Turning the searchlight on Rating Agencies

Dr B K Mukhopadhyay

The rating exercises by the well known intertiol rating agencies are on. For India Moody’s has upgraded the outlook on India’s sovereign rating to positive from stable -rating Baa3  - upgraded from ‘Stable to “Positive”, while Fitch has retained the stable outlook. The two ratings agencies noted many positives after the new government came to power; but still they saw many concerns.

The very process followed on this score must be clearly publicized in as much as variations on this score remain. If the transparency is there and users become confident about the appropriateness of the exercises, the same process gives rich dividends over time. Let us see in details.

Is the Process Followed Always Unbiased?

The ratings are being scanned from every quarter. Not only in case of India, in the recent past a lot of words been exchanged on rating issues. The American Banks started accusing the rating agencies on improper rating, which, in turn, ultimately led to sub-prime mortgage crisis – they put the onus on the rating agencies saying and indicating that as the rating exercise was not appropriate the mortgage loans turned bad! On the other hand the rating agencies had been refusing the charge on the ground that they rated the borrowers on some specific are and at specific times and any assessment whatsoever should have been done by the bankers and these rating was just a part of the whole process - borrower’s activity wise and time-specific.

Comments Must Not be Lost Sight of

A good guide indeed! The case of India may be seen on this score. MOODY’S observe – ‘India‘s weaker performance on fiscal, inflation and infrastructure related metrics compared to peers - policies addressing these factors but the extent of likely improvements is as yet unclear…. Evidence over the coming months that policy makers are likely to be successful in their efforts to introduce growth enhancing and growth  stabilizing economic and institutiol reforms would lead to the rating being considered for an upgrade.’ A clear opinion is– ‘banking systems asset quality, loan loss coverage and capital ratios are relatively weak…Risks in higher levels of growth and infrastructure development will be accompanied by higher leverage.’

FITCH observes - ‘India’s relatively weak business environment and standards of governce, as well as widespread infrastructure bottlenecks, will not change overnight, but there is ample room for improvement. Translation of the reforms into higher real GDP growth depends on the actual implementation.’ So, such specific observations by such global rating agencies deserve appreciation indeed.

The Importance is Never Less

The merits of rating should not be diluted – for big or small, micro or macro-level.

Rating has already gained wide acceptance in the corporate sector, banks and fincial institutions and the capital market, among others. It is a dependable risk magement tool to identify the individual brisk level of a loan and to ensure that a bank earns a return to the risk the bank in question undertakes. Similarly for the SME Sector [Small and Medium Enterprises] more attention is being paid to risk assessment through rating exercise and the range of price and credit conditions are now definitely wider than before.

Any appropriate assessment helps explain the rating result and accordingly arrive at credit decisions. As such the rating criteria that takes into account the hard facts [fincial situation; fincial position; profitability]and soft facts [magement; fincial reporting; installations, products’ organizations’; market and market forecasts] as well as the warning sigls [profit cuts; cash losses; late handing over of annual accounts] should not be lost sight of.

Again, rating agencies are key players in the securitization are. Most asset backed issues worldwide are rated and in India rating is mandatory under Reserve Bank of India guidelines. In fact the rating agencies specify the level of credit enhancement and other risk mitigation arrangements to be maintained in structure and the rating sought from the rating agency is decided on the basis of investor’s preference. In India, practically an emerging market for securitization, anything below AAA may not find the investor’s acceptance. Still, it is virtually a matter of time before investors start accepting lower rated papers at higher yields. It remains a fact that the level of credit enhancements and other risk mitigation would vary for different ratings sought for.

The fact is: credit rating [measure of credit risk] agencies put a lot of reasons for the rating so that they do not necessarily get blamed in the event of a result which is a different one than thought of. For example: in a falling market if an investor does not exercise his own option, simply blaming the rating agency is not a correct proposition.

An investor, so to say, has to use the rating to his advantage – investing in highly rated bonds only; considering a bond lower than the highest rating [higher risk] and only if there is a secondary market for bond selling in case of a rating downgrade and thus developing a cut-loss-policy; in case similar rated bonds offer different ROI, the bonds offering higher ROI require to be further scanned for evaluating the risk factors; etc. Similarly, a bond having subordited obligation should not normally be graded AAA as in that case the rating would be misleading - so the onus lies on both the sides.

Such sort of rating is for ebling the investor to understand the safety of the instrument in which the banks, for example, would be investing. Rating of instruments can vary from highest safety, high safety, reasoble safety, safety, safe, not safe, risky, and too risky. As the rating moves from highest to lowest the risk of default goes up. That is to say, the need arises as to studying the organization in question, magement, assets quality as well as the business plans. The standing of the company coupled with the environmental alysis definitely helps the raters to arrive at meaningful conclusions as to whether the money to be invested would be least risky and rewarding. There definitely could be a degree of variation among these issues and accordingly the credit rating goes on varying.

In fact rating has a number of benefits to reap from. Credibility of the Institution goes up along with confidence building with partners [good rating gives comforts to lenders, customers and suppliers too]. It acts as a self-improvement tool. Any alytical report on the corporate strengths and weaknesses help, in turn, strengthen operations and improves visibility.

Rating of an instrument is related to the instrument issued and not meant for the company issuing the same. Rating is the opinion expressed based on logical reasoning, aiding the investor to invest. It is also a fact that the companies which use the initial rating with pomp and show for marketing the issues has to announce the downgrading to the investors as well. As such rating itself, has some inherent risks if not understood well. Rating is an effective risk assessment method in India.  The discipline has merits in many ways if understood well and at the same time if put into use appropriately.

Side by side: any Government has definitely the right to ask the very basis of such assessments in as much as any trust on the exercises only develops once practical and realistic approach takes the front seat, otherwise not only the economy suffers in many ways but the reputation of the rating agencies suffer from the risk element [reputation risk-loss of trust, loss of business, etc.] also. Globally a good score gets a better deal!

(The Writer, a noted Magement Economist and an Intertiol Commentator on contemporary business and economic affairs, attached to The West Bengal State University, can be reached at m.bibhas@gmail.com)