The principal concern of every lender is the repayment capability of a potential borrower. Creditors and investors need to form an objective opinion on the creditworthiness of the issuer of a debt instrument and the credit rating agencies (CRAs) assist them in doing this.
The opinion provided by the CRAs is an “informed indication” of the possibility of default on a debt instrument, relative to the possibility of default by other issuers. Nowadays procuring a credit rating has become a precondition for any debt offering in virtually every country with a debt market. However, CRAs have their shortcomings.
Answerable to none
Although the opinions of CRAs are relied upon greatly, their accountability for inaccurate ratings is minimal. Attempts to regulate CRAs have been resisted on grounds that the CRAs merely voice opinions and do not make recommendations. It has also been argued that CRAs, which depend on their reputations for their existence, are adequately regulated by market forces.
However, the recent financial downturn has shown the need for the regulation of CRAs. Suggestions made in the February issue of the Securities and Exchange Board of India (SEBI) Bulletin include to: (i) promote competition; (ii) require CRAs to disclose their income from related parties and activities, and their policy, methodology and procedure relating to ratings, etc; (iii) record the factors underlying a rating and the sensitivity of the rating to changes in these factors; (iv) record the rationale for any material difference between the rating implied by the model and one actually assigned, which is to be open for scrutiny by auditors and regulators.
Post-Enron and the global slowdown, questions have emerged on the ability of the CRAs, most of which function on an issuer-pays model, to deliver an unbiased and independent evaluation. This model is popular with issuers who depend on CRAs to vouch for their issue. For CRAs, the model assures financial returns, which is not the case for an investor-pays model.
However, the risk with the issuer-pays model is that CRAs may relax their standards as they try to maximize profits. In addition, when faced with a situation that warrants immediate corrective action, CRAs may raise the issue and cause panic among investors.
The investor-pays model has its own issues. As continuous interaction of CRAs with issuers is not always possible, surveillance may be affected. Also, as issuers may not make complete information available to CRAs, the rating quality could suffer. There is also a practical issue of which CRA will rate the issue.
The risk can be minimized by combining both models: the issuer must appoint one issuer-paid CRA and procure at least one more report from an investor-paid CRA. To ensure a balanced view, the details given to each CRA should be identical.
Conflicts of interests
Often there are conflicts of interests as CRAs work within corporate structures and there may be common directors between a CRA or its associates and the issuer and/or its group. The CRA or its associates may also be providing consultancy and advisory services and may find it difficult to go against the advice given by its group or associate. Such conflicts must be effectively controlled through legislation by enhancing disclosure and transparency requirements.
The US Securities and Exchange Commission addresses these issues through regulations that prevent CRAs from rating complex structured debt issues that they have helped design. In addition, analysts of CRAs cannot take part in fee negotiations.
In India the regulation of CRAs began in 1999. The Securities and Exchange Board of India Act, 1992, now provides details on (i) the eligibility criteria for the promoter of a CRA (ii) the agreements that need to be entered into (iii) the method and procedures for monitoring and reviewing ratings (v) disclosure of ratings and (vi) submission of details to regulators. In addition, there are restrictions on rating securities issued by companies in which a director of the CRA is a director.
The effective regulation of CRAs and creation of a level field in which competition among CRAs can increase is the best bet. This would result in CRAs giving more attention to the quality of their reports and give the investors an option to choose their rating agency.
Regulators should look to manage conflicts of interest, through governance reforms in rating agencies, improving the quality of rating methodologies and promoting fairness in the rating process. They should also work to increase transparency and disclosure obligations and to compile and make available to the public the default history and performance of the ratings by CRAs.
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