Rating the Ratings is imperative

CREDIT RATING – YET AGAIN ON THE BENDING MAT

It is three decades since CIBIL rating has commenced its operations and a decade since Brickworks has started. We also see the frequent sovereign ratings of Standard and Poor, Ind-Ra (Fisch) and Moody’s. Very recently, Nirmala Sitaraman, in the wake of serial failure of well rated corporates – eg., DHFL, IL&FS, and several other PSUs as well as Private Companies, mentioned her serious concern. Sovereign ratings are also not infallible. This article would like to see the present status and suggest the modifications.

Credit rating agencies (CRAs) are expected to play an important role in mapping the risks in the financial system. They facilitate investment decisions and can help investors in achieving a balance in the risk return profile. They assist firms in accessing capital at low cost. Allocative efficiency of capital across the sectors, and appropriate risk pricing would be the gain to the economy. Information asymmetry to an extent is resolved.

“A credit rating is technically an opinion on the relative degree of risk associated with timely payment of interest and principal on a debt instrument. It is an informed indication of the likelihood of default of an issuer on a debt instrument, relative to the respective likelihoods of default of other issuers in the market. It is therefore an independent, easy-to-use measure of relative credit risk.”[i]

If a bank chooses to keep some of its loans unrated, it may have to provide, as per extant RBI instructions, a risk weight of 100 per cent for credit risk on such loans. Basel regulations provide for supervisors increasing the standard risk weight for unrated claims where a higher risk weight is warranted by the overall default experience in their jurisdiction. Further, as part of the supervisory review process, the supervisor may also consider whether the credit quality of corporate claims held by individual banks should warrant a standard risk weight higher than 100%.

The working of the entire rating system was questioned after the sub-prime crisis resulted in collapse of not just Fennie May and Freddie Mac but even UBS Credit Suisse, Citi group, Deutsche Bank etc. This led the US Fed and the Wall Street to revamp the entire rating mechanism after a careful study of the processes they followed and the measurement they gave to different parameters. But such changes are not followed uniformly across nations.

Theoretically, internal credit scoring models are effective instruments for the banks in loan origination, loan pricing and loan monitoring.  But the banks’ rating architecture is different from the rating agencies and this is one of the reasons for the regulator to insist on a rating review mechanism to be part of the Banks’ Credit Risk Management Committee. 

The rating process involves assessment of Business Risk arising from interplay of five factors: industry risk; market position, operating efficiency, financial risk and management risk. While industry risk and market position can be assessed from the macro level data, operating efficiency and management risk can be captured by observation, frequent interaction and experience. Unless cross functional, sectoral, trade data from all sources is available on digital platform and that too verifiable easily, the rating agencies are bound to err.

As per Basel II (2000): “An Internal Rating refers to a summary indicator of risk inherent in an individual credit. Ratings typically embody an assessment of the risk of loss due to failure by given borrower to pay as promised, based on consideration of relevant counter party and facility characteristics.  A rating system includes the conceptual methodology, management processes and systems that play a role in the assignment of a rating.”  Understandably, there was a collapse of the rating instrumentality looking at the collapse of the corporate credit and investments almost without notice. 

One of the common failings noticed by informed circles, for example, has been, a firm that owes to MSMEs beyond Rs.2lakhs should have been rated lower than those that would have paid promptly. Most corporates both PSUs and Private Companies were chronic defaulters and this came to surface more prominently in all the NCLT-dealt with cases. Second, poor governance should have got bad rating. Including Banks, PSUs and Private Companies fare badly and yet got good ratings!!

Ever since the Rating is mandated by the RBI while extending credit, we have seen phenomenal failures in the well-rated corporates both in the private and public sectors, e.g., DHFL, IL&FS. SMEs have no option but to get the rating of one or the other agency and yet, the Bank concerned would have its own rating that would decide the quantum of credit.

Measuring policy risks, sovereign risks and governance risks is the major challenge and this challenge has become visible in the recent corporate rating failures. Banks severely compromised by pitching high on CIBIL ratings and particularly, the individuals and Directors of the Companies. The thirty-year old CIBIL needs to amend its ways if the ratings book should be cleaned.

Technology disruption, easy regulations governing payment platforms, data on merchant performance, changes in consumption patterns, differential product regulations across the nations for similarly placed products and increasing protectionism are all the new risk areas for capture by the CRAs.

