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