The Union Budget has
proposed a new credit rating process for infrastructure projects. This is
expected to support fund raising on reasonable terms for such projects. At this
juncture of Economy when need for such a different rating system has been
envisaged, then it would be also of importance to review the traditional
process of external rating system.
The credit rating
agencies are meant to provide lenders with an informed analysis of the risk associated
with debt instruments. These ratings are usually characterized by a letter
grade, the highest and safest being AAA, with lower grades moving to double and
then single letters (AA or A) and down the alphabet from there. The ratings
approved by these agencies have widespread implications for lenders.
Lot has been said about
the failing of credit rating’s efficiencies in warning the defaults since year
2008. The big three global rating agencies had come under intense scrutiny in
the wake of the global financial crisis. These agencies in year 2008 were
accused of offering overly favourable valuations of insolvent financial
institutions and approving risky mortgage related securities.
The Fee Model of Rating
Industry: Subscribers Pays or Issuer Pays
Most of the credit
rating agencies follow the Issuer Pay model wherein the borrower who is getting
its debt rated pays to the rating agency. Therefore, the borrowers who need
certain ratings in order to sell their debt to lenders may have been willing to pay more for their preferred rating. It is noted that under Issuer Pay model the
borrowers shop with the credit rating agencies for the desired/lenient rating
band. The competition among the rating agencies at one hand benefits the
borrowers but on the other hand affects the interest of lenders. It is evident
in the market that many borrowers, who are rated below investment grade shop
with the rating agencies, change their rating agency and are able to get
investment grade ratings if not very high but at least at lower end of the
scale. This helps such unscrupulous borrowers in passing the muster of lenders
for getting loans sanctioned. Lenders
carry out their own internal credit rating of the loans. The external rating presents
an external independent view. However, if the external view is investment
grade, it may create some positive impressions over the internal ratings also.
Its time to take
control of the Wheel
For long time, the
process of credit rating has been allowed to be handled by borrowers. When the
Budget envisages need for different rating system for infra projects then there
are enough good reasons for relooking at the rules for existing rating process
also. Excluding the rating process, many other exhaustive monitoring related
activities like Stock Audit, Concurrent Audit, Lenders Independent Engineer,
Valuations etc. are controlled and efficiently, cost effectively managed by
lenders. From that sense isn't the time ripe to control the external ratings
process of the loans also?
Like controlling the
exercises (which are lengthy and complex) of Stock Audits and
Concurrent Audits, lenders can also control/handle the External Rating process
of the loans. This would provide better information to rating agencies (since
the existing informal channel of interactions between the two will turn into a
formal one to one dialogue as it happens in Stock and Concurrent Audits),
facilitate information, and the open interaction between two would help in deeper
understanding the critical issues.
There are pros and cons
of everything. External credit rating has great importance since it is expected
to present an unbiased view on probability of default. Their independence can
not be compromised and allowed to be influenced by bigger forces (banks/FI
etc.) in the financial market. I agree that the above suggestion also has some
chances of influencing the freedom of credit rating agencies decisions as they
would need to deal with much bigger and powerful set of customers
(lenders/banks) who could then threat diverting business to the competitors following
lenders views.
Benefit in Interest
Rates/Subsidies
A balancing solutions
would be to have credit ratings from two agencies, one obtained directly by the
borrower and other done through the lender. This could be adopted for loans of
Rs.500 million and above. In case of large difference between the two, decision
makers will have enough warning signals for analysing the matter before taking
their call. For loans between Rs.100 million to below Rs.500 million government
may come out with schemes for subsiding the cost of second credit rating.
National Small Industries Corporation (NSIC) provides reimbursement of credit
rating fees to the small scale industries (http://www.nsic.co.in/creditrating.asp
). However, the option of two external ratings would further increase the cost
of borrowing and involve extra time & energy. To reward for the pain taken by
the borrower and reducing the cost, lenders may benefit borrowers going for two
ratings system by providing some concessions in interest rates/processing
charges.
Regulatory Compulsion
for Rating
One of the other
effective solutions could be putting restriction on changing the credit rating
agency within a period of 3 years from their appointment and making the
external rating compulsory for loans of above Rs.100 million before availing sanction
of loans from lenders. The borrowers who do not get their
rating re-validated timely or are not keeping their rating live may be
compulsory penalized by increase in applicable interest rates. Regulatory framework may be developed in this regard.
The Gold Standard of
Rating
The rating agencies community
also need to come out with a standardized product of Gold Standard Rating supported
by necessary changes in regulations, where the common high standards of uncompromised
rules and procedures may be defined. The borrowers may be encouraged to go for
such high standard Gold Ratings. The reward for such ratings would come in the
form of high investors/lenders interest with premium pricing. Adoption of these
high standards may be made more attractive by allowing certain low ticket Gold
Standard rated loans eligible for Priority Sector Lending (PSL) (https://en.wikipedia.org/wiki/Priority_sector_lending).
The Gold Standard rating would reflect the rigorous due diligence passed by the
borrower and reflects its high standards on accounting & audits, cash flow
management & monitoring, corporate governance, professionalism of
management like aspects. The rating agencies could be heavily penalized for
comprising any rule under such Gold Standards.
