Rating of Credit Rating Agencies: The New Imperative
It is three decades since the CRISIL Rating has commenced its operations and a decade since Brickworks did the same. We also see the frequent sovereign ratings of Standard & Poor's (S&P), India Ratings and Research (Ind-Ra) from the Fitch Group and Moody’s. Very recently, finance minister Nirmala Sitharaman, in the wake of serial failure of well rated corporates – Dewan Housing Finance Corporation Ltd (DHFL), Infrastructure Leasing & Financial Services Ltd (IL&FS) and several other public sector units (PSUs) as well as private companies, voiced her serious concern. Sovereign ratings are also not infallible.
 
This article examines the present status and suggests modifications.
 
Credit rating agencies (CRAs) are expected to play an important role in mapping the risks in the financial system. They facilitate investment decisions and can help investors in achieving a balance in the risk return profile. They assist firms in accessing capital at low cost. Allocative efficiency of capital across the sectors, and appropriate risk pricing would be the gain to the economy. Information asymmetry to an extent is resolved. 
 
“A credit rating is technically an opinion on the relative degree of risk associated with timely payment of interest and principal on a debt instrument. It is an informed indication of the likelihood of default of an issuer on a debt instrument, relative to the respective likelihoods of default of other issuers in the market. It is therefore an independent, easy-to-use measure of relative credit risk.”i 
 
If a bank chooses to keep some of its loans unrated, it may have to provide, as per the extant RBI instructions, a risk weight of 100% for credit risk on such loans.
 
Basal regulations provide for supervisors increasing the standard risk weight for unrated claims where a higher risk weight is warranted by the overall default experience in their jurisdiction. Further, as part of the supervisory review process, the supervisor may also consider whether the credit quality of corporate claims held by individual banks should warrant a standard risk weight higher than 100%.
 
The working of the entire rating system was questioned after the sub-prime crisis resulted in collapse of not just Fannie Mae and Freddie Mac but even UBS Credit Suisse, Citi group and Deutsche Bank. This led the US Fed and the Wall Street to revamp the entire rating mechanism, after a careful review of the processes they followed and the measurement they gave to different parameters. But such changes are not followed uniformly across nations.
 
Theoretically, internal credit scoring models are effective instruments for the banks in loan origination, loan pricing and loan monitoring.  But the banks’ rating architecture is different from the rating agencies and this is one of the reasons for the regulator to insist on a rating review mechanism to be part of the banks’ credit risk management committee.  
 
The rating process involves assessment of business risk arising from the interplay of five factors: industry risk; market position, operating efficiency, financial risk and management risk. While industry risk and market position can be assessed from the macro level data, operating efficiency and management risk can be captured by observation, frequent interactions and experience. Unless cross functional, sectoral, trade data from all sources are available on a digital platform and that too, unless verifiable easily, the rating agencies are bound to err. 
 
As per Basel II (2000): “An internal rating refers to a summary indicator of risk inherent in an individual credit. Ratings typically embody an assessment of the risk of loss due to failure by a given borrower to pay as promised, based on the consideration of the relevant counter party and facility characteristics.  A rating system includes the conceptual methodology, management processes and systems that play a role in the assignment of a rating.”  Understandably, there was a collapse of the rating instrumentality looking at the collapse of the corporate credit and investments almost without notice.  
 
One of the common failings noticed by informed circles, for example, has been, a firm that owes to the micro, small and medium enterprises (MSMEs) more than Rs2lakh should have been rated lower than those that would have paid promptly.
 
Most corporates - both public sector units (PSUs) and private companies were chronic defaulters and this came to surface more prominently in all the National Company Law Tribunal (NCLT)-dealt with cases. Second, poor governance should have got bad rating. But the banks, PSUs and private companies despite having fared badly, got good ratings!
 
Ever since rating is mandated by the RBI while extending credit, we have seen phenomenal failures in the well-rated corporates both in the private and public sectors, e.g., DHFL, IL&FS. Smalll and medium enterprises (SMEs) have no option but to get the rating of one or the other agency and yet, the concerned bank would have its own rating that would decide the quantum of credit. 
 
Measuring policy risks, sovereign risks and governance risks is the major challenge and this challenge has become visible in the recent corporate rating failures. Banks severely compromised by pitching high on CIBIL ratings and particularly, the individuals and directors of the companies. The thirty-year old CIBIL needs to amend its ways if the ratings book should be cleaned.
 
Technology disruption, easy regulations governing payment platforms, data on merchant performance, changes in consumption patterns, differential product regulations across the nations for similarly placed products and increasing protectionism are all the new risk areas for capture by the CRAs. 
 
In so far as the Indian financial sector is concerned, consolidation following the merger of public sector banks (PSBs), failure of non-banking financial companies (NBFCs), urban cooperative banks, and the lackluster performance of the micro finance Institutions (MFIs), metro-centric banking are all new challenges to the CRAs. Telecom regulations and their interface with the payment and settlement systems, internet of things, block-chain technologies are the new disruptors and even a moderate margin of error can impact heavily and the rating can collapse.
 
Further, product regulations have also become dynamic. In a way, all these aspects seem to have their shadow cast on the rating instrumentality as a risk mitigant. 
 
There is therefore an imminent need for a high level committee of the Securities Exchange Board of India (SEBI), RBI, the Pension Fund Regulatory and Development Authority (PFRDA), the Insurance Regulatory and Development Authority of India (IRDA), and the Telecom Regulatory Authority to examine the methodologies of CRAs for a more reliable rating process and pricing of rating agencies. 
 
(Dr B Yerram Raju is an economist and risk management specialist and can be reached at [email protected]. Also see my blog post on 11 June 2011 on the subject.) 
Comments
S Balakrishnan
2 years ago
The author's faith in the institutions mentioned is touching.
If only things were that simple. With honesty, competence and purpose, it would be different.
No lack of brains. Missing is integrity in the fin system from top downwards.
R Balakrishnan
2 years ago
Passing the buck. Instead of lenders doing their work, why do we want to regulate an opinion business? If there is a fraud, go after them. Do you regulate the business of the stock brokers for their stock recommendations?
Nakul Kumar Reddy
2 years ago
I will accept any help from your side,

I will give u 10/10 ratings .
B. Yerram Raju
Replied to Nakul Kumar Reddy comment 2 years ago
Thank you.
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