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INDUSTRY

Of financial debacles and rating agency models

Venkataraman S
DECEMBER 30, 2018 22:20 IST
UPDATED: DECEMBER 30, 2018 22:20 IST

A case of barking up the wrong tree?

The spotlight is on credit rating agencies (CRAs) once again, this time triggered by the crisis at,
and default by, Infrastructure Leasing & Financial Services (ILFS). In this, the ‘issuer pays’
business model of CRAs seems to have borne the brunt of criticism.
While this appears to be an intuitive response, a comparison of other possible CRA business
models would indicate that the problems lie elsewhere.

The tendency to associate CRAs with financial failures dates right back to early 20th century.
The most incisive of such inquiries followed the global financial crisis of 2008, conducted by
financial regulators including in the US and India.
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What is pertinent, however, is that, after detailed deliberations, the issuer pays model of the
CRAs was left untouched by all the regulators. This was an implicit endorsement of the
model’s relative superiority, or at the very least, of it being the lesser evil.
It is normal that credit ratings change over time. The primary concern surrounding ILFS’
ratings is about timeliness, abrupt and steep transitions, slow/inadequate change even after
evident distress, and inadequate use of ‘outlooks’ – that handy rating prognosis tool.

That warrants questioning of the CRAs concerned in recent cases – CARE, ICRA and India
Ratings – and also of others culpable in other instances.
To be sure, the inherent conflict of interest in the issuer pays model is undeniable, since the
rated entity is paying for the rating. But it is instructive to consider some nuances.
Any CRA business model must facilitate two objectives: 1) ensure ratings are of high quality,
and 2) ensure all market participants have access to such ratings at a reasonable cost.
Additionally, the models must involve minimal or no conflict of interest. ‘Minimal’ is a
considered usage here since conflicts cannot be entirely eliminated.

The issuer pays model

Under this, the issuer pays the initial and subsequent surveillance fees to CRAs, and the
ratings are publicly and freely available. Market dynamics determine the fees and issuers are
contract-bound to afford CRAs access to business and financial details, which facilitates better
analysis. The cost to investors is virtually zero. For issuers, rating fees count among the
smallest components of issue costs.
Two aspects need reflection regarding potential conflicts, whereby a CRA might systematically
assign inflated ratings to satisfy issuers.
One, if a CRA consistently indulges in such a practice, it will be harakiri, for sooner than later,
it will lose credibility, which is a critical success factor in the business.
Two, typically, CRAs collect upfront 100% of the non-refundable rating fee even before
beginning the exercise. This eliminates payment risk and significantly reduces the incentive to
assign favourable ratings. Even if an issuer delays or defaults on annual fees, the CRA is
obligated to monitor and disclose rating changes. Therefore, despite the inherent, and
potentially subversive, conflict in the model, these two aspects considerably mitigate the risk
of malfeasance in practice.

The analytical competencies and standards of CRAs are a different matter altogether, but these
are not frailties attributable to the issuer pays model. Three specific statistics lend support to
this argument: One, out of ~35,000 ratings currently outstanding in India, nearly three-

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fourths are in the ‘non-investment grade’ category. Two, during fiscal 2018, Indian CRAs
downgraded over 2,400 ratings. Both these suggest CRAs haven’t shied away from assigning
lower ratings or downgrading those who pay for the assessment.
Third is the ‘ordinality’ expectation in ratings default performance (higher rated firms
expected to have a lower rate of transition-to-default, than lower rated firms). This is a key
yardstick of ratings quality. The four largest Indian CRAs have systematically demonstrated
lower default rates for higher ratings. So while CRAs have erred in specific instances, this
statistic reflects overall good quality and consistency.

The ‘investor pays’ model

The investor pays model has the advantage of precluding the issuer-CRA nexus. But it poses
another, equally serious, conflict involving the investors themselves. Private placements of
debt account for about 90% of issuances in India, and the secondary market is subdued.
Therefore, if investors are the payees, they can influence CRAs to give lower-than-warranted
ratings to help them negotiate higher coupon rates. After placement, too, investors can resist
downgrades of the securities they hold, as it can trigger mark-to-market losses. The scope for
this conflict is real.
Then there are other problematic issues. One, only those who pay for a rating can access it.
Two, the cost of rating can be exorbitant since only a few investors may seek it, and the public
would likely be the most deprived. Lastly, under investor pays, issuers may not always share
full information with CRAs, which can, ab initio, jeopardise the quality of ratings. Therefore,
on all counts, the investor pays model is decidedly inferior.

The government (or regulator) pays model

Conceptually, the ‘government or regulator pays’ model can eliminate bias in ratings because
there is no pecuniary incentive for the CRA (public sector entities could be an exception). Here,
the regulator can also mandate free dissemination of ratings to all. So far, so good.
But this model introduces other complexities. One, the choice of the CRA and the payment
mechanism are extremely problematic, as it is difficult to conceive of either the government or
the regulator exercising a choice regarding CRA quality beyond a minimum threshold, or
paying market-determined/ negotiated fees for ratings.

On what basis would the regulator pick a CRA when the value proposition fundamentally
differs from that of auditors? Two, if fees are not market-determined, CRAs would be hard-
pressed to build capability and retain sharp analysts. Moreover, once business is assured, there
may be little incentive for quality and excellence.

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The most serious problem with this model is the ‘moral hazard’ wherein all ratings can be seen
as regulator-endorsed. This is antithetical to efficient market practices, and can pose
potentially disastrous consequences for the government/regulator in the event of poor rating
calls.
Which means, operational and moral hazard issues overshadow the intuitive appeal and
advantages of this model.

Conclusion
Sure, each model has its pros and cons, and conflict/moral hazard potential. It’s imperative,
therefore, to pick the model that best meets the primary objectives of credit rating – high
quality and open access – when offering the best opportunity to manage any conflict.
By those yardsticks, the issuer pays model recommends itself.

These arguments do not seek to absolve CRAs of poor judgement, lack of timeliness or the
incompetence they have exhibited from time to time.

But the cause of serious concerns that typically surface during financial debacles (and
therefore solutions) lie elsewhere.

Structurally and behaviourally, there is a need for a deeper understanding of credit rating
process, related systemic issues, and a more enlightened approach to evaluation of CRAs. That
would facilitate greater transparency, high quality ratings, and healthy competition.

The author is a Professor at IIM, Kozhikode

Disclosure: Venkataraman S worked for nearly two decades with a premier CRA in India and
was also the founder CEO of Caribbean-based regional CRA. He writes this as an independent
analyst.

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