It’s hard to identify a system-wide implosion, much less be able to call one. But India may currently be having its own “Lehman Brothers Moment.”
India’s Lehman Brothers is Infrastructure Leasing & Financial Services (IL&FS), a massive “shadow lender” to infrastructure projects across the country. Almost exactly a decade after the global financial crisis that Lehman’s crash triggered.
Why Lehman? Well, there are three stark similarities that also mirror as fundamental differences.
Debt, ratings and credit rating agencies.
Let’s start with debt. The defining term of the 2008-era subprime bubble was collateralised debt obligations (CDOs) – complex debt instruments packaged with individual fixed income assets. CDOs were sliced and diced ad infinitum till nobody knew what they contained or what they were worth. These CDOs, which were then sold across the world to banks, mutual funds, pension funds, and insurance companies, turned out to be junk. Which then set off a chain reaction pushing the entire global economy into recession.
In IL&FS’ case, debt is still the reason. The labyrinthine group with 347 different subsidiaries had total consolidated borrowings of Rs 91,000 crore (~$12.5 billion) as of March this year. Out of this Rs 24,297 crore (~$3.3 billion) (26.35%) was raised through debentures and around Rs 5,752 crore (~$785 million) (6.3%) through commercial paper (CP), as per a report by brokerage firm Nomura. Needless to say, many banking and financial institutions in India have lent to IL&FS.
Number two is ratings.
CDOs enjoyed super safe AAA ratings until companies started to file for bankruptcy, after which they went toxic and were conveniently reduced to default grade.
IL&FS enjoyed a AAA credit rating as late as August 2018. But after the crisis started to get talked about, the ratings started to fall. Ratings firm ICRA Ltd first decided to drop its rating by a level to AA+. Then, in September, ICRA and others like Fitch Ratings and CARE Ratings downgraded it to default after the parent and a host of subsidiaries defaulted.
Which brings us to the third similarity – credit rating agencies, or CRAs – essential gatekeepers of the financial ecosystem, who were caught napping.
The string of defaults by IL&FS and the sudden downgrade by rating agencies have created a panic in the Indian capital market and cast doubt on the credibility of rating agencies’ work. “Beginning from the failures from the 2008-09 crisis and the current scenario of IL&FS and two years back with office equipment company Ricoh India, all these are living examples of the message that rating agencies are not serving the purpose for which they were created,” says JN Gupta, former Executive Director of Securities and Exchange Board of India (Sebi) and MD of proxy advisory firm Stakeholder Empowerment Services.
“If [ratings agencies] fail to advise or fail to detect the future problems or some sort of a signal, then the question arises: what are they for?” Gupta says.
Debt is the new Black
Corporate bonds accounted for as much as 30% of outstanding system credit in FY18, as per credit rating agency CRISIL’s latest Yearbook in the Indian Debt Market. This is up from 21% in FY13.
The report further expects corporate bond outstanding to more than double to Rs 55-60 lakh crore (~$754-823 billion) by FY23, compared to around Rs 27 lakh crore (~$370 billion) at the end of FY18.
At a simple level, there are three key players in the bond market – issuers, buyers and raters. Issuers are the borrowing companies or institutions raising debt by offering interest. Buyers are the lenders.
Between them lies an important player, whose opinion matters a lot but has no skin in the game if a borrower goes bust – the raters, or credit-rating agencies. Each issuer (or borrower) or its debt offering is assigned a rating, without which, due to regulation, a debt instrument cannot be issued. The objective of ratings is to ostensibly make investors aware of the business health of the issuer and of its ability to continue servicing its debt. A rating is, thus, a creditworthiness assessment.
Except, that it isn’t really.
While the “opinions” of rating agencies can move markets, open or shut the tap for liquidity, and even play a major role in bringing a global recession, they have virtually zero downside risk to their own profits when they go wrong.
Which happens more often than you would think.
In the case of IL&FS, concerns around its viability started being raised nearly three years ago, as the rot in its finances became visible.
