower rating categories.

Ideally, rating agencies with lower default rates should be seen as more credible by investors and this should also lead to a differential in pricing of instruments rated by one agency over another.

Does this happen in reality? Tandon feels it does to some extent. “I do believe that today with all the data analytics at our disposal, it's possible to judge the difference between different agencies,” he said. Eventually, if there is a pricing difference, issuers should move towards ratings by agencies which allow them to raise funds at a cheaper cost.

Perverse Incentives

But performance of rating agencies is not the only factor at play. Investors and issuers can both have perverse incentives which can skew the ratings market.

In the case of issuers, the incentives are clear. The higher the rating, the lower the cost at which they can raise funds and the larger the investor pool they can tap. Even if there are small differences in pricing based on ratings by stronger versus weaker agencies, being put in a better rating category can help a company keep its costs down.

And so, “ratings shopping” as its often called, is far from dead, said Tandon.

But investors can also skew ratings for their self-interest.

For instance, in the case of bank loan ratings, banks would prefer to have loan parcels given higher ratings so that they need to set aside lesser capital. Similarly, mutual funds would have an incentive to keep ratings of instruments they're invested in at a higher level since that pushed by the net asset value of the scheme.

Tandon added that rating agencies are also sometimes cautious in downgrading instruments sharply because it becomes “self-fulfilling”. Such downgrades can prompt panic selling from investors who invest with a certain mandate but there may be no buyers and the market can freeze, he explained.

What Are The Correctives?

Given the troubles faced in recent months with ratings assigned by certain agencies and to certain companies, what are the correctives needed?

Tandon argues that the answer lies in tighter supervision and not new regulation.

Tandon doesn't believe that alternate models like ‘investor pays' or ‘regulator pays' will work. In the case of the ‘investor pays' model, the key question to ask is how this would work in the case of retail issues of securities.

The suggestion to introduce mandatory rotation of rating agencies could have an adverse impact by allowing weaker rating agencies to corner more of the business, he said.

“At the end of the day, the consequences of mistakes have to be high but you have to remember that they, by and large, get it right. We always remember the failures,” Tandon said.

Watch the full discussion here:

This story has been updated to correct an error in the table on default rates.