RBI reveals the trick companies use to get better ratings

MUMBAI: After getting it badly from markets watchdog Sebi, credit rating agencies (CRAs) whose role in the bad loan implosion has been under scrutiny for years now, the Reserve Bank has blasted them for allowing low-rated companies to do "rating shopping".It can be noted that rating agencies have been largely blamed for their lax policies and oversight for the 2008 global financial crisis, which primarily spawned from junk-type mortgage bonds and their derivatives worth trillion of dollars that the Wall Street bankers invented and hawked across the globe to get AAA ratings and finally imploded.Back home, a fortnight before IL&FS went belly up in September 2018, rating agencies India Ratings, Icra and Care had given its debt papers AAA/AA+ ratings.This finally had the Sebi last Friday penalising Icra, Care and India Ratings Rs 25 lakh each for their "lapses in their duty to investors by not taking timely action" when they rated NCDs of IL&FS which owes close to Rs 1 lakh crore to the system. Sebi also found the agencies guilty of excessively relying on assertions of the IL&FS management.These CRAs had given IL&FS the highest rating of AAA, even when its subsidiary, IL&FS Transport Networks, defaulted in June. There was also an abrupt downgrade in the ratings of bonds sold by IL&FS and related entities, after they defaulted in September. Soon after they downgraded the bonds from AA+ to default or junk.In the 25th edition of the Financial Stability Report (FSR) released on Friday, the RBI has warned of 'rating shopping' by companies for long-term bank loans based on indicative ratings given by CRAs which are not available to the banks or investors.Rating shopping refers to how, a company or a debt paper manages to get same or better rating from another agency within three months of it getting a poor rating.The report notes that "most rating shopping happened around 'BBB' or lower graded instruments and has called for closer scrutiny of instances of rating shopping".The FSR also notes that recent Sebi findings noting instances where rating agencies have provided 'indicative ratings' to issuers without entering into written agreements with such issuers and "since such 'indicative ratings' are not disclosed by CRAs on their websites, it becomes difficult to identify instances of possible rating shopping", says the RBI."Some instances of possible 'rating shopping' can still, however, be ascertained by looking at the dynamics around rating withdrawals where outstanding rating issued by a CRA was withdrawn and a new rating was provided by a different CRA within three months of each other; and in more than two-thirds of the cases new ratings were provided before the withdrawal of the old ones since April 2016," according to the FSR.It can be noted that since 2016, Sebi had changed the regulations governing raters at least six times.The central bank has also pointed out that there are clear indications of investors in debt instruments using additional credit-screening mechanisms, along with ratings given by raters."Similarly, given the inherent incentive on the part of the banks to boost capital adequacy through optimistic external ratings, while at the same time adopting additional mechanisms to control aggregate credit risks, the issue of movement in external ratings requires additional scrutiny," the FSR said.The share of 100 large borrowers in banks' total loan portfolios and their share in GNPAs accounted for a whopping 16.3 per cent and 16.4 per cent of their gross advances, as per the report.Long-term loan rating is a primary device for credit screening for banks. It also has regulatory implications as the capital adequacy of banks is directly linked to external long-term ratings that they are exposed to.This implies that these investors must be adopting additional credit screening mechanisms apart from borrower rating during credit selection. Similarly, given the inherent incentive on the part of the banks to boost capital adequacy through optimistic external ratings while at the same time adopting additional mechanisms to control aggregate credit risks, the issue of movement in external ratings requires additional scrutiny, the FSR noted.Clearly, for ratings that are withdrawn, the new ratings assigned are either the same or an improvement over the earlier ratings. Although replacement of withdrawn ratings by better or similar ratings by a different CRA is visible across all rating grades, such instances are particularly pronounced at BBB and below possibly because the rated universe has a big concentration around these rating grades.There are only nominal cases where withdrawn ratings were better than the assigned ratings.The issue of possible rating shopping behaviour on the part of obligors clearly requires serious attention. This is particularly relevant as some of the rating agencies have a much greater share in ratings assigned compared to their share in ratings withdrawn. Yet, given the fact that the universe of rated obligors is around 40,000, the sample where such distortionary movements are seen represents only a small fraction of the rated universe and may not make the external ratings based capital adequacy framework infructuous, the RBI concludes.

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