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"The reliability of ratings is well established in India"
Ratings agencies perform the critical function of assessing the fundamentals and future prospects of corporate houses that continuously seek to raise money from privat e investors or the public. That puts the onus on ratings agencies to get their systems of governance right, both within their own companies and the companies they assess. How do they do it? How do they ensure a rating or grading reflects the actual state of the company. D Ravishankar, founder and MD of Brickwork Ratings, India’s youngest ratings agency, talks about this and much more in an interview with B V Rao and Geetanjali Minhas. Edited excerpts:
Considering the current economic situation how is life for India’s youngest and fully home grown ratings agency?
For the benefit of your readers we must differentiate between global ratings agencies and those in the domestic sector. If an Indian company raises money in the domestic market, it requires compulsory rating by a domestic credit ratings agency. Whereas if the same company wants to borrow outside the country in dollars or euros, the overseas investors require ratings agencies registered outside the country to rate the borrower. In India when we say we have rated a company it is relative to companies within the country. When S&P or Moody’s assigns a rating it is relative to all companies in the global space. There are two business models for ratings agencies – traditional and structured.In the traditional model, the issuer comes to the agency and the agency assigns a rating after due process. In the structured rating, for example, where a bank may have a housing loan portfolio consisting of 10,000 borrowers, it will not go and evaluate each and every borrower. Rather it will assess overall quality of the loan portfolio on certain parameters based on certain models of assessment.
It is in the structured rating that the problem started globally in 2008. For structured rating the model of assessment must be validated periodically as its behaviour can vary from time to time like during an upturn economy and downturn economy. The model has to be stress-tested. You must have noticed that on the one hand interest rates were moving up while on the other real estate prices were falling.These models may have been individually tested for rise in interest rates and fall in real estate prices but the correlation was not looked at by anyone and that caused the crisis.
In the Indian context we have not come across rating of structured products since the sizes are small, highly regulated and as a result not impacted by global issues. Secondly, unlike other countries India has specific regulations even for governing credit ratings agencies, whereas in other countries regulations were introduced post-crisis. For example, pre-crisis the four global ratings agencies did not have a registration certificate from NRSRO whereas in India we have had regulations for more than two decades now.
There are two aspects – one, of ratings from agencies such as yours and the other is the customer/investor interest. While strict regulations are good for the latter, do ratings agencies feel stymied or boxed in in India?
This is an interesting question. If you look at the business model of the ratings agencies, can there be a conflict of interest in terms of the ratings agency being aggressive, conservative or neutral. But there is something called balancing factor. Let’s say, for example, a company wants to raise money in bond market. The higher the rating, lower the cost for the company. This is from the issuer’s perspective. From the investor’s perspective, if the ratings are higher his yields will be lower. So there is a balancing factor between the issuer and investor. An issuer will always like to have a good rating while the investorwould want the right rating. That is one balancing factor.
The second balancing factor is competition among ratings agencies. If one ratings agency gives a higher rating compared to the other, both of them will have to explain themselves. If a ratings agency is consistently different from the others then it has to prove itself right in the market place. So at least in India the so-called conflict of interest of ratings agencies is taken care of by these two balancing factors.
Also, it is just a perception that a new ratings agency in order to build a better market share will be aggressive and dole out better ratings. If you carefully note, 95% ratings assigned by Brickwork are same as other agencies and only 5 percent could be much higher or lower. The fact that investors decide to invest on basis of its ratings proves its acceptability.
Something that precedes regulation is an organisation regulating its own business practices through self-regulation and good corporate governances.How does Brickwork achieve that?
There are three aspects to this. First, every ratings agency is also a member of the Association of Credit Ratings agencies (ACRAA) in Asia. Members of ACRAA follow certain best practices. Second, the regulator in India insists that all ratings agencies must adhere to the ISO code of conduct. The third aspect, I keep saying, is that we should not look to regulators for our own governance. We should follow internal best practices. Within the agency there must be articulation on potential areas of conflict that can arise in the course of business. Conflicts of interest will be there; it is about how we manage that conflict and how we document it. We submit that to the board and also to the regulator.
You spoke about good corporate governance of a ratings agency. What about corporate governance of the companies you rate? Do you factor that into your rating of a company? How do you capture that?
We may not use the expression ‘corporate governance’ in the ratings framework but we certainly look at that. I mentioned four broad factors we look at – management risk, industry risk, business risk and financial risk – that are common across all ratings frameworks. For management risk we look out for the board of directors, the independent directors, their numbers and the process of their appointment. It is very difficult to get and measure that information as corporate governance is an evolving concept in India but we do look at it. We look at the qualifications of senior management personnel, their depth in business, etc.