In so far as Indian financial sector is concerned, consolidation following the merger of PSBs, failure of NBFCs, Urban Cooperative Banks, and the lackluster performance of the MFIs, metrocentric banking are all new challenges to the CRAs. Telecom regulations and their interface with the payment and settlement systems, Internet of Things, Blockchain technologies are the new disruptors and even moderate margin of error can impact heavily and the rating can collapse. Further, product regulations have also become dynamic. In a way, all these aspects seem to have their shadow cast on the rating instrumentality as a risk mitigant.

There is therefore an imminent need for a High Level Committee of the SEBI, RBI, PFRDA, IRDA, and Telecom Regulatory Authority to examine the methodologies of CRAs for a more reliable rating process and pricing of rating agencies.

*Dr. B. Yerram Raju is an economist and risk management specialist and can be reached at yerramr@gmail.com Also see my blog on the subject June 11, 2011

Published in the Money Life on 28.11.19

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[i] Report of the Committee on Comprehensive Regulation for Credit Rating Agencies, Ministry of Finance, Corporate Affairs Division, December 2009

Negotiating a Loan during Slowdown

Ten-Point Recipe for Loan Negotiation with a Bank in Slowdown

Most first generation entrepreneurs, CFOs and CEOs of mid-corporates find it tough to negotiate a business deal with a bank. Banks usually are tight-fisted in times of recession to grant enhanced limits. They also claim full information of the enterprise, ecosystem in which it operates and the depth of the export markets. They also have a track record and credit record of the enterprise seeking to expand its operations. Economy in slowdown is tough time both for Banks and Enterprises. One has to run twice the speed in slowdown to remain where they are like Alice in the Wonderland.

Exacerbated NPAs despite the IBC have made Banks risk averse. Increase in frauds further accentuated risk aversion. The enterprises requiring higher working capital and those in export markets requiring packing credit facilities are facing formidable challenges. However, Banks may not like to lose good clients. Further, particularly those in PSBs, are also under pressure from the government to expand the portfolio in farm and MSME sectors.

Banks also actively work on the recoveries, write-offs of NPAs and topping up their Balance sheets. They are under pressure on the Asset side of the Balance sheet and therefore, look for clients who, despite slowdown, come up with a good proposal. And a good proposal in their parlance means that they would have little to exercise their thinking. Their time is under pressure most times in video conferences, meetings, Seminars, publicity and several internal committees.

Look at Mr. Raman who understands the predicament of the current banker and who is a CFO of a mid-sized corporate entrusted with the task of increasing domestic market by 100% and overseas market of the Company’s innovated tablets and injections duly approved by the US Food and Drug Administration. He is sure that the Banks would not like to lose a good client for another bank. Since his Company has proven track record, he was hopeful of the deal for higher limits on both working capital and export packing credit.

He took an appointment with the GM (mid-corporates) of the Bank one fine morning. He did his homework well. He gathered full data of the enterprise; environment in which the entire industry has been working; economics of his proposal; the area into which the Company would like to expand; the types of clients the company are targeting; the distribution system of the new markets; the incentives Company has on table; the drug controls of both India and the Asian economies in which the Company is going to operate; the disease patterns there; government health care and insurance mechanisms; the IPR and above all the financials. He also worked on the stress testing of his projections.

He presumed that in the first instance the Bank would know of the enterprise and ecosystem equally well. He started off with all humility. During the discussions, when he noticed that Bank officials do not have half the information, he had either on the product or competitiveness but are looking at only the financials and spreadsheets and not the rationale behind them, he pitched his fork high. He left some issues deliberately for the bank to come up with subsequently. He did not press for a solution instantaneously. He left a cooling time with the Bank.

After three days, when the call came, he went with his accounting team and with the required project proposal in the bank’s usual format. He took care to ensure that no additional collaterals would be offered. He kept under his armpit the directors’ individual guarantee to offer when necessary. Finally, when asked, he just mentioned that it was the company’s intention to go for public issue at a propitious moment and raise equity to meet future needs and therefore, it would be difficult to offer the same at the moment. The deal got through.

The recipe is simple:

1. Do your homework well: know your own enterprise, its SWOT.

a. Brainstorm possible implications of the proposal with the Board and internal management.

b. Cushion the proposal with adequate collaterals and guarantees but keep it undisclosed.

c. Go as a team for presentation with your confident technical and financial team for discussion.

