Credit rating: New perspectives

There is a need for greater precision in quantifying risk and assessing quality through a finer gradation of risk categories

Of late there have been calls to set up international credit rating agencies from different regions of the world. Recently, BRICS economies have announced their intent to set up a rating agency. Credit rating agencies generate investor-lender confidence and help develop capital markets. A rationale for a rating agency is to provide independent unbiased view on a borrower’s ability to honor its financial commitments. Sound ratings are directly linked to health of a financial system. From an Indian context, the existence of large-scale non-performing assets on the books of financial sector players is reflective of the nascent state of rating infrastructure.

While international rating agencies rate both offshore and onshore obligations, domestic rating agencies end up rating onshore borrowings. The existence of rating agencies is a prerequisite for a sound capital market infrastructure. As countries develop capital markets especially for non-local currency financing, they need to have in place sound rating agencies. Emerging economies require access to non-local currency funding options and having an own rating agency will facilitate access to borrowing in non-US dollar and non-euro currencies from the capital markets. 

The sector has undergone improvements but there are calls for changes and for blending them with new perspectives. Rating agencies rate sovereigns, sub-sovereigns, municipals, corporates, bonds, structured instruments, and SMEs. They get paid a fee by the rated entity and in some cases by the lender or investor but reimbursed by the rated entity. The issue is if the rating being expressed is really an independent or unbiased viewpoint. Could there be a conflict of interest? Could the rating be influenced by shareholders or regulators of the country of jurisdiction of the rating agency?

An issue of contention is the sovereign rating methodology when borrowings are denominated in local currency. For corporates, the rules of the game are simple as the ratings are based on access to cash flow in likely default scenarios structured on the principle of ‘cash repays cash’. International best practices in risk assessment are becoming more relevant due to globalisation. Credit rating is no longer region or country specific. Emerging economies often lack quality and reliable infrastructure for independent risk assessment.

Credit rating is all about ‘exercising sound credit judgment’ and ‘doing the right thing’. Credit risk is the primary financial risk in a banking system and exists virtually in all income producing activities. Rating systems measure credit risk and differentiate individual credits by the risk they pose. A credit rating is a mere opinion and not a substitute for cash. While a rating agency may have rated trillions of dollars of debt, its own capital may be under a hundred million dollars. In this context, the involvement of a multilateral as a sponsor would be useful. Multilateral ownership will take away the criticism of an agency being controlled by policies and framework mandated and regulated by one particular country.

The credit rating system generally works on a scale of 1 to 11. There is a call to assign ‘life of a loan’ rating not subject to a rerating, especially a downgrade. A ‘one size fits all’ principle is no longer valid. Ratings are witnessing new building blocks that include default probability, severity, portfolio exposure, asset liability mismatches etc. Countries need to train regulators, encourage best practices in accounting and auditing, improve transparency and disclosure norms and promote national and regional rating agencies.

Rating agencies undertake an economic assessment for sovereign rating. Economic assessment is based on three key drivers — income levels, growth prospects, and economic diversity. It is adjusted for positive or negative potential on an economy’s growth prospects and volatility. No adjustment is being undertaken for environment degradation, climate change, soil degradation and so on. An aspect for consideration is inclusion of green ratings with credit ratings. Multilaterals could push for setting up of green ratings for blending with credit ratings. Investors will be better able to understand the nuances of climate change and resultant financial stability issues by having rating agencies focused on climate change and green finance aspects.

Multilaterals can play an important role by actively promoting investor education, encourage cooperation to arrive at common methodology, provide technical assistance and policy advice. Multilaterals can help build a dynamic risk rating system that provides for uniformity and consistency in risk rating across countries. There is a need to provide greater precision in quantifying risk and assessing quality through a finer gradations of risk categories.

The author was formerly with Asian Development Bank Philippines. Views are personal