Debt markets are at the heart of the modern financial system. Credit flow is the lifeline of any economy.
In the modern debt market there are three principal players. Lenders, borrowers and the third one which are the Credit Ratings Agencies or CRAs.
Credit rating agencies stand between borrowers (Issuer of Debt) and the lenders (Investors who buy the Debt paper). Credit Ratings are responsible for giving an expert opinion in the form of ratings on the credibility of the borrower/issuer and their ratings help the lender to decide whether it will get its money back on time.
Credit rating agencies have no skin in the game. Legally they claim that their ratings are just an opinion and they cannot be held responsible if they are wrong.
In 2008, RBI made it mandatory for issues above Rs. 5 crore to get the ratings done without which debt instruments cannot be issued. In 2017, it made it mandatory to get ratings from two ratings agencies to be able to issue a Commercial Paper.
Credit rating follows what is called the ‘Issuer Pay’ model where the issuer of the debt paper or the borrower pays for the ratings. It suffers from inherent conflict of interest. It has many a times resulted in ‘Ratings shopping’ where the Issuer goes to the rating agency which is ready to issue the best ratings.
The inherent idea is that a credit rating agency will do all the proper due diligence because if they fail to do so it will affect their credibility. And over a period of time, business will move to Rating agencies which are more credible. Issuers which have nothing to hide will move to better perceived credit rating agencies to earn investor’s trust.
Credit Rating agencies in the last 30 years have failed Investors who rely on them multiple times.
In the run up to the US Subprime Crisis, Rating agencies assigned AAA ratings (which is the top notch ratings) to financial instruments which were actually junk. It was a case of Ratings shopping. Leading Credit ratings agencies Moody’s and S&P were charged with fraud and had to pay hefty penalties.
In India too, IL&FS blow up had a similar story. The problem with the group was evident way before but it enjoyed AAA rating right up till it started defaulting.
It is widely known that the ‘Issuer pay’ model isn’t working. But a viable alternative is yet to be found. One alternative is the Investor Pay Model where the investor or lender pays the CRA. The issue with this is that there are multiple investors with different holding periods. It is too fractured a space to make it viable for CRAs. Also, there is conflict of interest. The lender would want a lower rating so that it can ask for a higher yield from the borrower/issuer.
It is important to understand the underlying mechanics of how CRA business works if one were to rely on ratings.
It is yet another example of the mental model of power of incentives.
“Show me the incentives and I will show you the outcome” – Charlie Munger