For starters, India’s central bank, the RBI itself, had expressed concerns about the operations of an IL&FS subsidiary, IL&FS Financial Services (IFIN). In its annual inspection for the year 2014-15, it had pointed out that the net-owned funds of the finance company had been wiped out and that it was over-leveraged.
“Rating agencies can demand the inspection notes of the regulator. How can your assessment be complete without getting the statutory audit report of the issuer, the internal audit report of the issuer, inspection report of the issuer? You really have to go through all that stuff,” says Ashvin Parekh, founder of Ashvin Parekh Advisory Services in Mumbai.
It didn’t stop there.
Over the last three financial years, IL&FS’ borrowings shot up by 44% even as it remained a loss-making group. In its most current financial year, FY18, its losses stood at Rs 21,000 crore (~$2.8 billion).
It was as if nobody paid attention to the consolidated accounts, where intangible assets were rising rapidly, rendering the company insolvent. IL&FS’ consolidated net worth stood at a negative Rs 7,500 crore (~$1 billion) in FY14, and had risen up to a negative Rs 23,000 crore (~$3.1 billion) by FY18.
And yet, what ratings did it enjoy?
AAA. Which, as per ICRA, refers to “instruments considered to have the highest degree of safety regarding timely servicing of financial obligations. Such instruments carry lowest credit risk.”
IL&FS is now experiencing what happened with footwear company Bata India and tractor manufacturing firm Escorts in the 90s, says independent banking analyst, Hemindra Hazari, who pointed out the above mentioned red flags.
“With Bata and Escorts, the ratings agency had not done cash flow analysis. In those days, cash flow was not a mandatory disclosure in the accounts. But you could calculate it. Cash flow is the heart and soul of financial analysis, and agencies had missed that,” Hazari says. “Escorts had an A+ rating for their debentures, but their cheques were bouncing,” he adds.
Hazari says that these deteriorations don’t happen overnight. “Once you look at the account and start to analyse, it is evident. In the case of IL&FS, it was extremely relevant,” he says.
In Ricoh’s case, the credit rating agency had upgraded their non-convertible debentures rating to IND AA- from IND A without having access to updated financial information. With the Amtek Auto bond default, CARE had sharply downgraded and withdrawn ratings on the bonds and CRISIL had downgraded JP Morgan’s corporate debt fund eight notch within a month in 2015. This sudden downgrade made securities regulator Sebi send a show-cause notice to the two ratings agencies.
“At the end of the day, the problem that IL&FS had was that they were lending long and borrowing short, which I think should have been visible to the ratings agencies,” says an analyst covering rating agencies, who requested for anonymity. In fact it was very visible to everybody who was buying the papers, the analyst says.
In an interesting twist of fate, not only has there been no negative consequence on major credit rating agencies (the top three – CARE, CRISIL and ICRA – are listed and control 80% of the revenue market share), they have been outperforming both respected stock market benchmarks like the Nifty and PSU bank index over the last 10 years. Over the long-term, CRAs have been wealth generators for investors.
Remember the proverb about the monkey who offered to help two quarrelling cats divide their piece of bread “equally”, till there was none left to divide? Well.
The ratings cake
CRISIL, the first rating agency in India was set up in 1987. Shortly after, ICRA was established in 1991 followed by CARE in 1993, and at present, there are a total of seven RBI-recognised ratings agencies in India.
The objective, back then, of having a ratings agency in India, was to spread the awareness about credit that was independent on the name recognition of a company and to use a good rating to deepen the debt market. Otherwise any well run, well managed company, with no public profile could not normally tap debt markets, says R Balakrishnan, who was a founding team member of credit rating agency CRISIL, former head of research at investment banking and brokerage firm DSP Merrill Lynch and former CEO of First India Mutual Fund.
“Credit Rating helps create awareness of names beyond the well known. Credit rating also sometimes helps shatter illusions. When a company does not have a rating, questions arise,” he adds.