The management gives financial projection to banks in the form of CMA (credit monitoring arrangement). We look for previous years’ CMA and check their performance in relation to their projections which gives you a picture of particular trend of management. You will know whether they are aggressive, passive etc.
Speaking of financials, we always look at quality. For example auditor’s remarks, role of independent auditors and if it company appointed auditor or outside, action taken report by management on the comments of the auditor and if the company follows separate supporting policies. All this can give you inferences on financial quality. So we are not rating a company on corporate governance but it finds a place in each of the factors in the parameters.
Finally it is the company that has to give you information. No matter how much information you seek, it can reveal as little as it wants. In that perspective, is the entire model of rating in conflict? Is it at conflict because (a) you are paid by the company you rate and (b) yet the company has the authority to disclose whatever it wants. How do you get over this hump?
That is a challenge… to make the process subjective. At the time of taking a rating mandate we have some terms and conditions like offers of acceptance. So we clearly articulate what is the information and extent of information required. You cannot invent numbers for the company so you have to rely on the company. We have standardised what information we require from a company such as their business vision and the management traction to understand how far they are in line with translating that vision into implementation.
The question now is whether companies provide all information. Sometimes you will find some missing information as not all companies have abilities to generate it. So then we treat it internally as a policy or information. More information provided could generate higher ratings for the company. There is a common view that because a company is providing information so it will always present a rosy picture. Because of our experience we try to validate that. For example a pharma company currently operating at 80% capacity is adding capacities and gives a future projection of 95% capacity. We try to understand the differences and wherever required modify projections.
Have you ever walked out of a contract because the issuer company did not give you enough information or gave you inaccurate information?
When a company agrees to give information it generally does. It understands that since it is accessing the market its stakes are very high. Also, if it wants to be rated, there is no reason why it should not give information, otherwise it may as well stay out of rating system. Yes, the quality of the information can be questioned and that is where we do our validation. If it is a large or listed company you will find a lot of publicly available information. If it is not listed then we have to fill the gap. We do this by interacting with stakeholders and customers. We gather information from the top five customers and suppliers and take details of payment patterns etc. We get some feedback to give us an idea about the quality of management but not on financial risks for which the balance sheet is already there.
Having said that I must admit that there are some unique cases. The way private sector companies provide information, public sector companies do not. Where private sector gives information for the next five to six years, public sector will give for just one year. We have to internally make sense of things. Because of their systems and permissions, they may give broad information on capital commitments and implementation but not structured financial projections.
You referred to the 2008 crisis. Nothing happened to ratings agencies that painted a brilliant picture of companies that went bust in a matter of weeks. Why do ratings agencies get to know of a company’s collapse only around the same time that a lay man comes to know? Where did that model go wrong? Is it a problem of corporate governance?
As I mentioned earlier, this has happened in structured finance projects where the model requires continuous fine tuning and validation and this was not done. This scenario should not happen in India because of well defined regulations.
But we did have our Satyam scam too.
That is a slightly different story. As I said, ratings are based on information shared by the client. If there is engineering behind that sharing of information, it is difficult to detect especially if it has been going on for seven to eight years. For something like this to happen in India or anywhere else in the word the chances are very less now because of very strict regulatory oversight.
Have we made it any tougher in India to avoid a situation that took place in the 1990s and early 2000 when nearly 200 fly-by-night companies entered the IPO market, mopped up money and disappeared?
That time IPOs were not being graded by ratings agencies. There is a difference between rating and grading. In case of rating, information is provided by the company whereas grading is done on the basis of publicly available data, the ratings agency does not have access to privileged information. Secondly ratings agencies in grading an IPO don’t come to comment on the price behaviour because nobody can know how it would behave. The stock price performance is a function of three things: fundamentals of the company, liquidity issues in the market place and market performance. All three are important for performance of IPOs. When a ratings agency grades an IPO it is commenting only on one of the factors, the company’s fundamentals. The other two factors could be the dominant factors for price behaviour. I do not find any relationship between IPO grading and price behaviour. But yes, whenever there is a sudden rush of IPOs it is not good.
So it is a thing of past now...
No, if a ratings agency gives a company a grading of 5, you cannot say that there will no loss for the investor from issue price. You can only say that the company has grown by 14-15% and is expected to perform in the same way. Price is dependent on the timing of market etc. and many factors. We all know that people have lost a lot of good money investing in very good companies. It is not that such companies have performed badly or they will perform badly in future. We should be careful not to mix up issues when we talk of grading IPOs. But let me say this with some pride: Many good companies have defaulted in US and other countries whereas as in India companies with AAA rating have seldom failed. It may have happened in one or two cases because of fraudulent information being provided. Otherwise reliability of ratings is well established in India.