s&p global ratings Archives

Credit Rating Agencies(CRAs) are generally privately-owned entities that do the job of rating securities like bonds, debentures, shares, and other instruments. Believe it or not, but Credit Rating Agencies(CRAs) seem to be running the show globally.

Standard and Poor(S&P), Moody’s, and Fitch group are known as the ‘Big Three’ and own close to 80% in the international credit rating. Each of the three has a setup in India, that is:

CRISIL, an S&P Global Company
India Ratings(Ind-Ra), a wholly-owned subsidiary of Fitch Ratings
ICRA, a subsidiary of Moody’s
CARE, not owned by either of the Big Three.

CARE, CRISIL, and ICRA are listed on National Stock Exchange(NSE) and Bombay Stock Exchange(BSE).

CRAs have been controversial for almost half a century. They have been deemed responsible for a few of the many financial or industry crises throughout history; Penn Central Rail Road Crisis and the infamous 2008 Housing Market Crisis to name a few. In India, the IL&FS crisis is said to have taken place due to improper credit ratings.

In this piece, we explore how credit rating agencies make money, what is so special about them and how they perform on Dalal Street.

The Business Model

Broadly speaking, a CRA has three sources of revenue:

Ratings
Research
Advisory

Ratings

Every time a company issues a bond, it has to get rated by a CRA as per norms set by regulatory agencies globally. Based on risk and credit analysis, credit ratings of bonds range from AAA(+/-), AA(+/-), A(+/-) to………. CCC, CC, C D. AAA is considered as the highest grade, and D is considered the lowest grade. If a bond is rated higher, generally it shall receive more buyers in the market since it is less risky. If the bond is rated lower, it shall be deemed risky and generally receive fewer holders.

Every time a company issues a bond, it has to get the bond rated for a price. The rating markets follow the more popular ‘Issuer-Pays Model’ where the issuer or the company issuing the bond pays the CRA to get itself rated. This wasn’t always the case though,

In the 1970s, there was an ‘Investor-Pays Model’ that lost popularity over time, where the buyer of the bond had to actually pay the CRA to access the ratings.

Another major source of income for CRAs is Bank Loan Ratings. Every time a company or an individual borrows money from a bank, a Credit Rating Agency has to rate the borrower based on several factors. Bank refers to the credit report before granting a loan.

Apart from bonds and loans, CRAs have to rate MSMEs, companies, other debt instruments, shares and even the economy of countries. All of these contribute to the revenue stream.

Research

If you have ever gone through a Red Herring Prospectus(RHP) or a report a company files before an IPO, chances are that the report contains research done by a CRA. Banks, companies, and even governments hire credit rating agencies to conduct research on a requirement basis. Sometimes CRAs release reports in the public domain for marketing and maintains their position and reputation in the market.

There have been instances where CRAs have released a negative outlook towards a company or a sector its share price fell on the stock markets. This is how important a research report by a CRA is. A research report by an established CRA gives a clear picture to investors as well as organizations to make well-informed decisions.

Advisory

CRAs have all the data they need in the world. This gives them a better insight into global markets than many businesses. This is why businesses even avail advisory services offered by CRAs. This is done on a contractual basis for the necessary period.

Credit Rating Agencies As An Investment Option

Credit Rating Agencies despite running the show haven’t been running up themselves when it comes to investor returns. Their stocks have caught up only in the past year because of the bull run seen in the Indian markets. Even there, the stocks of ICRA, CRISIL and CARE ratings have barely managed to beat the NIFTY 50 benchmark index. Coming to return on investment for the past one year, CRISIL has returned ~76%, CARE Ratings returned ~69% and ICRA returned ~29%. Even here, the shares did not spike up in one go, rather they moved up in a consolidated manner over a period of time.

The Revenue and Net Profit of CRAs haven’t been consistent for the past three years. This is since CRAs aren’t selling a straightforward product. They are selling an opinion. If their customer doesn’t like it, they can always move on to the rival CRA and get a better rating.

The Big Picture

In 2008, there was a global financial crisis. It all started when CRAs gave a higher rating to bonds with a poor asset or credit quality. They were bribed/incentivized to do so. Yet, there was no action taken against them even after a global downturn.

In India, something similar happened during the IL&FS crisis in 2016. CRAs gave the now failed IL&FS securities a good rating despite knowing of poor asset quality and financial condition of the company. IL&FS did not pay back the money it had borrowed from banks and lenders. Finally, it led to a major credit crunch in the system where banks and financial services companies were hesitant to lend money and the economy remains affected by it even in 2021.

The sector runs in an Oligopoly. Apart from the Big Three, there are only a few independent CRAs, this means that only a few entities get all the business. Barriers to entering the market are high and opportunities are less. Even if the CRAs play foul, SEBI can atmost fine them as they did in the IL&FS crisis in 2016.

