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Are Leading Credit Rating Agencies Manipulating Risk Assessment To Appease Clients?
Regulators must come out with a better system to discourage conflict of interest between rating agencies and clients, the regulators or exchanges should pick the rating agencies and ask all the companies to submit the information as per given format which can be used for rating
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As an independent investment and business analyst and advisor, I was reading the credit rating of a large company in the construction sector by a globally well recognise MNC backed rating agency, I was surprised to note, how professional rating agencies are so poor not only in their assessment but also in their data gathering. They have highlighted many serious risks in their commentary but still gave the [AA+/A1+] rating for their debt instrument of Rs. 21,000 Crore. Are we planning for another big-ticket NPA in coming months?
In the last 10 years, Non-Performing Assets (NPA) and Stressed Assets have grown considerably in the economy and most of the proportion is skewed towards corporates. Please note they all had a good credit rating.
Consequently, credit risk assessment, credit administration and monitoring have come increasingly into scrutiny and criticism. The suitability of the current credit risk assessment system has often come into question.
In the financial world, the Credit rating agencies across the globe are becoming a vital agency in the value chain of credit risk assessment because credit rating is an indicator to measure the creditworthiness of borrowers and acts as an intermediary between the issuer (borrower) and investor (banks) to minimise information asymmetries about the riskiness of investment products on offer. The bigger question is, are credit risk agencies playing their role objectively and with credibility or favouring the clients?
In general, credit rating provides a third party with independent information on default risk i.e. the probability of default of an issuer on a debt instrument, relative to the respective probability of default of other issuers and therefore becomes a useful ready-to-use tool for assessing credit risk.
In the case of sanctioning loans, banks use ratings as a filter and sometimes perform an additional check through an independent due diligence review or credit matrix. So, banks may use the credit rating issued by CRAs to the debtor as essential information during the credit appraisal.
The informational value of credit rating is being debated globally. The important question is whether the rating agencies are being able to predict the default risk better than the markets.
The financial the crisis has demonstrated that despite credit rating agencies having access to confidential information, they have not been able to assess the borrower or financial instruments effectively from a credit risk perspective. In my view, this can be either due to professional incompetence or professional conflict of interest.
It is imperative that the business model of the CRAs need to ensure that credit ratings are of high quality, accurately measure creditworthiness and should be the product of a strong and independent process. A possible inaccuracy in ratings can pose a threat to financial stability by underestimating the riskiness of investments of regulated entities. In case of a bank loan rating of a borrower, the problem of underestimation of risk can lead to inaccurate capital calculation due to inflated ratings and could pose a significant threat to the financial stability of individual financial institutions as well as the whole financial system. The recent large disclosures of banks of NPAs and SAs is one of the examples of how the entire system was rigged in favour of borrowers,
After the IL&FS fiasco, the markets regulator has tightened disclosure norms for credit rating agencies after they failed to warn investors in time about the deteriorating credit profile of Infrastructure Leasing and Financial Services Ltd (IL&FS). The rating agencies will now need to disclose the liquidity position of the company being rated. A company’s liquidity position would include parameters such as liquid investments or cash balances, access to unutilized credit lines, liquidity coverage ratio, and adequacy of cash flows for servicing maturing debt obligation, the SEBI circular said.
Credit rating agencies would also need to disclose if the company is expecting additional funds to pare its debt along with the name of the entity that will provide the money. Credit rating firms will also have to analyse the deterioration of liquidity and check for the asset-liability mismatch.
Why Leading Credit Rating Agencies (CRA) failing in their objective assessment?
Let me share one live case which I mentioned earlier in the article about the functioning of a leading Credit Rating Agency in India. Moody’s is known for credit rating worldwide and they have agency in India caller ICRA. They have allocated a credit rating of [AA+] and [A1+] i.e. stable and outstanding rating for various instruments worth Rs. 21,000 crores for Shapoorji Pallonji and Company Private Limited (SP Group). Both are very respected companies in their domain.
Here are the observations from all the ICRA reports:
* Between Dec. 2017 and June 2018, ICRA was not even able to get the Annual Report and statement of accounts of the company and using the old data of March 2017, in June 2018 to calculate key financial indicators? Based on these outdated numbers ICRA has maintained AA+ rating. The fact is we have seen many construction and real estate companies going burst doing this period. This will give the misleading status of liquidity position for the company. Can we say ICRA has done a professional and credible job in rating this company?
* Why liquidy can be an issue is with this company because in the rating agencies say credit strength of the company is a strong portfolio of land, property and buildings but in the credit challenges, ICRA says slower than expected progress on asset monetization plans has delayed the deleveraging the of its balance sheet. This clearly indicates the risk is building in the company but still the rating agencies have maintained the rating of AA+. Is ICRA communicating the clear risk assessment of the company or pleasing the client? We know most of the real estate and construction companies became NPAs because they were excessively leveraged and unable to service the debt.
* ICRA also says SP group has a strong investment portfolio and enjoys the high financial flexibility. It is common knowledge that SP group is the largest shareholder of Tata Sons Limited with an 18.37% stake. The fact is there are severe transfer restrictions on these shares as per the Articles of Association since the inception of TATA Sons Private Limited. This erodes the notion of financial flexibility. I wish ICRA must have highlighted the same in their risk assessment report before granting AA+ rating.
* ICRA report clearly highlights that existing balance sheet is highly leveraged and high quantum of contingent liability is on balance sheet because SP group has extended credit support to various group companies in various forms. If ICRA new all this, why there were not willing to accept that it is a high-risk situation and allocated AA+ rating for the debt instruments of Rs. 21000 crores.
This clearly indicates either rating agency is not competent to undertake risk assessment or management of the rating agency is keen to bend the professionalism to please the big fee client.
In the competitive business world, no one wants to lose the big fee and big client. Imagine what will happen in ICRA downgrades the SP Group rating? Will ICRA’s rating business goes up or goes down? What should be the accountability of ICRA if Rs. 21000 Crore debts become NPA? These are vital questions to clean the system.
How to improve the Credit Rating System?
Regulators must come out with a better system to discourage conflict of interest between rating agencies and clients, the regulators or exchanges should pick the rating agencies and ask all the companies to submit the information as per given format which can be used for rating.
Professional fees will be paid by the regulator or exchanges to the credit rating agencies from the investor's protection fund. Rating agencies can be shortlisted based on pre-defined criteria and fee can be based on completive bidding for the work allocation between credit rating agencies. The regulator may charge the service changes from the company those who want a rating for their risk profile before listing and seeking debt. This will ensure quality and rating agencies can be made accountable for their manipulated ratings. With time this can emerge as a “Rate the Rating Agencies” system in the country because we need a credible and honest rating of the financial products and instruments in the country. We will also need the “Audit the auditors” system to supplement the same to prevent conflict of interest in financial systems for sound and faster development of India.
PMO, concerned ministries and regulatory agencies must ensure accountability of Credit agencies and strict action should be taken, like it was done against auditors in case of Satyam. All stringent steps must be taken to ensure that trust of common man and investor is protected and Rating of India as country should go up.
Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.