But the biggest wind in the sails of CRAs came in 2008 when the RBI all but made them mandatory. Because nothing sells like regulatory obligation.
The RBI mandated banks to resort to external rating for credit limits above Rs 5 crore (~$685,824). This exploded the CRA business and the industry then grew at a compounded annual rate of 48% over the next three years.
Then, in 2017, the RBI gave a mandate to corporates to seek ratings from two agencies in order to issue a commercial paper. Backed by regulatory reform, the bond market has seen steady growth in India, clocking a 13% annualised growth in the past five years.
What happened next shouldn’t surprise anyone who knows what happens whenever regulators mandate a service without adequate checks – easy money sans responsibility. And inherently conflicted business models.
A flawed business model: The conflicts and incentives
In the case of CRAs, this means they’re an “issuer pays” business model; they’re paid by the very borrowers whose creditworthiness they’re meant to be rating.
“The issuer pays model is a system world over and is prone to conflict of interest. Repeatedly, in the last 30 years, the system has let investors and the bond market down,” says Saurabh Mukherjea, Founder, Marcellus Investment Managers.
The global ratings industry is about a century old, and it started in India just three decades ago. “Given that we came late to the scene, we could’ve learnt from the mistakes of others, but we didn’t,” Mukherjea says. Instead, India replicated the same faulty incentive structure for compensating the CRAs, and now we have agencies whose ratings are increasingly challenged, not just in India but also globally, he adds.
In the case of Moody’s and Standard and Poor’s, both the rating firms were charged with fraud for their role in the 2008 crisis and had to pay a hefty penalty. The lawsuit against Moody’s had claimed that the ratings were influenced by its desire for fees, despite claims of independence and objectivity. It also accused Moody’s of knowingly inflating ratings on CDOs.
Flawed as it might be, “issuer pays” is working swell for CRAs, as all the three listed firms are debt-free and have margins in the range of 30-35%.
“Issuer pays” also prevents new and potentially better competitors from emerging, as it imposes a high entry barrier for newcomers by giving the incumbents an unfair advantage based on their “trust” and “ reputation”. Which has only become more cemented as the global ‘Big Three’ ratings, Moody’s, S&P and Fitch have found their way into the Indian markets as well.
Over time, S&P has acquired a 68% stake in CRISIL whereas Moody’s is a parent holder of ICRA and has 50% stake in the company. India ratings, which entered the market in the late 90s, is a 100% owned subsidiary of the Fitch Group. CARE Ratings, which does not have a promoter, saw its rival CRISIL buying 9% stake in the firm last year in June.
“The model was not wrong, the model is not wrong. The issuer pay model is the principle model followed all over the world. It is the same concept as is with auditors, who get paid by the company they are supposed to audit. This is because you can never get better information from anyone else except the company itself. It’s impossible,” says Pradip Shah, co-founder of CRISIL and founder of IndAsia Fund, a corporate finance and investment advisory firm.
Shah is right, in that numerous firms around the world have tried alternatives to “issuer pays”, but none have succeeded.
“For continuing to be a good rating agency, we need to have good information and cooperation from the companies we are rating. They have to periodically provide us with the information we want in order to assess their creditworthiness. It is a question of continuity and accessibility to the superior information you can get from the company itself,” says TN Arun Kumar, executive director at CARE Ratings.
But as with all exchanges, when you give away something, you also receive something. In the case of borrowers, it is their right to “refuse” a rating.
Faced with a bad or critical rating from one agency, a borrower can hire another agency with the implicit understanding that it will deliver a better rating. Because better ratings mean lower borrowing costs.
This practice, termed as ‘ratings shopping’, does not bode well for investors.
“I will not quibble a lot on ‘ratings shopping’, because, at times, some rating agencies openly say that they’ll give a one-notch higher rating than their rival but in the process, such liberal agencies risk their own reputation,” Shah says.
