On Feb. 11, 2019, when the Standing Committee on Finance submitted a report to Parliament titled ‘Strengthening of Credit Rating Framework in the Country’ it possibly signalled two things. First, it reinforces the critical role of well-functioning credit rating agencies to the economy. Given the recent issues around rating agencies, there remains huge scope for improvement. Second, lawmakers have had to step in with suggestions despite the presence of an otherwise well-regarded regulator, SEBI. Indian lawmakers may be justifiably worried that India is competing with China not just on GDP growth, but also on defaults by high investment-grade debt rated AAA or AA.
Investor Pays Model: Deja Vu
Globally, whenever there is a systemic crisis or a blow-up in the fixed income market, fingers get pointed at the credit rating agencies. Then, what is identified as the root cause of rating agencies’ shortcomings is the ‘issuer-pays’ model – where the entity whose bond is rated by the credit rating agency, also pays the credit rating agency.
While the potential for conflict-of-interest is undeniable, identifying that as the root cause of all rating related shortcomings is over-simplistic.
On a lighter note, most vehement criticism of the ‘issuer-pays’ model usually comes from business writers, while practicing financial-economists (a dwindling breed!), fixed income professionals, and lastly, regulators are more guarded. This is not without reason.
‘While the issuer-fee model naturally creates the potential for conflicts of interest and ratings inflation, most [hearing participants] were of the view that this conflict is manageable and, for the most part, has been effectively addressed by the credit rating agencies.U.S. SEC In 2003
Credit rating agencies came into being in the early 1900s. Then, the core model was ‘investor pays’. This continued well into the 1960s. Then technology disrupted the business model. Photocopiers came into being and rating agencies were plagued by ‘free rider’ investors. Incredible as it may sound, the New York Times reported in 1968 that S&P had lost money on its municipal rating service in 1967. Such losses raised concerns about the quality of ratings.
A 1970 Wall Street Journal article documents investment analysts doubting whether the rating agencies had sufficient staff and technological resources to meet the increased demand for their services. It is between 1968 and 1975 that the rating agencies shifted to the now much-maligned ‘issuer-pays’ model.
The Many Avatars Of ‘Conflict Of Interest’
There are broadly two ways of addressing conflict of interest in financial transactions: prohibition, and disclosure. In the event that prohibition is not possible, the next best option has been disclosure. Any regulatory-mandated change in the rating agencies’ business models has the potential to replace one form of conflict of interest with another.
For instance, if a mutual fund or a pension fund pays for the rating, it can be argued that once a security is part of a portfolio it is not in the best interests of the fund manager that the bond is downgraded. Extending this hypothetical scenario further, the fund manager may, potentially, end up paying a rating agency to keep the rating intact.
This hypothetical scenario is not far-fetched. We’ve witnessed the issues the banking sector has had in not recognising defaults and non-performing assets promptly, before an asset quality review is mandated. Arguably, if the conflict of interest in the investor-pays model is not resolved, then secondary bond market development would be hampered. Secondary buyers could fear that they are buying a bond from its previous owner at what could be an inflated rating.
Issuer-Pay Model Not Unique To Rating Agencies
The conflict of interest in the ‘evaluated-pays-evaluator’ system is not unique to rating agencies. It is also how companies are audited, and students are evaluated by the institution that they pay fees to.
If the education system, by and large, works well, it because students and institutions are made to adhere to certain norms, are subject to market forces, and face high reputational risks. If students do not like the grades given by a school or college, they cannot refuse to accept the grades. However, a rated company can refuse to accept a rating if it does not find the ‘rating’ acceptable.
Allowing an evaluated company to disown or bury a rating is similar to allowing students instruct a university not to publish results, while in the meantime the students hunt for a more understanding university, whose grades meet expectations.
Arguably, this regulatory lacuna may be the genesis of the rating shopping alleged to be taking place.
Broaden The Payer Universe
In a marketplace, those that avail and benefit from a service pay for it. With credit ratings, the issuer as well as the investor benefit. In this context, the recommendation of the Standing Commitee which has asked SEBI to consider ‘investor pay’ and ‘regulator pay’ models, assumes significance. Currently, SEBI mandates that only the issuer should pay the rating agency.
We may want to consider allowing a parallel mandate from an investor or a regulator/competent authority to rate an issuer.
Then, the reviews paid for by the issuer and by the investor or regulator can be compared. Inconsistencies, if any, will be out in the open. Multiple views also add to market efficiencies and aid more information becoming public.
Meaningful And Meaty Disclosures
While the level of transparency associated with the rating process has increased over the years, more can be done. The objective of the disclosures should be to enable an investor or an analyst to independently assess the level of consistency and objectivity associated with the decision of the rating agency to assign a specific rating level. This can be done with the release of three data sets.
1. Public disclosure of median ratio: The rating agency can be made to publish the median s of the critical ratio selected by the regulator, for a specific industry, across various rating levels, for last five years. This will allow an investor to compare whether the current rating, given the corresponding ratio, is less or more stringent and whether the rating agency’s standards have been consistent over a period of time.
2. Enhanced transition matrix: Investors should know the default rate of AAA/AA/A rated bonds over three to five years from issuance and not just one year.
Withdrawn ratings should also be a category and defaults occurring within one year of a rating being withdrawn should be included in default study.
As such, all ratings ever assigned by the agency should be available on its site. Currently, past uncomfortable ratings, are often not found on the agency’s site.
3. Cross-referring ratings: In their press release, rating agencies can be asked to mention the outstanding ratings of the other agencies, and any previously withdrawn rating from another agency, with the reason. Such measures may prevent in-your-face rating shopping.
Rethink Public Risk Assessment System
The regulator can encourage mutual funds and other institutions who invest public money, to disclose their internal ratings associated with each of their investments. To the extent, it is the fund managers who actually invest the money and get paid by the investor. Investors should know whether their fund houses agree with the agencies’ rating as well as the funds’ credit risk assessment skill set. Likewise, the concerned regulator must encourage usage of machine learning-based models for risk assessment of corporates at banks and MFs at least for portfolio monitoring and surveillance. Last, but not the least, the rating agencies should be protected under the law to express their opinion about the credit profile of any issuer without fear of litigation.
Clearly, there is a lot of scope for regulatory action to enhance the functioning credit rating agencies. However, piecemeal, knee-jerk responses should not be the path chosen.
Deep Narayan Mukherjee is a financial services professional and a visiting faculty on risk management at IIM Calcutta.
The views expressed here are those of the author and do not necessarily represent the views of Bloomberg Quint or its editorial team.
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