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Last Updated : Oct 17, 2019 09:29 PM IST | Source:

Explainer | How companies 'shop' for favourable ratings and mislead investors

According to industry sources, CRAs in India are currently witnessing customer churn rate as high as 35 percent, as compared to 8 percent internationally.

Credit Rating Agencies (CRAs) in India have come under fire for failing to warn investors about major defaults that rocked the banking system in recent years. An underlying trend could be the high customer churn rate that CRAs are facing currently.

What is a credit rating?

Credit rating is a metric that banks and investors use to determine the creditworthiness of a borrower. In simple terms, it tells you how capable the borrower is to repay its debt and whether it is safe to lend. The higher the rating, the lower are chances of a default by the borrower and lower the cost of borrowing. Typically, the highest-rated paper carries ‘AAA’ rating and lowest ‘D’ which refers to default. What was shocking about the recent defaults, was that CRAs maintained investment-grade ratings (‘BBB-‘ and above) in all cases. The ratings were downgraded only after the companies defaulted on their debt obligations.

What is rating shopping?

In the model that is followed world over, the borrowing company pays the CRA to get its papers rated before approaching the investors. This is called “issuer pays” model. The problem with this model is that there may be a conflict of interest as the issuer naturally favours higher ratings and CRA may be tempted to oblige in order to protect its revenues. In a shallow debt market like India, the borrowing company can shop around for favourable ratings, misleading investors about the actual health of the company.

How bad is the situation in India?

According to industry sources, CRAs in India are currently witnessing customer churn rate as high as 35 percent, as compared to 8 percent internationally. This means that companies either discontinue cooperating with or withdraw rating from the existing CRA and move on to another agency for a better rating. This has happened as the number of CRAs in the country increased over time. The higher competition also led to lower revenues. The CRA industry in India, that comprises of seven agencies, makes about $150 million currently, while the revenues of the top three globally renowned CRAs runs into tens of billions.

What are the regulators doing about this?

While CRAs play an important role in the banking industry, they are supervised by the markets regulator-Securities and Exchange Board of India (SEBI). It has tightened the norms governing CRAs several times over the past years. As a result, CRAs in India function in a heavily regulated environment, as compared to their global peers. However, this does not guarantee that the quality of ratings is up to the mark. Limited and timely access to financial data is often cited as a challenge faced by CRAs. Also, these agencies cannot carry out forensic audits to unearth frauds and hence, are often caught on the wrong foot when such issues emerge.

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First Published on Oct 17, 2019 09:29 pm
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