The issuer should be allowed to shop but it’s the investor that should go for the best rating which then lets the market forces decide on the credibility of an agency, he adds.
Markets regulator Sebi has taken note of this practice and has acted on it. Since January 2017, it has introduced a concept of “unaccepted” rating disclosure where it has mandated all rating agencies to disclose ratings assigned by them, irrespective of whether the rating is accepted by an issuer or not.
But could other revenue models such as “investor pays” or “regulator pays” also work?
Each and every jurisdiction has looked at alternate methods of rewarding the work of rating agencies but they’ve drawn a blank, Parekh says.
“With an “investor pays” model, you are not expecting each and every shareholder or debenture holder to pay for the professional work done by the rating agencies, and that leads to a very fractured market and makes the business unviable in the long-term,” the ratings agency executive quoted above says.
There is no continuity in the investor pay model, Kumar says.
Kumar goes on to explain that in the “issuer pays” model, a ratings agency enters a long-term contract with the issuer for the life-cycle of the paper, whereas in an “investor pays” model, the investor can sell-off the debt instrument in a year and move on.
“However, the new investor may not agree to the previous terms and conditions and may decide to terminate the contract. So, the whole thing goes flat,” Kumar adds.
Also, the investor pays model is not exempt from conflicts. “When an investor pays they’ll want lower rating, to get a higher spread, similar to when companies demand a higher rating because it brings down their cost of borrowing,” Kumar says.
Individually, none of them is going to be a perfect model, but maybe having sort of a hybrid of the two could reduce some of the conflicts.
Deep Narayan Mukherjee, visiting faculty at IIM-Calcutta, says that ratings agencies should not exclusively stick to the issuer pays model.
“We need to evolve to a place where if an investor wants to get a rating on a company, it can get into a mou [memorandum of understanding] with the ratings agency and the company and pay for the rating,” Mukherjee says.
“That option should be there; the investor should be able to pay for a rating and the company should cooperate,” he adds.
Is IRB the answer?
The existing Basel II framework, which requires financial institutions to maintain enough cash reserves to cover risks incurred by operations, gives banks two methods to calculate their credit risk and capital adequacy — the standardised approach and the internal ratings-based (IRB) approach.
Under the standardised approach, external credit rating agencies such as CARE or CRISIL calculate the credit risks for the banks.
With IRB, banks use their own internal estimates in determining capital requirement for a given credit exposure.
Implementation of the Internal ratings-based (IRB) approach could impact volume for the bank loan rating (BLR) segment, which accounts for around 45-50% of revenue, as per a report by brokerage firm Elara Capital.
In December 2011, RBI released guidelines that allow banks to migrate to the IRB approach, and until 2014, 14 banks had applied for the IRB implementation out of which seven qualified, the report says. “Private banks are in a position to move to the IRB model and some even have but public banks won’t do so until or unless the NPA mess gets resolved. They’ll move to total accountability only then,” says Ritika Dua, AVP-Institutional Equities Research at Elara Capital.
In such a scenario, only a deeper bond market could be a saviour. Compared with developed countries like the US, where the debt market is mature, the Indian market is still underpenetrated and banks are still the primary source of funding for Indian corporates, which means there is a huge untapped potential.
If we look at the performance of ratings agencies as a business across the world, they have largely been outperformers, barring, say, the dotcom bubble and subprime crisis, when there was a liquidity crunch in the market.
It’s like a lock for your house that works beautifully each time you and your family members use it, but fails the two times burglars came calling.
Any company or sector that is paid regardless of its performance is one that will eventually underperform. Having no skin in the game should not make the ratings industry complacent as their entire business runs on the brittle foundation of trust, and if they keep on breaking that trust, then it will sooner or later bite them back.
An “opinion” that is mandatory
The root of the rating-agency problem, of course, is an over-reliance on these grades throughout the financial system. “In my view, credit rating has been given exaggerated importance by the regulator. The regulator and investor are equally responsible. The regulator is guilty by making something compulsory without knowing what it is and the primary failure lies with the mutual funds or the investor who failed in their own due diligence to analyse credit,” Balakrishnan says.
