Above: Standard & Poor’s, one of the largest CRAs in the world
The government wants to increase regulations on the credit rating agencies. This won’t prevent another IL&FS. It will only increase compliance costs and prevent the entry of new innovative companies
By Sanjiv Bhatia
Financial regulators are always guilty of closing the barn door after the horse has bolted. The IL&FS crisis is an excellent example of this. Despite all the warnings, no gatekeeper (SEBI, RBI, banks, accountants, credit rating agencies, directors) raised any red flags until it had turned into a full-blown crisis. The contagion effect of IL&FS is now being felt throughout the economy with an almost complete shutdown of credit for non-banking financial companies affecting projects worth tens of thousands of crores in real estate development, construction and infrastructure.
The fingers have started to point and the role of credit rating agencies (CRAs) has come under scrutiny. The serious fraud investigation unit (SFIO) is investigating four CRAs for inflating the credit rating of IL&FS and its financial arm IFIN, and for failing to adjust their ratings on IL&FS debt despite obvious red flags, including internal warnings from analysts at the rating agencies.
CRAs are not new to controversy. There is a broad consensus that CRAs contributed to the 2008 financial crisis. They underestimated the risk associated with mortgage securities and other derivative credit products and failed to adjust their ratings quickly enough to deteriorating market conditions. Prior to the outbreak of the financial crisis, CRAs were mostly unregulated, but as the crisis progressed, and the finger-pointing started, calls for regulating CRAs grew louder. They were accused of methodological errors in their rating process and unresolved conflicts of interests.
What are CRAs, what role do they play and why are they so crucial for debt markets? CRAs provide opinions about the creditworthiness of bonds (and other debt instruments) that are issued by corporations, municipalities, sovereign governments and the like. Such information is the foundation for the operation of any credit market. There are high fixed costs of gathering and analysing this information and many lenders may be too small or lack the expertise to collect and analyse the data themselves. This leads many investors to outsource this service to credit rating agencies who have professionals who can gather the appropriate information and analyse it using proprietary risk models.
The CRAs summarise their research into an alphabetical rating of debt. While each CRA has its own rating system, the general convention is to provide ratings on a letter scale, with AAA being the safest credit and C representing the highest risk borrowers (instruments rated D are in default). These ratings have huge significance for the interest rate paid by companies on their debt instruments. The lower the credit rating, the greater the risk and higher the yield investors demand. Thus, B-rated bonds currently have to offer a yield of about 350 basis points higher than their A-rated counterparts. As the ratings could mean significantly higher borrowing costs and lower profits, firms and CRAs have been accused of colluding and gaming the system. The IL&FS case is a classic example of this gaming—both IL&FS and IFIN debt had AAA ratings which were downgraded to junk, not gradually as would be the case for a company whose financial position was slowly deteriorating, but overnight, and only after the financial deficiencies of the firm had been exposed.
The modern credit rating industry originated during the late 19th century in the US as a service to evaluate the riskiness of railroad bonds that were used to finance American railroads. In 1890, Poor’s Publishing Company, the predecessor of today’s Standard & Poor’s (S&P) Financial Services, started publishing the Poor’s Manual with reports and elaborate details about financial data for individual railroad companies. Later, John Moody, an entrepreneur, started collecting these details and synthesising this mass of information into an easily digestible format which eventually became the Moody’s rating system. By 1924, several rating companies started publishing ratings on bonds. These early agencies made money by charging investors subscription fees, unlike today where the rating fee is paid by the company whose bond is being rated.
The credit rating industry went into a general decline after the 1929 crash. Investors, stung by the poor record of these agencies in anticipating the sharp drop in bond values, lost interest in purchasing ratings. They recognised that the ratings were not valuable and were based mainly on publicly available information. According to a study of 207 corporate bond rating changes from 1950 to 1972, credit rating changes generated information of little or no value. The changes merely reflected information already incorporated into stock prices—and indeed lagged that information by as much as 18 months. As a result of this investor apathy, the rating business remained stagnant for decades.
All of this changed in the 1980s with growing privatisation and the increased globalisation of finance. With investors seeking returns worldwide, there was an increase in the demand for information about the creditworthiness of issuers, instruments and countries in foreign markets. CRAs jumped in as gatekeepers to reduce the information asymmetry between lenders and borrowers. And their business blossomed. An investor in the US, for example, would be unable to do independent research on a bond issuer in India—so she/he is forced to rely on the credit rating provided by the CRA. As of 2018, Standard & Poor’s, the largest CRA in the world, had credit rating opinions outstanding on approximately $40 trillion of debt, including 7,45,000 securities issued by roughly 42,000 obligors in more than 100 countries.
