External Credit Ratings: Time to Change the Process and the Gold Standard of Rating

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.