Ever wondered how your friendly neighbourhood Rating Agency makes money? They do so from the very companies whose bonds they rate. Now that's an arrangement that has 'potential conflicts of interest' written all over it: in large, bold font!
If you thought that was bad, digest this - a very large percentage of the Rating Agency's top line comes from a bunch of services that are lumped together as 'non-rating' activities: research, risk management consulting, pre-rating analyses, mutual fund research, and the impact of hypothetical transactions on the credit rating of the issuer, to name a few.
Let's say that I run a Rating Agency, and I advise you (a company) that a merger with another company will take your credit rating up a notch. Post-merger, things don't work out quite as expected, and the combined entity takes a nosedive. Not only am I morally obligated to downgrade your rating after taking your money (if the situation warrants it, after an unbiased evaluation), but I'll also need to admit, to both you and to the world, that it was on my behest that the decision to merge was taken; leading to the ratings downgrade in the first place! The knotty web just gets more and more difficult to disentangle, doesn't it?
The role of the big three Rating Agencies (Moody's, S&P & Fitch) in the subprime mortgage crisis of 2008 has already been well documented, and has gone down in the annals of history as one of the more shameful instances of conflicted interest in the financial services industry. Hundreds of Billions of Dollars' worth of purported AAA rated securities were downgraded to 'junk' status within a couple of years, contributing to the disappearance of three legacy investment banks (Bear Stearns, Lehman Brothers, and Merrill Lynch). Readers are advised to watch 'The Big Short' for a more colourful representation of this tangled web of deceit.
Baghai et. al. released an important paper in 2015 (http://bit.ly/2ftOk4G) in which they evaluated payment flows of Rating Agencies in India. The gist: issuers that contribute 'non-rating' revenues to rating agencies receive better ratings - the higher the revenue, the higher the rating. What's more: default rates are higher for issuers who have paid for non-rating services. Oops - pop goes the customer!
Here's a snippet from an internal S&P email from United States of America v. McGraw-Hill Companies Inc., et al that tells the story quite succinctly: "I mean come on we pay you to rate our deals, and the better the rating the more money we make?!?! What's up with that? How are you possibly supposed to be impartial????"
Possibly recognizing this inextricable conflict of interest between advisory and rating, CARE recently decided to bow out of the advisory game altogether - a bold and welcome move. Others may follow suit.
In a bid to protect the relatively uninformed end consumer from this welter of confused priorities, SEBI released a circular titled "Enhanced Standards for Credit Rating Agencies (CRAs)" on November 1, giving our venerable rating agencies a window of 60 days to implement the recommendations outlined in it.
The circular instructs Rating Agencies to frame an Operations Manual/ Internal Governing Document and disclose it publicly on their websites. This document will detail out the precise rating criteria employed by the agency, including but not restricted to matters such as default recognition and post-default curing period, financial ratios and how they are evaluated, securitization transactions, public finance and infrastructure ratings. The circular also mentions that "CRAs are mandated to have in place a proper rating process and disclose the same on their website" (this made me wonder - were they functioning with an 'improper' rating process to this day?)
Among other things, the Internal Governing Document also needs to disclose the "general nature of compensation arrangements with rated entities", as well as provide a disclosure on how the agency manages conflicts of interest. Formats of press releases have been standardized too.
To further strengthen the Chinese Wall between the business side and the rating side, SEBI has now mandated that any employee having business responsibility is expressly disallowed from being part of the ratings committee. Internal Audit criteria have been further tightened as well.
Non-cooperative issuers who do not provide requisite information for ongoing reviews of their instruments will now have to make do with a rating that carries the rather ungainly postscript: "Issuer did not co-operate; Based on best available information". Watch out for these in the days to come. A word of advice - avoid these bond issues!
It'll be interesting to observe the longer-term impact of the implementation of the circular recommendations on the credit ratings ecosystem. As always, execution will hold the key. Will agencies collectively focus their energies on implementing creative solutions to circumvent the circular clauses? Or will they aim to remodel their businesses to foster a much-needed environment of increased transparency - perhaps at the cost of their toplines, but in the interest of the end consumer of these ratings (the uninformed investor)? When one considers the deep reliance that the common man places on the 'AAA' stamp while evaluating an investment decision, I hope it'll be the latter.
Either way, it's good news that the regulator is taking pre-emptive action in this regard. The last thing we hapless investors look forward to is another 2008. Here's hoping that a sequel to 'The Big Short' never sees the light of day.
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