Of rating, rating assessors and rating process

The rating exercises by well-known international rating agencies are on. The Moody's has upgraded the outlook on India's sovereign rating to positive from stable while the Fitch has retained the stable outlook. The two rating agencies noted many positives with the new government coming to power, But still there are many causes of concern.
The very process followed on this score must be clearly publicised as much as the variations happen on this score. If the transparency is there and users become confident about the appropriateness of the exercises, the same process gives good dividends over time. Let us delve deep into the details.
Is the process followed always unbiased?: The ratings are being scanned from every quarter. Not only in case of India, but also in the recent past had a lot of words been exchanged on rating issues. The American banks started accusing the rating agencies of doing improper rating, which, in turn, ultimately led to the sub-prime mortgage crisis - they put the onus on the rating agencies saying and indicating that as the rating exercise was not appropriate, the mortgage loans turned bad. On the other hand, the rating agencies were refuting the charge on the ground that they rated the borrowers in some specific arenas and at specific times and any assessment whatsoever should have been done by the bankers and the rating was just a part of the whole process - borrowers' activity-wise and time-specific.
Comments must not lose sight of: A good guide, indeed! The case of India may be seen in view of this score. The MOODY'S observes about India: 'Evidence over the coming months that policy makers are likely to be successful in their efforts to introduce growth-enhancing and growth- stabilising economic and institutional reforms would lead to the rating being considered for an upgrade.' Clear opinion: 'banking systems asset quality, loan loss coverage and capital ratios are relatively weak…infrastructure development will be accompanied by higher leverage.'
FITCH observes: 'India's relatively weak business environment and standards of governance, as well as widespread infrastructure bottlenecks, will not change overnight, but there is ample room for improvement. Translation of the reforms into higher real GDP growth depends on the actual implementation.' So, such specific observations by such global rating agencies deserve appreciation indeed.
The importance is never less: Whatever it is, the merits of rating should not be diluted - for any big or small, micro or macro-level. Rating has already gained wide acceptance in the corporate, banks and financial institutions and the capital market, among others. It is a dependable risk management tool to identify the individual brisk level of a loan and to ensure that a bank earns a return to the risk the bank in question undertakes. Similarly for the SME Sector [Small and Medium Enterprises] more attention is being paid to risk assessment through rating exercise and the range of price and credit conditions are now definitely wider than before.
Any appropriate assessment helps explain the rating result and accordingly arrive at credit decisions. As such the rating criteria that take into account the hard facts (financial situation, financial position, profitability) and soft facts (management, financial reporting, installations, products' organisations, market and market forecasts) as well as the warning signals (profit cuts, cash losses, late handover of annual accounts) should not lose sight of.
Again, rating agencies are key players in the securitisation arena. Most asset-backed issues worldwide are rated and in India rating is mandatory under the Reserve Bank of India guidelines. In fact, the rating agencies specify the level of credit enhancement and other risk mitigation arrangements to be maintained in structure and the rating sought from the rating agency is decided on the basis of investors' preference. In India, practically an emerging market for securitisation, anything below AAA may not find the investors' acceptance. Still, it is virtually a matter of time before investors start accepting lower rated papers at higher yields. It remains a fact that the level of credit enhancements and other risk mitigation would vary for different ratings sought for.
The fact is: credit rating (measure of credit risk) agencies give a lot of reasons for the rating so that they do not necessarily get blamed in the event of a result which is a different one than that thought of. For example: in a falling market if an investor does not exercise his option, simply blaming the rating agency is not a correct proposition.
An investor, so to say, has to use the rating to his advantage - investing in highly-rated bonds only, considering a bond lower than the highest rating (higher risk), only if there is a secondary market for bond selling in case of a rating downgrade and thus developing a cut-loss-policy, in case similar rated bonds offer different ROI, the bonds offering higher ROI require to be further scanned for evaluating the risk factors, etc. Similarly, a bond having a subordinated obligation should not normally be graded AAA as in that case the rating would be misleading - so the onus is on both the sides.
Such sort of rating is for enabling the investor to understand the safety of the instrument in which the banks, for example, would be investing. Rating of instruments can vary from highest safety, high safety, reasonable safety, safety, safe, not safe, risky, and too risky. As the rating moves from highest to lowest, the risk of default goes up.
The need arises as to studying the organisation in question, management, asset quality as well as the business plans. Standing of the company coupled with the environmental analysis definitely helps the raters to arrive at meaningful conclusions as to whether the money to be invested would be least risky and rewarding. There definitely could exist a degree of variations among theses issues and accordingly the credit rating keeps varying.
In fact, rating has a number of benefits thus to reap from. Credibility of the institution goes up along with confidence building with partners (good rating gives comforts to lenders, customers and suppliers too). It acts as a self-improvement tool. Any analytical report on the corporate strengths and weaknesses help, in turn, strengthen operations and improves visibility, of course.
Rating of an instrument is related to the instrument issued and not meant for the company issuing the same. Rating is the opinion expressed based on logical reasoning aiding the investor to invest. It is also a fact that the companies which use the initial rating with pomp and show for marketing the issues has to announce the downgrading to the investors as well. As such, rating itself has some inherent risks, if not understood well. Rating is an effective risk assessment method. The discipline has merits in many ways, if understood well and at the same time put into use appropriately.
Any government has definitely the right to question the very basis of such assessments. Otherwise, not only the economy suffers in many ways but also the reputation of the rating agencies runs the risks (reputation risk, loss of trust, loss of business, etc.). Globally a good score gets a better deal.

Dr BK Mukhopadhyay, a Management Economist, is attached to the West Bengal State University, India.
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