Credit Rating Agency Methods: A Closer Look at India’s Rating

Context: This article is based on an Editorial “Why has the Indian government criticised the methodologies of global credit rating agencies?” which was published in the Indian Express. The Finance Ministry released a document titled “Re-examining Narratives: A Collection of Essays,” to present alternative perspectives on various aspects of economic policy.

India’s Rating

• India, currently holds the lowest investment grade and has witnessed substantial improvements in its economic metrics since the onset of the pandemic.

Credit Rating Agency in India

Currently there are seven registered CRA’s in India viz. CRISIL, CARE. ICRA, SMREA, Brickwork rating, India rating and research Pvt. Ltd. 

Global Credit Rating Agency

• It is highly concentrated, with three leading agencies viz. Moody’s, Standard & Poor’s, and Fitch.

Credit Rating Agency and their Different Credit Rating Scales

• Credit ratings use alphabetical symbols (AAA, AA, A, B, etc.) to assess the creditworthiness of corporate financial instruments. 
• Higher ratings suggest a lower risk of default, with AAA being highly favorable, indicating strong financial capability. 
• Ratings below BB are considered indicative of poor creditworthiness.

Need to reform Credit Rating System

• The Chief Economic Adviser of the government emphasized the need for credit rating agencies (CRA) to reform their sovereign rating process.
  • This reform is essential to accurately represent the default risk of developing economies.

Credit Rating Agency and Issues with their Methodologies

• Discrimination against Developing Nations: Credit rating agencies evaluations overlook the welfare and development functions of public sector banks in a developing country.
• Lack of Transparency in Assigning Weights: The rating agencies do not transparently communicate the specified weights assigned to each parameter under consideration. 
• Non-Transparent Selection of Experts for Assessment: The experts consulted for rating assessments are generally chosen in a non-transparent manner.
• Over Reliance on Subjective Assessments: Sovereign Risk Judgement by Fitch includes an excessive reliance on the World Bank’s Worldwide Governance Indicators (WGI); and the inclusion of Qualitative Overlay.
• Dominance of Perceived Institutional Strength: The impact of composite governance indicators and perceived institutional strength outweighs the combined impact of other macroeconomic fundamentals in determining an upgrade for developing economies.
• One-size-fits-all Approach: Achieving a credit rating upgrade for developing economies requires progress along subjective indicators derived from a collection of one-size-fits-all perception-based surveys.

Challenges Faced by Credit Rating Agency

• Excess Competition: In India, there are a number of agencies competing with each other which has led to a decline in transparency and quality of product delivered.
• Communication of Fraudulent Data by Companies: Companies furnish fraudulent data to rating agencies due to which certain malpractices escape detection leading to the dissemination of inaccurate information.
  • Ex- Grant Thornton’s forensic audit report revealed that favors and gifts provided to rating agency officials resulted in favorable ratings provided to IL&FS group.
• Concerns with Issuer Pays Model: Under this, a company getting rated pays the Rating Agency: This incentivizes the agency to ignore debtor’s capacity to repay debt. 
  • It also leads to a ‘conflict of interest‘ resulting in compromising the quality of analysis or the objectivity of the ratings assigned by the agencies.

Way Forward 

• Improving Transparency in Working of Rating Agencies: Rating agencies need to disclose their processes transparently and refrain from making indefensible judgments.
• Regulatory Strengthening:  A dedicated regulator needs to be established for rating agencies.
  • The regulator can be a specialist division of RBI or SEBI as well as a third party can be involved for monitoring the rating and routing payments to the agencies. 
• Rotation of CRA: Mandatory rotation of rating agencies should be explored as it would aid in avoiding negative consequences of long term associations between the issuer and the credit rating agency. 
• Alternative payment Models: SEBI, in consultation with RBI and credit rating agencies should determine the suitable rating fee structure payable by the issuer.

Conclusion

India wants credit agencies to reforms their ways for a fair assessment of developing economies. Transparency, strong rules, and better payment methods are crucial for building trust in credit agencies.