Saturday, November 30, 2019

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.


“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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