I Am Worried About Competitive Populism In Rating

Q: The A+ rating that CRB Capital has secured from CARE has brought into question the role and utility of rating agencies in India.

A: The rating industry is relatively new in India but has acquired a good measure of credibility. Rating agencies have made a distinctive contribution to the development of the financial markets. We now find that in the market there is a discriminating judgment on interest rates for differently rated instruments. This fine tuning of interest differentials, calibrated to rating differentials, has come to stay. Also, increasingly, there is insistence by institutional investors that issuers have their privately placed debentures rated. Further, issuers and rating agencies are collaborating to develop new products and new financial instruments. Banks and institutions are increasingly turning to these agencies for inputs in their decision making process. Over the last five years, rating agencies have contributed to developing an ambiance where the market is increasingly coming to recognise the value of credit rating. The agencies can thus claim to have made a good contribution to financial sector reforms.

 

Q: The rating agencies can be useful if they function properly. But when they dont, the question arises: should they wind up or be made to function well as they are vital to the system ?

A: Rating agencies are public institutions and have responsibilities to different market participants. They have really four stakeholders, whose interests they have to keep in view. First, an agency gets a mandate from the issuing company which would like to widen and deepen its access to the market. Two, they help investors in making their choice among different instruments, depending on the risk return combination of their own portfolios. Third, they have another role recognised all over the world: a responsibility along with the regulator in preserving the delicate market mechanism which is so vulnerable to credit default and lack of credit integrity. Lastly, they help the market participants in improving the liquidity and marketability of different debt instruments. Each of these stakeholders have a right to ask the rating agency what it has done for the proper development of the rating and credit culture? So not merely the shareholders of the agency, but also the stakeholders have a right to ask the

questions being asked today.

Q: After the CRB episode, investors feel let down.

A: Yes. But we must be clear what rating is all about. It is an opinion on the ability of the issuers to service debt obligations. To do that you look at the unit, its management, past record, the dynamics of the relevant industry, policy and the regulatory environment, and life of the instrument. There are risk factors which are rooted in the unit and its industrial environment. At the same time, there are certain protective factors which can shield it, either wholly or partly, from the risk factors. So a rating agency takes a balanced view and makes a judgment on the likely nature of cash flows during the life of the instrument and the likelihood of default. It is, after all, a judgment of a group of people and you have to accept that. Now this judgment is given at a point of time. You look at it again when certain developments take place, which may be adverse or favourable, and the judgment changes. That explains why over the last one and a half years there has been a good number of changes in ratings.

Q: That is the theory. What is happening on the ground?

A: In some recent instances, there have been very sharp changes in perception. There is, therefore, a legitimate concern. A rating agency is not a concurrent audit or inspecting agency. It accepts the statements, documents and information provided by the company and makes such adjustments as is necessary to facilitate a well informed and unbiased judgment. But it is difficult to guard against wrong and misleading disclosures willfully made. When the stakes are high, it would help investors if they have the benefit of opinions from at least two agencies. I recall that about three years ago, the RBI governor made this point at an international conference: Rating is after all an opinion; so why not have two opinions for investments above a certain amount. This is an accepted practice in developed markets, particularly the US, where the market expects at least rating from two agencies.

Q: You are saying that to lessen the probability of bad ratings in individual cases, go in for more ratings. The sceptic can say that you are merely arguing for more captive business?

A: We should not look at it from the point of view of business impact on the agencies but from the larger interest of the investors.

Q: Can an agency say that we looked at the balance sheet and gave the rating?

A: Analysing the balance sheet is the first step. Then it has to be adjusted for auditors qualifications, accounting treatment and an adjusted balance sheet, profit and loss account and cash flow statement are prepared. If inconsistencies raise suspicion, they have to be investigated. If the issue is the quality of assets like shares, then that has to be gone into and examined whether those are speculative assets. But an agency cannot be expected to detect fraudulent and active concealment in the course of a due diligence exercise typically conducted over three to four weeks.

Q: Would you say that the rating industry needs to be regulated in the interest of proper market development?

A: This is difficult to answer. This industry is not regulated anywhere. So we need to debate whether we should have regulation and if so what type of regulation. One should not pass hasty judgments on the rating industry on the basis of one or two instances. The industry has so far assigned ratings for hundreds of instruments and given a commendable account of itself. The process needs to be facilitated and strengthened. I am afraid that, as it has happened on many occasions, regulatory overzealousness may stifle the development of the industry. But having said that, I must confess to some concerns.

Q: What are they?

A: The agency which is doing the rating, must be a fit and proper person to do so. In the US there is no such fit and proper criterion. As of now, rating agencies are just registered with the SEC. But I think, given the difference in the way the market is functioning here, the question of a fit and proper category for any new entrant has to be addressed. Second, the agencies have to bring about an equivalence in the ratings assigned. If an agency gives a rating A, and another agency also gives a rating A, the market should accept it as equivalent. You can have different opinions about a company, but no confusion as to the meaning of a specific rating symbol. For example, if one agency gives a rating for fixed deposits to a company for upto a particular amount, and other agencies do not specify the amount, then the two exercises are not the same.

Q: Do you have any concerns on the way the rating agencies are functioning in India ?

A: I am worried over the competitive populism which has developed in the rating industry. Issuers are taking advantage by playing off one agency against another. They are demanding quick rating and the agencies are under tremendous pressure to complete the due diligence process within a very short time. Also, undercutting of fees is reportedly taking place on a large scale. This is not healthy for rating agencies which depend critically on high cost, skilled manpower. Unless these tendencies are curbed soon, I see a positive threat to the quality of performance in the rating industry. This is not to say that the problem can simply be solved by a regulator. Rating agencies have behaved fairly responsibly for the last five years and with a bit of self-governance among them, they can tackle the problem. The regulator may move to facilitate this process.

Q: What do you feel about the reactions to the crisis so far ?

A: We should never be panicky. Take the reported move for business compartmentalisation for merchant bankers, that is they should not also function as NBFCs and deposit takers. This is the wrong end of the stick. The market is increasingly moving towards universal banking and becoming so integrated and interrelated that the best value to customers can be provided under one umbrella. We should go into these issues more carefully. Take the plea for deposit insurance. Insurance is not the panacea. With greater disclosures and transparency, market operations can be carried on in an investor-friendly manner. This will help investors make the right choices. They have to be educated to become more responsible and should understand that they have to bear the consequences of their decisions. The rules of the game should be so framed and enforced that investors are encouraged to take rational decisions in the market environment. We must accept however that no regulatory agency can plug every conceivable loophole and

even under the best of conditions, frauds will surface. We have to learn to live with them. Whoever defrauds any institution must be punished swiftly. But we should not rush to take steps which may impede the process of market development. It is difficult to guard against wrong and

misleading disclosures willfully made. When the stakes are high, it would help investors if they have the benefit of opinions from at least two agencies.