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Rating: Transparency, dimensions and gaps

B. K. Mukhopadhyay | Published: April 12, 2017 20:45:44 | Updated: October 17, 2017 10:16:09

Rating: Transparency, dimensions and gaps

Rating race is on - difficult to judge the better from the rest! Numerous agencies started forecasting on the wide differences in gross domestic product (GDP) leaving the investors totally confused. Part of the recent assessments made by biggies for the macro-level, Fitch Ratings maintained its stable outlook for India's Better Business Bureau (BBB) ratings. "Policy management will be the key factor in determining whether economic and financial stability is maintained in India following the intensified pressure on currencies and asset prices." 
Simultaneously, financial services company Standard & Poor's (S&P) opines that India will maintain negative outlook for the economy as currency depreciation is adversely impacting investor confidence. "We view the capital outflows and depreciating rupee as an indication of weakening investor confidence in India. We maintain a negative outlook on the country's sovereign credit ratings." Cutting its outlook on India's BBB rating to negative last year, S&P expects a one-in-three chance of a downgrade in the next one or two years.
Despite the unfavourable reality, everyone expect that an exercise should be done with utmost cautions due to its broad consequences. If India's rating continues to decline, a number of business indicators and the prospects of capital flow would be affected. A downgrade to junk status might cause upward overseas borrowing costs for Indian corporates and hurt India's ability to attract foreign direct investments (FDIs).
Obvious enough, the plunging Indian Rupee has intensified concerns over the country's economy and raised the question whether Asia's third-largest sovereign credit rating may soon be downgraded to 'junk' status. The fall of rupee is negative for Indian economy as it stokes inflation, raises the country's import bill and puts further pressure on the current account deficit. 
Meanwhile, India's economy experienced an intense deceleration over recent quarters expanding just 4.8 per cent in the January-March of 2013. In the coming months, growth is expected to remain under pressure due to tighter liquidity conditions and deterioration of capital investments and consumption. Besides, the government's response to bolster the falling rupee through tightening liquidity and restricting capital outflows has not been successful enough to instil confidence in investors. 
Undoubtedly, a downgrade is likely to increase if weak sentiments cause business conditions and investment growth to deteriorate further - putting India's durable growth prospects at risk. Similarly, S&P view the governmental measures merely as a temporary fix: "We view the capital outflows and depreciating rupee as an indication of weakening investor confidence in India. Measures introduced by the government to restrict capital outflows have also increased uncertainties among investors both foreign and domestic." 
Likewise, the ratings are being scanned from all quarters. Countless words have been exchanged on rating issues in the recent past. American banks often accuse the rating agencies on improper rating that leads to subprime mortgage crisis - they put the onus on the rating agencies indicating that mortgage loans turned bad because the rating exercise was not appropriate! Conversely, rating agencies have been refusing the charge since they rated the borrowers at specific time and situation while any assessment whatsoever should have been done by the bankers - rating as just a part of the entire process with activity-wise and time-specific transactions.
Nevertheless, the government has the absolute right to ask the very basis of such assessments as any trust on such exercises only develops once practical and realistic approach takes the front seat. Otherwise, the economy suffers variably while reputation of such rating agencies suffers from the risk element as reputation risk equals to a loss of trust and eventually loss of business. Globally, a good score gets a better deal regardless of the merits of rating being diluted or not - for big or small, micro or macro level!
Already, rating has gained a wide acceptance among the corporates, banks, financial institutions and the capital market. 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 a risk the questioned bank undertakes. Similarly, Small and Medium Enterprises (SMEs) are paying more attention to risk assessment through rating exercise. Thus, present range of price and credit conditions is definitely wider than before. 
Moreover, any appropriate assessment helps explain the rating result and hence arrive at credit decisions. So, the rating criteria that takes into account the hard facts (financial situation, financial position, profitability) and soft facts (management, financial reporting, installations, products organisation, market and market forecasts) as well as warning signals (profit cuts, cash losses, late handover of annual accounts) should not lose sight. If the transparency is there and users become confident about the appropriateness of the exercises, the same process ultimately gives rich dividends. 
To be more specific, scoring technology scans historical data, identifies links between client characteristics and behaviour as well as ensures the persistence of such links to predict client activity. Plus, credit scoring helps the institution to analyse client behaviour in the past to make more reliable loan application decisions, devise more effective collections strategies, better target marketing efforts, and ensure customer retention. Therefore, a client with zero business experience is more likely to default on loans. Scoring technology can deliver goods in specific areas like - pricing of loans based on individual clients' risks as well as accurate provisioning against loan losses. So, scoring technology is useful to lay the foundation for advanced capabilities.  
Furthermore, rating agencies are key players in the securitisation arena. Since most asset-backed issues are rated worldwide, rating is mandatory in India under the guidelines of Reserve Bank of India. In fact, the rating agencies specifies the level of credit enhancement and other risk mitigation arrangements to be maintained in structure and the ratings sought from a rating agency is decided on the basis of investor's preference. As an emerging market for securitisation, India may lack investor's acceptance with anything below AAA. Still, it is a matter of time before investors start accepting low-rate papers at higher yields. The level of credit enhancements and other risk mitigation would vary with different rating sought for.
In events of a result that is different from the one that was thought of, credit-rating agencies tasked with measuring credit risks somehow find reasons to stay immune from eventual blames. In a falling market, the investors should not simply blame the rating agency without exercising their innate options. 
Arguably, an investor must use the rating to his advantage. Since investment for a low-rate bond is a higher risk, it is better to invest only in high-rate bonds unless there is a secondary market for bond selling in case of a downgrade rating. Thus, developing a cut-loss-policy is important. In case of similar rated bonds offering various Return on Investment (ROI), the bonds offering higher ROI should be scanned further to evaluate risk factors. In contrast, a bond with subordinated obligation should not be graded AAA as such rating would be misleading. Such ratings are crucial to the investor's knowledge of safety of the instrument in which banks would be investing. Rating of instruments varies - highest safety, high safety, reasonable safety, safety, safe, not safe, risky, and too risky. As rating moves from the highest to the lowest, the risk of default increases. 
By definition, credit rating is a method to evaluate the credit risk of investments and to conclude what rating agencies like CRISIL, ICRA, CARE and D&PE undertake - a professional exercise to find or evaluate the financial soundness of companies in question. Thus, various aspects are taken into consideration: cash flow; business operations to check fund adequacy or availability, profit element to meet the interest and repayment commitments; quality and adequacy of assets; the company's client profile - to verify correctness and feasibility of business projections. 
Usually, there is an intrinsic need to study the organisation in question along with management, assets quality and business plans. Coupled with the environmental analysis, standing of a company actually helps rating agencies to arrive at meaningful conclusions as to whether an investment would be least risky and most rewarding. A degree of variations among such issues exists according to variables of credit rating.
Performance credit rating has a number of benefits to reap from. Credibility of the Institution (CI) goes up along with confidence building with partners as good rating gives comforts to lenders, customers and suppliers acting as a self-improvement tool. Any analytical report on the corporate strengths and weaknesses helps to strengthen operations and improves visibility.
Lastly, rating of an instrument is related to the instrument issued and not meant for a company issuing the same. Rating is an opinion based on logical reasoning to aid an investor for investment. Companies using the initial rating with pomp for marketing the issues have to announce the deterioration to investors as well. Hence, rating itself has some inherent risks if not understood well. Nonetheless, rating is an effective risk assessment method in India and elsewhere.  The discipline has several merits if understood well as well as put into appropriate use.

Dr. B. K. Mukhopadhyay, a management economist, is attached to West Bengal State University, India. 
m.bibhas@gmail.com
 

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