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Can credit rating firms be unbiased?
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August 30, 2007

Apart from their competence, questions need to be asked about whether credit rating firms can be unbiased about a client who pays them.

Susan Thomas, Assistant Professor, IGIDR

Markets have found replacements for raters - the problem arises when ratings become mandatory for investors

Concerns about credit rating agencies have been gathering weight in the world of finance for a while now. Starting from the problems of highly rated companies like Enron which proved to be insolvent, to countries like Argentina, to the more recent problems of the default of sub-prime loans, the reputation of CRAs have been taking a beating over the last two decades.

In response, new ways of thinking about credit risk have proliferated. One of the most important alternatives for thinking about the default risk of a corporate bond is the "KMV model" which utilises the stock price to produce continuously updated measurement of the default probability of a firm.

Financial practitioners have already de-emphasised the role of CRAs. In a competitive market, CRAs would have faded away, or reinvented themselves.

The distortion in the role of the CRA comes from the responsibilities vested by the government - when regulators of different financial intermediaries mandated that credit ratings be obtained before these intermediaries could invest in the bonds of firms.

This paved the path for firms to pay CRAs to get their bonds rated, in order to get investments from banks or insurance companies.

But once the firms started paying for their ratings, the incentive structure for the CRA to do a trustworthy job became bent towards more favourable ratings. This perverse incentive reached a pinnacle with the role of the CRA in helping to structure securitised products such as mortgage loans or sub-prime credit products.

Given that there would tend to be a larger fraction of poor credit to good credit in any economy, sub-prime loans was a volumes business that earned the CRAs large profits.

By definition, the sub-prime loans business was also greater risk, which showed up as large losses with the increase in high market volatility of the last six months or so.

CRAs are facing the responsibility of what they reaped such rich profits from: as they reaped, so they are sowing.

In a competitive market, there would not have been the regulatory mandate the CRAs have benefitted  from. In a competitive market, existing CRAs would lose market share to more sophisticated alternatives. India is specially worrisome when it comes to the regulatory responsibility of credit ratings.

Listed firms have to mandatorily get credit ratings for bonds; non-government pension funds and gratuity funds can invest only in investment grade bonds with two credit ratings; commercial banks can invest only in rated non-SLR bonds; and the latest peculiarity, a Sebi mandate that IPOs must be "graded".

If these regulatory responsibilities persist in the role of the Indian CRA, then we will indeed have to get serious about "rating the raters".

Instead, if the credit information business can be fundamentally re-engineered so that CRAs pass the market test and compete to obtain subscription revenues from investors, without payments from firms for credit information sent by government agencies, we won't have to worry about it.

Roopa Kudva, Managing Director & CEO, CRISIL Ltd [Get Quote]

Raters have voluntarily adopted, disclosed and visibly practised codes of conduct to maintain their objectivity

Absolutely yes. And indeed rating agencies are constantly subject to scrutiny, evaluation and questioning by investors, media and regulators. Since ratings are opinions, it is important that markets are convinced about their robustness before acting on them. Rating agencies therefore publish extensive data on rating default and transition statistics, and metrics on predictive capability of ratings vis-a-vis macro-economic and corporate performance.

CRISIL regularly holds investor discussion forums where its methodologies and views are hotly debated by about 100 analysts present at each such event.

How should raters be evaluated? Firstly, through a long-term record demonstrating that higher ratings are consistently more stable and have a lower probability of default than lower ones.

Adherence to clearly stated and widely disseminated criteria is another parameter. The governance and business practices are critical in evaluating their independence. Some of these include: multi-layer decision-making processes, dedicated criteria and quality assurance teams, prohibition of analysts' involvement in fee decisions, and analyst compensation not linked to assigned ratings. India's rating industry scores well on these counts.

There is a two-decade history of credible and robust default statistics. Since credibility is its bedrock, the rating industry has proactively and suo motu provided its report card to the market.

The issuer-pays model is much debated, but would investors paying work? When a rating is assigned, the investor is generally not known. Issuers have to commission ratings and provide them to a range of potential investors who then decide whether to invest.

And if investors paid, only paying investors would get access to ratings. Markets should not underestimate the huge benefits of the public disclosure of ratings - today all ratings and rating changes are available to the entire market free of charge, as they are widely disseminated.

Rating agencies are the most independent providers of credit opinions compared to other potential opinion providers - borrowers, lenders, investment bankers or brokers. Ratings have a vital role to play in India's credit markets.

The Indian rating agencies proactively alerted the market to the impending risks in the NBFC sector in the 1990s, well before the crisis precipitated. The contingent liabilities of state government guarantees as a risk factor were first highlighted by CRISIL.

The potential problem in the collective investment plantation schemes was nipped in the bud by rating agency alerts.

The recent actions by CRISIL highlighting the heightened risks associated with leverage in corporate balance sheets to fund their global expansion were keenly appreciated by the market. Not surprisingly, Indian investors' acceptance of ratings preceded regulatory recognition. Even today, investors demand ratings in areas, which go well beyond those where regulations make them mandatory.

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