Not so long ago, news came in that credit rating agencies approached financial market regulators, seeking permission to withdraw ratings for more than 10,000 companies. Before we delve further let us see how the ratings of a company actually affects the key stakeholders.
How the ratings affect the banks? Banks extend credit facilities to the companies and the rate of interest charged depends on the ratings of the borrowing companies. To break it down the interest charged has three broad components.
- Borrowing rate for the bank.
- Administration expense of the bank.
- Risk premium.
The higher the risk of default the higher is the risk premium. Hence an accurate rating is important to charge the real risk premium in order to have cushion for the riskiness. Moreover banks are mandated to set aside capital to absorb the shocks in case of defaults. RBI mandates the use of CRAR (capital to risk weighted asset ratio), the basics tenet of the computation is higher the risk- higher the capital requirement whereas lower the risk -lower the capital requirement.
Banks’ computation of risk in terms of exposure and loss given default rely a lot on the ratings provided by the agencies. The dependency is so high that CreditMetrics (developed by JP Morgan), which happens to be one of the popular methods used is based on transition matrix of ratings! So one can’t over emphasise the need to have an accurate rating.
The story till now…..
May it be the financial crisis of 2008 or the IL&FS debacle, rating agencies always had a role to play. Just two weeks before IL&FS (one of the largest NBFCs of the country) defaulted on its payment obligations, the rating agency responsible for assessing the creditworthiness, had rated the loans AAA (gold standard), which translates to negligible likelihood of default. SEBI levied fine of Rs. 25 lacs on CRA, CARE, and India Ratings — three of India’s foremost credit rating.
We must realise one thing that the agencies function in an environment of “conflict of interest”. We are well aware that rating agencies should give a fair rating based on the facts, without any undue influence but in reality, most of the agencies feel obliged to give a higher rating if they want to retain the client. Companies want to get rated as it enhances their chance of obtaining credit. Even a junk rating is better than having no rating. There have been many instances of company paying the rating agencies to give a favourable rating. One can’t classify such financial arrangement as bribe as it would be too crude. Such payouts are called “professional fees” as rating is labour intensive and the computations are done by professional with high salary packages, hence the cost gets “justified”.
Redemption?
Well this news is about the agencies setting things right by withdrawing the ratings of the undeserving companies. The reason stated was, most of the companies didn’t share requisite details necessary to rate and amidst this pandemic where performance has actually plummeted it is highly unlikely that the companies will share the details. However the rating agencies need to obtain a NOC from the lending banks before they can proceed further with withdrawals of the ratings.
The banks had already loaned out amounts to these companies based on the ratings provided. Now if those ratings are withdrawn, all such loans will be deemed risky, which is something that the banks want to avoid. The consequence of such withdrawal is two fold, one- the loans will become risky which will affect the various calculations. Second is that bank will have to deploy additional resource to measure the risks and be vigilant, the role that was being performed by the agency will now have to be performed by the banks!
Will the NOCs be issued?
We have already highlighted the financial consequences of withdrawals in the preceding paragraphs, but there is a behavioural side to it. If the ratings are withdrawn and the companies default then banks will have no one to pass the blame. Banks will no longer be in a position to say that the rating agencies didn’t perform their duties! It will highlight the banks’ poor judgement and over reliance on the agencies. Maybe if the rating agencies had been completely transparent and honest with their ratings, right from the start then things would have been different. I would like to ask the age old question posed by the Roman poet Juvenal “Quis custodiet ipsos custodes?” which literally translates to “who will guard the guards themselves?”.
The Enigmatic Pen 