Rating the raters

Most investors take note of a credit rating (AAA, BB, BB+, etc) only when it comes to IPOs, more so because the company advertises it aggressively. Are the ratings important and can the agencies that conduct this exercise be trusted? A recent report by an RBI committee raises such pertinent questions about credit rating agencies (CRAs). Here are some:

Do investors need rating?
Given the vast amount of data that is available, CRAs play a useful role in helping investors sift through it and analyse the credit risks they face while purchasing an issuer's debt and debt-like securities. As some instruments are complex, an independent assessment of the risks involved acts as an important input for the investor. Also, some regulators, such as the Insurance Regulatory Development Authority (Irda), have incorporated ratings in the investment guidelines. Rating, thus, provides an additional layer of comfort for the regulators in their assessment of product risk and overall systemic risks.

What is worrying the regulators?
The CRAs often undertake a variety of non-rating activities too. Some, for instance, have set up research arms to complement their rating activities, and make it available to external subscribers for a fee. Others have diversified into various advisory services. Regulators are concerned that such activities will lead to a potential conflict of interest (see Regulators' concerns).

How can CRAs be made more accountable?
According to the committee, while revealing the rating rationale to the public, a CRA should disclose the following:

• Details of fees collected by the CRA from the issuer for the current/previous rating assignment during the past three years.
• Details of fees collected by the CRA from the same issuer for activities other than rating.
• Disclosure of money received by promoters of the CRA for any financial transaction with the issuer in the past three years.

Besides, the RBI report says the CRAs should not be allowed to conduct any business that may directly or indirectly have a conflict of interest with rating. It also suggests disclosure of default and transition studies, along with the methodology used for computation, to judge the general efficiency of CRAs. This should point out where the issuer has defaulted even if the latest rating of the instrument issued indicates investment grade.

The number of recommendations that will be implemented remains uncertain, but for now investors need to take credit ratings with a pinch of salt.

Regulators' concerns

• Conflict of interest: This is inherent as the issuer of a new instrument pays the CRA for being rated. The CRAs sometimes provide ancillary services and the issuer can use the incentive of providing the CRA with more business to secure a higher rating.
• Lack of accountability: The CRAs are not legally bound to be accurate and are often protected against liability in case of inaccurate ratings.
• The oligopolistic nature of the rating industry is worrying because of natural or proprietary barriers of entry, leading to a lack of competition.