The investor should pay

The credit rating system in India needs reform

The head of a leading Indian credit rating agency has complained that there is unhealthy competition among too many players in the sector. This is leading to “rating shopping” by issuers of paper and competitive undercutting of fees by agencies. It will inevitably lead to dependence on poorly paid analysts doing a substandard job. Normally, competition should benefit the consumer but in the case of rating the end consumer – the investor – does not pay for the rating, the issuer does. The latter’s aim is only to market its paper successfully, whereas it is the investor who is left holding the paper. Competition improves efficiency, though price pressure-induced cost cutting beyond a point can affect quality. But the fact is the absence of effective competition has not improved the quality of rating in a country like the United States. There are a dozen agencies approved by the US Securities and Exchange Commission termed Nationally Recognised Statistical Rating Organisations or NRSROs (including the Canadian- and Japanese-owned) but Moody’s and Standard & Poor’s are way ahead of the others in terms of business share. The latter did roaring business in the run-up to the financial crisis of 2008 and then dragged the name of rating into mud. When the US housing bubble burst, it brought down with it triple A-rated structured finance products, which included sub-prime mortgages, and the reputation of rating. The Indian leaders rest their claim to quality and premium pricing on their allegiance to the two US leaders, but those labels now stand discredited.

India has six credit rating agencies recognised by the Securities and Exchange Board of India (Sebi), which should provide for the right amount of competition and no more. But to get the market for rating right, it is necessary to address the dilemma over who should pay for the rating. The investor should pay, and there is a strong case for Sebi to have a dialogue with the leading institutional investors’ body, the Association of Mutual Funds in India (AMFI), which represents fund managers. These, between themselves, should pay for the rating of all issues of any consequence and the ratings should be made public. There are already two US rating agencies, Egan-Jones and LACE Financial, which accept mandate only from investors. It is argued that when a firm knows that the rating will be published irrespective of whether it likes the outcome or not, it will not cooperate with the rating exercise, thus reducing its value. The key additionality that rating offers beyond published past financial accounts of companies is the insight gained from detailed discussion with the issuer’s management. On the other hand, when the issuer pays for a mandate, it has the right not to use the rating if it finds it unsatisfactory and the agency then cannot make public the rating. While there is a chance of information being restricted under both the systems (issuer pays versus investor pays), ultimately an issuer’s interest lies in getting a good rating and for this it is likely to cooperate with the rating exercise irrespective of the final outcome. So, it is time to get investors to pay for rating in India to move to a better system. There is a need to involve AMFI and get it to encourage fund managers to pay for rating.