Rating difficulties

Credit ratings are a subjective assessment of the chances that a debenture will go into default. On any one debenture, the rating agency can be wrong""sometimes, a low-rated bond can actually perform, and equally a high-rated bond can go into default. But, over the years, evidence gets built up on the track record of each agency. It isn't difficult to find out what proportion of (say) AAA-rated bonds by ICRA (one of the four large rating agencies) defaulted over the first five years of the life of the bond. In this indirect way, over the years, it is possible to measure the performance of a rating agency, and investors can form judgments about the extent to which any particular rating agency is reliable. If investors feel that the rating adds value, then issuers will voluntarily buy ratings. This weak kind of accountability is all there is for credit ratings.

Now Sebi (the stock market regulator) wants to extend the notion of "rating" to initial public offerings (or IPOs). This is a dubious concept. If the IPO auction is done properly, the IPO price will be essentially the first listing price. Buying into the IPO is then like buying a stock on the secondary market. Stock prices fluctuate""there is a 50-50 chance of the price going up or down. Buying an IPO is then a speculative view taken by the investor. What role can there then be for a rating agency? Is the rating agency going to tell you which prices will go up and which will go down? If not, what will the rating agency say? More likely, the rating agency will have fees without accountability.

If it makes sense to have ratings for IPOs, then it makes sense to have ratings for all shares traded on the secondary market. These are called "analyst reports". This newspaper, like every other, carries articles where someone expresses an opinion about whether some share price will go up or down. If a credit rating agency is good at this, it should sell its analyst reports in the competitive market for information, analysis and advice. It is not the role of Sebi to force the IPO issuer to become a customer of the credit rating agency.

Equally dubious is Sebi's notion of "rating stock brokers". The only charitable interpretation of the rating of a stock broker is that it is like a credit rating, which identifies the chance that brokers will go bust. But the proprietary trading positions of stock brokers change at blinding speed. A stock broker can flip around positions by hundreds of crores of rupees in one hour. No credit rating can deal with this speed of information flow. The realtime risk management systems of the exchange are the only ones who know the default probability of the stock broker. And the exchanges correctly shut down stock brokers when their collateral is not commensurate with their risk. There is no meaning to credit ratings of stock brokers""even if the stock broker is doing a bond issue.