Overhauling the credit rating system in India

Overhauling the credit rating system in India

If we need to bring about a change then we need to do a complete overhaul of the rating system

Representative image. Credit: iStockPhoto

The US Railroad companies were the first ones to use credit rating for their Bond issuances in 1850 though the bond markets had existed for more than three centuries but mainly for sovereign debt.

In 1909, John Moody was the first one to publish a Credit information and assigned the first credit rating opinion on the credit worthiness of bonds issued by US Railroad companies.
In India too, Crisil was the first credit rating agency to be set up in 1987 as we saw the demand for bonds being issued by top notch companies. We have seen over 3 decades of credit ratings in India and now India has 7 credit rating agencies and 5 credit scoring companies.

While credit rating companies focus on corporate credit, the credit scoring companies focus on individual credit scores. To be able to get an AAA rating, a company needs to go through several years of good financial performance and rigorous analyses by the rating agencies so it is quite surprising to know how an AAA rated company could get downgraded several notches overnight and turn into illiquid paper. 

The regulators and the government both have been thinking how to fix this problem and be able to pre-empt some large-scale default so that it does not affect the economy. Until a few years ago, a lot of companies boasted about their AAA ratings but not anymore. The small investors have become a nervous lot and are wary of blindly investing just based on an AAA rating.

This is not a healthy sign for an economy that is just about to start its run for super growth ahead of its peers. The nation’s capital markets need to be conducive to raising large amounts of capital through its bond markets.

Factors affecting Corporate Credit Ratings in India:

Rating shopping by corporates: A better rating always means a better rate for raising capital and this is a major driving force behind corporates shopping around for better ratings.

Issuer Company Pays for Ratings: It is only natural that if a company is paying for the rating exercise, they will try to influence the rating agency for a better rating.

Small investor education: Small investors always look for ways and means to get better returns for their savings and whenever they are presented with higher rates of return, they jump at the opportunity without really doing their due diligence. The importance of the return ‘on’ the investment is given more importance than return ‘of’ the investment.

Annual rating review: Corporate Ratings are reviewed annually so the rating agency gets to know about the performance of the company once a year and if they need to analyse and warn the investors, they can only do so after performing a rating review annually which may be quite late on the day.

Ways to overhaul Indian rating agencies

If we need to bring about a change then we need to do a complete overhaul of the rating system.

Technology to help us: Given the advent of fintech, we have witnessed a major disruption of financial services with the help of technology. We have now witnessed huge progress made by India and China in the payments space and banking is completely being reshaped from a physical to a virtual domain. The Government of India has built various online platforms for statutory dues viz GST, Income Tax and TDS. If the rating agencies can do a deeper due diligence based on the above at a regular interval, they will be able to analyse a wealth of data on corporate performance and be able to predict the probability of default much earlier on a cognitive basis.

Separating the payer and appointer of rating agency: If the regulators can evaluate the option to separate the user of and payer to the rating agency, then perhaps we could obviate the conflict of interest that exists today. The bond investor should pay for the use of the credit rating instead of the corporate and include it in the upfront fees that they charge
when they invest into bonds and debentures.

Revamp of rating agency boards: A rating agency is a pillar to the nation’s financial markets and large amounts of capital are raised based on their credit ratings, but they are also
answerable to their shareholders so while they may be privately held, they need to have a board that takes due care of the investor fraternity. In view of the same, it is necessary to
have senior and experienced industry participants (from Banks, RBI, SEBI, Law Firms) duly approved by the Government to be a part of their Board of Directors.

Penal provisions: A provision for levy of financial penalties for sudden defaults may be required to be imposed on the rating agencies for not executing their duties related to rating
actions periodically and for not being able to perform their roles.

Publishing quarterly rating defaults probability ratios (like Claim settlement ratio in Insurance): Rating agencies need to publish data on their total default actions taken
periodically as a percentage of the ratings and such data is to be analysed by their regulator SEBI on the rating actions. This data should also be compared to the defaults that take place in financial markets.

(The writer is Chairman and MD, Beacon Trusteeship Ltd.)