Credit rating is a highly concentrated industry and three big CRAs—Moody’s Investors Service, Standard & Poor’s (S&P) and Fitch Ratings—control 95 percent of the global market. The three largest rating agencies in India—CRISIL (owned by S&P subsidiary), Care Ratings and ICRA (owned by Moody’s)—account for 85 percent of the rating business in India. The rest is shared by India Ratings and Research (a subsidiary of Fitch), Brickwork Ratings India Pvt Ltd (promoted by Canara Bank), Smera Ratings Ltd (owned by Dun and Bradstreet Information Services India Pvt Ltd and some banks) and Infomerics Valuation and Rating.
Credit ratings continue to present an unusual paradox: rating changes are important, yet they possess little informational value. Most CRAs are behind the curve and provide rating downgrades only after the company has defaulted. Yet, governments insist that public pension plans and public sector banks invest only in high-rated instruments.
Credit ratings also don’t help in mitigating risk because ratings are relative—a AAA-rated bond in India is not the same as a AAA-rated bond in the US, because the credit rating is relative to other companies in the country (region). CRAs are also not widely respected among sophisticated investors, yet their services are increasingly valuable. And CRAs face egregious conflicts of interest—they continue to be paid directly by issuers, they give unsolicited ratings to pressure issuers to pay them fees for rating upgrades and they market ancillary consulting services related to ratings. Yet, their ratings are far more valuable than the opinions of most prominent and respected financial writers.
The financial services industry is a complex one. And it has spawned a plethora of gatekeepers—banks, accounting firms, mutual funds, CRAs, financial advisors—all providing services to mitigate information asymmetry for investors. The interesting thing is that while other gatekeepers have paid huge penalties for malfeasance—banks have paid billions in fines from the 2008 crisis, and accounting firm Arthur Anderson was shut down after the Enron crisis—CRAs have managed to insulate themselves from civil and criminal liabilities. Their defence is that their business is financial publishing and their ratings therefore are “opinions” protected by freedom of the press and free speech. In the US, several lower-court judges have accepted the rating agencies’ argument that ratings are opinions protected by the First Amendment.
There are various proposals to control the behaviour of CRAs—one group suggests greater regulation and the other greater liability. Despite the urge to use regulation to get the CRAs “to do a better job”, it is not clear what a regulator (like SEBI) can do that is beneficial. None of the regulators helped identify the IL&FS crisis before it became public, and none were helpful in preventing the NPA crisis.
It is important to remember that the bond market is largely a wholesale market where the overwhelming percentages of bonds are held by large financial institutions like large pension plans, insurance companies and mutual funds. The primary investor in the bond market is a bond portfolio manager for a financial institution, who should have the expertise and resources to be able to decide which third-party providers of creditworthiness are reliable. They shouldn’t need guidance from a regulator.
Also, the cost of compliance (lawyers, accountants, analysts, etc) arising from a tougher regulatory environment, increases the fixed costs, which becomes a barrier to entry for new, innovative firms that want to enter the credit rating business. The fact that only three firms control 95 percent of the global rating business suggests that increased regulation has only succeeded in bolstering the market share of the larger, established, CRAs. That is the opposite of what is required to bring efficiency in the industry. The credit rating business needs competition so that the business model is driven by concerns for long-run reputations—especially in the context of a wholesale market where most players are well-informed and sophisticated. New entrants are often the source of innovation in an industry, and any effort to increase regulation will discourage new ideas, new methodologies, new technologies, perhaps even new business models for credit rating firms.
In response to the IL&FS crisis, the government is contemplating increased regulations for CRAs. Increased regulation is, sadly, the typical response to all crisis in India. Regulation, while it sounds appealing, has a very poor track record of preventing financial disasters. And it imposes a huge cost on competition and in the end leads to oligopolies and even greater excesses.
The ideal reform should reduce the value of regulatory licenses to encourage competition and innovation in the sector, and also increase the threat of civil and criminal liabilities for gaming the system. Currently, there is no discussion of civil liabilities in case of gross negligence or even fraud, although in the US and the European Union, civil liability can be imposed on the CRA in the event of gross negligence or damage to investors. The ideal proposals would help create incentives for credit rating agencies to generate greater informational value while reducing the impact of ratings on markets and forcing CRAs to be more judicious gatekeepers for investors.
—The writer is a financial economist and founder, contractwithindia.com