Tuesday, 31st December
If you'd like these posts in your Whatsapp Inbox every morning, join our list: Whatsapp
Credit rating agencies across the globe have been infamous for playing the role of morticians when they were supposed to be a diagnostician, always correcting ratings after the worst has already happened. In the recent past they had faced rebuke from SEBI for the unchecked IF&FS crisis with ICRA & CARE giving it a AAA rating two weeks before the blow-up. Looks like the worst isn't behind them yet, and they are now under the scanner of the RBI for allowing rate shopping. In today's post we try to understand what rate shopping is, the incentives for both parties to allow it, and the potential impact of this if left unchecked and try to think of potential solutions.
What is rate shopping?
When firms come out with bond issuances, they need the debt rated by a credit rating agency so that people participating in the issue have a better idea of the quality of the firm and the loan and its ability to service it. A lot of these loans are "issuer paid" meaning the firm coming out with the bond pays the credit rating agency to rate its issue. What a lot of companies, especially lower down the quality spectrum have been accused of is moving to another rating agency if they don't like the rating with the first agency until they find a better rating. Indian credit rating agencies have an infamous 35% churn compared to a 8% global benchmark, driven in large part by this behavior.
The motivations of both parties and the behavior this promotes?
With atleast three equally popular rating agencies in the market, corporates know that they have a good amount of options to choose from. The issuer paid model, and the ability to switch to another CRA increases the leverage they have, something that the unscrupulous amongst them use to get themselves a higher rating. Credit rating agencies, on the other hand, seem to be stuck in a weird race to the bottom as the "most lenient" in the mix gets preference, and hence the revenue, rather than the fairest or the one with the best quality analysis.
What happens if left unchecked?
Over the last few years we have had many instances of firms having exceptional credit scores before they suddenly blow up. If the firm in question is of sufficient size this sort of shock could affect the whole system (many NBFCs still suffer the impact of the IL&FS blow up, which has consequently affected numerous other industries including auto.). Another longer-term implication is the lower trust in the system for ratings, leading to a widening credit spread (i.e. If investors aren't sure of the quality of your AAA rating, they are likely to demand a higher rate than if they were sure you were a high-quality AAA) leading to negative consequences for the good firms.
So is there a way out?
This is a problem that has been plaguing the system for a long while and luckily there has been no clear solution, or each solution has some issues. We try to list a few of these solutions with the repercussions. The first one changes the fundamental model from an issuer paid to a state/regulator paid or state/regulator managed. Both of these put manpower and capital stress on the state/regulator, which would eventually have to be borne by the issuer indirectly, leading to an inefficient system. The second is a bit simpler to execute but would require changes to regulations which dictate issuer permission as necessary before rating declaration. If we have more transparent disclosures by the rating agencies when a customer/shopper leaves, including potential disclosure of rating, atleast to the regulator if not the broader market, so that the regulator can then take a call whether to look into the issue it would help improve the overall accountability and trust in the system and prevent excessive rating shopping.
All in all the issue of credit rating agencies is not an easy one to solve and is something that even in the developed markets have been struggling with. But given the importance and potential risks it entails, it is definitely a problem we should attempt to solve.
Sign-Up to get these posts straight in your inbox every morning! Also, if you like the content, please share it with your friends, colleagues, and family!
We interact with our customers and share Zapp5, a condensed read of the 5 top news items of the day on Instagram. Do consider following us there to be more integrated with the GSN Invest community.