2. Do not thrust yourself at inconvenient times for the banker.

3. Be transparent during negotiations.

4. Be humble; but do not compromise on limits sought as it might affect profitability.

5. ERP will help keeping the data required by the Bank and tax authorities transparent and timely.

6. Go with a vision, objectives and goals for the future.

7. Keep also the succession plan ready.

8. Give reasonable time to the Bank to think and come back with their offer,  but indicate your expectation for the result and also indicate that a Bank and a leading NBFC have also indicated their willingness to look at the proposal to attract competitive pricing of the loan.

9. Post sanction and post disbursal, keep compliance of terms and conditions tidy.

10. Make sure of half-yearly review of the limits by the Bank by feeding the required data online.

The above principles work equally well for the MSMEs. Since the MSMEs lack the attributes of a CFO and accounting team, they need to look for committed process consultancy firms like the Telangana Industrial Health Clinic Ltd (TIHCL) who handhold them and help scaling up with strategic interventions at the right time.

Published in Telangana Today 

Pre-Budget Blues for the Union Budget 20-21

Suggestions for the Union Budget 2020-21

Focus on Manufacturing MSMEs;

Industries should bloom like flowers 

We have the potential to overtake China if we trust our MSME sector more than now and provide long-lasting solutions.

Manufacturing Micro enterprises with specific focus on agro based industries and rural enterprises, which are unique and provide maximum employment need to be separated from Small and Medium enterprises and the existing MSME Act needs to be amended accordingly. All micro enterprises in future may be encouraged to be set up in clusters only with suitable infrastructure and marketing facilities. They should be enabled for scaling up and the required support system should come from the Entrepreneur Development Centres (EDCs), proposed to be co-located at the DICs. The DIC officials’ performance should be evaluated basing on the number of micro enterprises scaling up to small enterprises. Although this comes under the State domain, the Amended MSMED Act should provide for this appropriately.

The SMEs may be defined based on sales turnover and employment to incentivise them to join the formal sector and achieve GST compliance.

2. All the incentives from the government and other agencies to the MSMEs need to be linked to the employment they provide to people directly. 

3. All the subsidies and other payments by the governments and their bodies to MSMEs must be paid within 45 days from the due date. Any delay beyond this and up to 90 days should attract penal interest rate at twice the RBI repo rate. Delay beyond 90 days should be treated as criminal violation. Since the purchase and sale is a contract between the buyer and seller, Indian Contract Act should be amended appropriately, simultaneously.

4. An Independent Evaluation Office on the lines of IMF may  be set up as independent agency under Ministry of MSME/Finance/NITI Aayog to evaluate the policies, programmes, implementation and payments to MSMEs and submit a report to the Government for action and placing before the Parliament at the beginning of the Year.

5. SIDBI has had limited impact. The role and responsibilities of SIDBI may be re-examined by a High Level Committee.

Fiscal Incentives:

¡  2% to 5% of Income Tax / GST for up to every 10 in Micro & to every 25 persons employed in small evidenced by self-certified muster roll and corresponding increase in the expenditure on wages and salaries in the annual P&L statement.

¡  Micro: 1. No Cess on GST; 2. First 5 Years waive income tax for manufacturing enterprises

¡  Small: First 3 years for firms graduating from Micro exempt income tax; No corporate tax

¡  Small to Medium Enterprises: First 3 years 2% less than the usual Corporate tax for large enterprises;  

¡  Medium to Large Enterprises: First 2 years < 2% of the usual corporate tax applicable to the Corporates

¡  Technology: Micro to Small: transition with new or imported technologies – Duty to be exempted.

¡  Small to Medium: Duty to be 2% less than for large.

There should be no levy of Cess on export duties to enable the SMEs to be major contributors to export markets.

Banks and NBFCs helping revival of MSMEs:

Income Tax reduction of 1% if the institution revives 100 enterprises in a year – demonstrated by the increase in capacity utilization by 40% in six months from the date of revival for 80 percent of units revived.

Manufacturing Micro and Small Enterprises post revival earnings of up to Rs.5cr should be exempt from income tax.

With inputs from Dr. Subbaiah Singala, General Manager, CAB, Pune whose views are also personal.