It is time rating agencies stepped up their game

Indian credit rating agencies (CRAs) have been facing rough weather in recent years, a combined outcome of a multitude of economic factors. However, the most damaging dent on their reputation has undoubtedly been the IL&FS debacle, which is still fresh in public memory. Despite glaring systemic vulnerabilities, CRAs have gotten away with small penalties on the premise that ratings are, after all, a subjective opinion, an opinion can’t be penalized.

Rating being a regulation-supported business, survival was never a problem, but their credibility is indeed at stake. For one, rating agencies are perceived to be behind the curve. Often, CRAs overlook material issues affecting credit.

There have been instances when they first assigned a higher credit rating then lowered it over time to a more reasonable level. The market is ahead of the curve almost always in pricing in the risk, which reflects in higher yields quoted in spite of the instrument being highly rated; we have seen rating downgrades follow later. This defeats the very purpose of a CRA. I hear, a few private banks are tightening their internal assessment mechanisms to reduce their dependence on CRAs.

The fault lies in the way the CRA business is structured, since the issuer pays for his own rating. The truth is that CRAs often have limited access to corporate managements. This access suffers even more if there is a rating downgrade. This inadequacy is bound to impact the surveillance income of CRAs.

The moot question now is: How exactly are CRAs countering the challenges of credibility? There seems to have been little action on this front so far. When the sub-prime lending crisis hit the US, the Senate blasted CRAs for their slippages that contributed to the crisis.

The CRAs in the US swung into action launched a number of initiatives to move up the value chain—including separation of commercial credit rating functions, detaching credit rating non-credit rating businesses, independent review approval of changes to credit rating methodologies, consideration of aggregate credit rating performance in deciding the compensation of certain types of employees, conducting exams training programmes for analysts, cleansing curating databases, investing in technology.

However, despite the IL&FS crisis the consequent backlash, there seems little acknowledgment from CRAs in India, let alone action. There has been no reassuring communication to investors. In fact, one CRA audit report failed to even make a passing mention of the IL&FS fiasco.

Board compositions of CRAs leave a lot to be desired. Their boards need holistic representation from seasoned professionals across diverse sectors, not just from the banking sphere. Bankers do bring a key perspective, but it is not wholly representative. Tie-ups with global agencies is one way of ensuring a better representation, but a wider representation from a cross section of corporate veterans—people who are well-versed with the intricacies dynamics of the ratings business—is a must.

From a minority investor standpoint, the performance policies of CRAs are far from inspiring. Their capital allocation is questionable, especially given that they have an assured market, asset-light business, strong balance sheets, zero debt, low capex, zero receivables, high returns on equity, free cash. Helped by such glittering positives, why don’t they return cash to shareholders or reinvest prudently?

All their woes flaws apart, CRAs do enjoy a strong moat in terms of barriers to entry scale-up for any potential competitor. Currently, the business environment is constrained, the credit cycle is down, but things could look up soon. When the pandemic fades away, the economy will get back on track, the private capex cycle will pick up corporate bond market will deepen. Measures such as the PLI scheme increased ease of doing business are expected to boost capital expenditure in the next five years. Given that bank credit is expected to double in the next five years, the long-term value proposition of CRAs seems intact, the game is certainly wide open. But CRAs need to step up improve their own ratings, before they set about rating others making the most of the business opportunity that lies ahead.

In pulling up their socks, they will have done a world of good not only to their investors, but also to the country in ensuring that the economy grows on a strong footing.

Amar Ambani is senior president head of research, institutional equities, at YES Securities.

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