“The banks are the ones lending the money, mutual funds and insurance companies are investing customers’ money. They should be doing their own homework,” he adds.
Bankers and fund managers should’ve spotted it, it’s their job, they get paid for it. Now they can’t turn their back and put the entire blame on the rating agency.
The former ratings agency executive quoted above says that each one took comfort in the fact that the other has their duty and this created a chain of negligence, and at the end of the day you realise that none of them had done their job.
“Everyone took comfort in the fact that the company has shareholders with deep pockets and everyone turned to the other and no one is taking the ultimate responsibility; if that’s the case then the agencies should’ve mentioned this in their report,” he says.
“The first thing that we should remove after the Lehman crisis was the reliance on a sovereign. It really doesn’t help. Look at IL&FS, the Rs 4,500 crore (~$617) rights issue is not happening. Where are all these marquee investors gone?” the analyst quoted above says.
As far as the usage of the rating is concerned, theoretically, the conflict of interest may potentially extend beyond the rating agency and the issuer which pays it. In fact, it may be argued that certain users of the ratings such as banks, mutual funds and other financial institutions, given certain specific aspects of regulations, may be tempted to prefer inflated credit ratings.
If the end users start accepting ratings at face value then that sharply increases the risk for the entire ecosystem.
After the 2008 crisis, the US Securities and Exchange Commission (SEC) tried to reduce the reliance on rating agencies and encouraging investors to do their own analyses. A similar approach is needed in India to have a more accountable system.
Sebi should make mutual funds disclose what is their internal rating on their portfolio and put the onus on the regulation of the fund and the board, Mukherjee says.
“So, in the scenario when an AAA rated paper defaults, one should question the mutual fund and ask them on their internal rating,” he adds.
Investors should play a more proactive role in order to bring transparency in the market. If any investor finds that there is a gap in the rating agency’s analysis and they are not in agreement with the evaluation or they find it incomplete, then they should make that public, not in the form of a complaint but rather as an independent evaluation.
Need for a stick
The ratings given by these are just ‘opinions’ and because of this nature, it has kept them exempted of any liability in case they go wrong. The reason why the regulator prescribes a certain rating is because they believe that the agency is carrying out a fair and thorough evaluation.
“It is more than just another opinion, it is a regulatory requirement. Either the agency should come forth and say that this is ‘my opinion’ but it does not apply to the bond and I want to be kept outside the regulatory purview. If that’s the case then its fine but if it’s got a regulatory cover then the regulator should have the right to fine them,” the senior executive quoted above says.
“If they don’t want to be penalised then their bond ratings cannot be used as one of the two ratings required for the issue. I am regulating you then I have the right to fine you. If I am not then your rating will not be accepted,” he adds.
Let’s not make a general rule that rating agencies are going wrong and need to be penalised for every wrong rating but I think the exception of IL&FS should teach them a good lesson, Parekh says. “For example, reports say that Sebi has now issued a show cause notice to the agencies rating IL&FS, so they may get penalised,” he adds.
“Only in the case of gross negligence of malafide, a penalty should come, otherwise not,” Gupta says. If the regulator feels that the agencies have done a fraud then it should be investigated under the economic offences wing (EOW) or the Serious Fraud Investigation Office (SFIO), and if they are found guilty, then they should be penalised, he adds.
Hazari, however, has a stronger opinion on the matter. He says that none of these agencies has any proper accountability. “When they do well, they give themselves huge bonuses but when they go wrong it becomes a very diffused accountability.”
“These fellows either should have their licenses permanently suspended or taken away for a couple of months and the head of the rating committee has to be sacked,” Hazari says.
Going forward, rating agencies would have to be more vocal and transparent in their reports. Otherwise, more and more institutions will start working on their own ratings and would take the agencies’ rating as just one of the inputs. That, of course, would go terribly awry.