In popular opinion, there is rising support for the ‘Regulator Pays Model’ for CRAs where market regulators like SEBI(India) or SEC(USA) would pay the credit rating agencies to rate bonds. The benefit of it could be that CRAs would not play foul or give false ratings to companies. The disadvantage could be that the reports of the CRAs could be influenced by the opinions of the ruling majority or the government.

How do you think we can solve the loopholes in the credit rating industry? What are the growth opportunities for them? Let us know in the comment section in the marketfeed app available on Android and iOS.

By now, most of our readers would have thoroughly understood the recommendations of the RBI’s Internal Working Group Report. marketfeed had prepared a detailed article on it. You can read it here. One major suggestion put forth by the group was that large NBFCs could be converted into banks if they follow specific criteria. However, our former RBI Governor Raghuram Rajan has stated that allowing corporate entry into banking is a ‘very bad idea’. Global financial analysts also have similar concerns about India’s banking sector. Let us find out why.

Inputs from a LinkedIn Post

On 23rd November, the former RBI Governor Raghuram Rajan and Deputy Governor Viral Acharya posted a joint article on LinkedIn. They have questioned the Internal Working Group’s recommendation to allow industrial or corporate houses to promote banks in India. An important question mentioned in the article is “Why now? Have we learnt something which allows us to override all the prior cautions on allowing industrial houses into banking?”.

Let us look at why they are worried about this particular suggestion:

Risky Lending Activities

According to the former heads of our central bank, a corporate entity can get funds very easily from its in-house bank (the bank which they own). These funds could be diverted or used for other activities. It would become very difficult for regulators to find faults in such lending activities. In case the corporate entity fails to repay its loans, things would become highly problematic. Also, the information shared on failed loans by the Indian banking system is not accurate. The banks also seem to cover up or conceal the information from regulators.

An example of risky lending can be attributed to the case of Yes Bank. The information regarding failed loans remained to be concealed for a long time. The private bank had to be rescued by the RBI, with the help of funding from large domestic banks. Just recently, Lakshmi Vilas Bank was similarly bailed out.

They have also stated that the RBI would sometimes be under political or economic pressures. This would force them to ‘loosen their grip’ in the financial sector. Rules and regulations would become very lenient. Ultimately, a few financial companies would have the chance to expand their businesses. These entities would also raise funds through loans to support their growth. Ultimately, such transactions would impose more risk on India’s financial system.

The Concentration of Power

The article also stated that allowing large private players to set up banks would lead to the concentration of economic and political power in certain entities. “Even if the banking licenses are allotted fairly, it will give undue advantage to large business houses that already have the initial capital that has to be put up.”

According to Rajan and Acharya, most of the corporate firms have political connections. These connections will help the large entities to have an incentive to obtain a banking license. This will lead to an increase in the importance of more ‘money power’ in Indian politics.

Why Bring up Such a Recommendation Now?

The economists have come with two main reasons as to why private corporations need to get full-fledged banking licenses at this point in time.

The Indian Government is looking for more private players to bid for its public sector banks. As we know, most of the public sector units in our country are being privatized, and public sector lenders would be next in line. However, the former RBI officials have stated that this move would be “foolish”. They have argued that certain public sector banks have been under poor management over the years. Things would become even more difficult if these banks come under a highly complicated structure of ownership by large corporate houses.

Rajan and Acharya have also stated that the recommendations would prove to be beneficial for a chosen few. There could be certain industrial or corporate houses that hold payments bank licenses. And, they would be looking forward to transforming it into a universal bank.

Concerns from S&P Global Ratings

S&P Global Ratings is an American credit rating agency and a division of S&P Global. It publishes financial research and analysis on stocks, bonds, and commodities. They have also said that allowing corporate ownership of Indian banks would be highly risky.

“The RBI will face challenges in supervising non-financial sector entities, and supervisory resources could be further strained at a time the health of India’s financial sector is weak,” – S&P Global Ratings in a statement made on November 23.

The credit rating agencies’ concerns are very similar to that of Raghuram Rajan’s and Viral Acharya’s. They have further stated that corporate ownership of banks raises the risk of intergroup lending and diversion of funds. As per their analysis, the performance of new banks set up in India over the past three decades has been mixed. Of the 14 new universal bank licenses issued by the RBI since 1993, Global Trust Bank and Yes Bank Ltd. had to be bailed out by government-owned banks.

S&P Global Ratings has also stated that the conversion of NBFCs into banks will be very complex and difficult. It will also incur additional costs for these financial companies.

Conclusion

As we can see, many prominent figures and agencies have come forward to express their views on corporate entry into banking. These are very valid and relevant facts that have now questioned the objective or aim of the Internal Working Group’s Report. However, do bear in mind that the report only contains suggestions. The RBI, through further discussions and deliberations, has the final say in whether the inputs are to be implemented or not.

Let us look forward to seeing if the RBI reviews the concerns from its former head, and also from financial agencies or analysts. Do keep a close watch on the NBFC and banking stocks in the days to come.