The recent spate of defaults, delayed payments and missed payments by several large bond market borrowers has heightened the focus on the role of credit rating agencies. The insinuation is that credit rating agencies generally issue optimistic ratings with little ex-post accountability for their ratings. While the former is a matter of individual perception, the latter is true – should it turn out that a rating agency has made a mistake there is little, if any, consequence of that to a rating agency. To fix this, the Securities and Exchange Board of India (Sebi) recently issued a fresh set of guidelines that among other things increased the disclosure requirements for rating agencies. More importantly, Sebi has introduced a concept of probability of default (PD). This is a welcome regulation, but only the first step. Sebi needs to take two further steps – which is a uniform interpretation of rating categories and clawback of fees to ensure that rating agencies have ex-post accountability for their actions to better align the interests of rating agencies with those of investors.
In its circular dated June 13, 2019, Sebi has increased the disclosure requirements for credit rating agencies and for the first time mandated that rating agencies disclose a Probability of Default (PD) benchmark for each rating category. What this means is that every rating agency must now put a number to its rating categories. A rating agency will now publicly state, what a ‘AAA’ or ‘BBB’ rating means. For instance, as per the Sebi circular, a ‘AAA’ rating has to mean a 0 percent probability of default over a three-year time frame. While Sebi has stated the PD for a couple of categories, for most other categories the rating agency has to come up with its own PD after consultation with Sebi. This, as per the Sebi circular, is to ‘enable investors to better discern the performance of a credit rating agency’.
And this is true. Hitherto, it was difficult to distil the de-jargonised meaning of a ‘AAA’ or ‘AA’ or ‘BBB+’ (SO) rating. A rating agency would use words such as ‘highest safety’ to describe a ‘AAA’ rating or ‘high degree of safety’ to describe a ‘AA’ rating or ‘moderate safety’ to describe a ‘BBB’ rating. But there was no way to judge what phrases like ‘highest safety’ or ‘high degree of safety’ or ‘moderate safety’ actually meant for an investor. Sure, there were rating transition matrices and historical default rates, but they were just historical data. Neither was a formal statement by the rating agency linking its rating category to what the investor should in the future. But that changes now.
Every rating agency has to now link their rating category with a quantitative number. No more hiding behind words such as ‘high degree of safety’ or ‘moderate degree of safety’. And this allows critical evaluation of a rating agency. If, hypothetically, a rating agency says that a ‘BBB’ rating means a 10 percent three-year default rate and if the actual default rate was 15 percent, one can point finger at the rating agency and say that they have had lax standards over the preceding three years in this particular cohort. Hitherto, this was not possible. The new rules give a quantitative and objective way of judging a rating agency’s performance. This is welcome. But it is not enough. There are two other things Sebi must do, building on the PD concept, to better align the incentives of rating agencies with those of investors.
The first is to standardise PD benchmark across rating agencies. A ‘AAA’ or a ‘BBB’ rating should connote the same thing to investors irrespective of which rating agency has given the rating. In the current regulations, it is possible that one rating agency defines a ‘BBB’ rating as a 10 percent PD while another defines it as a 15 percent PD. Instead, the interpretation of rating categories ought to be standardised across agencies and the agencies are then free to assign different ratings depending on their individual assessment. This is a relatively small change because the guidelines issued a few weeks back require the rating agencies to prepare their own PDs, but in consultation with Sebi. So presumably Sebi will not allow a significant difference in PDs across different rating categories. A scenario wherein, hypothetically speaking, a ‘BBB’ rating of one agency corresponds to a ‘BB’ rating of another, in PD terms, would be very confusing for investors and should be avoided.
The second is a provision for clawback of rating fees if the post-facto performance of ratings is out of sync with ex-ante disclosed PDs. The higher the deviation from PD, the higher the revenue which is clawed back. This revenue should either go back to the original investors or the Sebi’s investor protection fund. This ensures that if a rating agency does make mistakes, it not only has a loss of face but also a loss of profits. Today, if a rating agency has a poor track record, it has a loss of face, but that is about it. Given that the rating industry is oligopolistic in nature, the risk of permanent loss of business is also low. The 2007 global financial crisis, for example, did not cause any lasting damage to the rating agencies or throw any of them out of business. The point is that there aren’t any fundamental incentives for a rating agency to be conservative.
One way to fix this issue is by linking rating revenues to rating outcomes. This is now possible given that rating agencies have to commit to a PD for every rating category. This thus just builds on the recent Sebi circular. This is akin to the standard practice of providing a ‘warranty’ by manufacturing companies in general and consumer goods companies in particular. These companies give a warranty that the product will perform to certain specifications for a certain period post purchase. And if it does not, the company repairs to replace the product, at its cost. There is no reason why the opinion of a rating agency about servicing of a bond should not be subject to this principle.
Of course, this principle cannot be ported as it is since a rating agency deals with workings of business and economy which are far less precise than workings of machines. Hence, there have to be modifications to this principle. So, instead of applying the clawback principle to every rated instrument, it should be applied at a portfolio level (for every category) which allows for some unexpected scenarios to cancel each other out. Perhaps the clawback can kick in only after the PD threshold has been exceeded by a certain margin – say half a standard deviation.
A likely pushback against this will be that this will make rating agencies conservative and increase the cost of capital to some issuers. But then, getting rating agencies to become conservative is very much the objective here. If that means that some esoteric structures face a higher cost of capital or some types of borrowings and lending becomes unviable, then so be it. It is not the job of a rating agency to ensure the availability of low-cost finance to any and every borrower. The job of a rating agency is to present an investor with an objective assessment of the issuer. The primary accountability of a rating agency lies to the investor, not to the borrower.
Ashutosh Datar was the Economist at Institutional Equities desk of IIFL for over a decade. He is now an independent economist and the founder of IndiaDataHub.com. IndiaDataHub.com is a platform that brings together all the public data relevant to India, be it economic or social, in a user-friendly format. Read Ashutosh Datar's columns