Failure of the regulatory system: Need to freshly look at CRA-based risk assessment framework

Published: March 26, 2019 3:21:07 AM

The job of a CRA is to assess the risk on an issuer’s obligation (say, a loan). The risk, as of today, on a loan means that the issuer can default at a later date. The rating assigned by a CRA is thus predictive in nature.

It is quite hilarious and yet disappointing to see how the regulators and policymakers across the world have, over the years, misunderstood the role of CRAs. (Illustration: Rohnit Phore)

By Hemant Manuj

Credit rating agencies (CRAs) have lately been in the spotlight for not being able to downgrade several issuers before the latter defaulted on their obligations. The Reserve Bank of India (RBI) Governor held a meeting with CRAs in which he is said to have expressed unhappiness with their performance.

It is quite hilarious and yet disappointing to see how the regulators and policymakers across the world have, over the years, misunderstood the role of CRAs. This is a classic case of first tying yourself in knots and then trying to unknot by blaming the ropes for the knot. Let us see how.

Understanding the problem
The job of a CRA is to assess the risk on an issuer’s obligation (say, a loan). The risk, as of today, on a loan means that the issuer can default at a later date. The rating assigned by a CRA is thus predictive in nature.

As with any kind of predictive activity, the rating is subject to error. While a lot of research has been devoted to models (Altman, KMV and others) for improving the predictive accuracy of ratings, it will still always be subject to errors.

In view of the above, how should policymakers design their expectations of the role of a CRA? Is it rational to expect that rating agencies must achieve a certain level of accuracy?

Lopsided regulations
When we think of the above questions, the irrational framework of the regulators becomes clear. Globally, the rating industry is dominated by a few players only. There are strong barriers to entry for establishing a CRA. It is far easier for a new player to commence a business of selling the assessments of other risks like equity or currency than of credit risks. To be sure, the barrier is not for intellectual reasons. The factors in a credit rating model are now quite well-researched and it is not rocket science.

The barriers to entry are two-fold:
– Strength of the incumbents: The economies of scale and the deeply entrenched relationships of the existing CRAs deter new entrants from establishing their businesses.

– Regulatory imperative: The Basel Accord and the RBI regulations ask banks to maintain capital, based directly on the ratings assigned by CRAs to the loans on the books of the latter. In fact, RBI mandates all bond public issues to carry a valid rating from CRAs.

The combined impact of the two factors is that the market forces are not allowed to work through the credit ratings business. There is less than optimal competition amongst CRAs, who have a large captive market available to themselves.

The customers of CRAs, mostly banks and mutual funds, are subject to regulations like capital adequacy, disclosures and market discipline. In order to meet the desired standards of outcome, they are expected to diligently undertake the risk appraisal on their loans and bonds. However, in reality, in cases of failure of the credits underwritten by them, they conveniently shift the blame on to CRAs. Their implicit argument behind this behaviour is that since the regulators have mandated them to get their loans rated by CRAs, the blame should, at least partially, lie at the doors of CRAs.

The regulators are caught in a predicament on account of their own stipulations. They have asked the banks and mutual funds to assign capital based on ratings of CRAs. So, how can they now ask the former to not hold CRAs accountable for the errors in credit assessments?
RBI may ask CRAs to improve their performance. But it is missing the central flaw in the framework. The performance of CRAs cannot be improved through mandates. As an analogy, a pharmaceutical regulator cannot mandate a producer of a cancer treating drug to cure the disease with a given level of accuracy. That can happen only through the right kind of market structures, innovations and behavioural incentives.

Suggested changes
The regulators should, therefore, review the credit rating framework in entirety. I would suggest the following.
– Make it optional (against the currently mandatory) for banks and mutual funds to use the ratings assigned by CRAs. At the same time, the lender or investor should be held solely, and fully, accountable for its failures in assessing the credit risk.
Each bank or mutual fund will then decide the extent to which it wants to use the ratings assigned by CRAs. This decision of a bank or mutual fund will be based on its own expertise, nature of portfolio and business model.
This will be similar to the internal ratings model as per the Basel norms. The key change would be that the banks can choose to, but will not be required to, adopt the ratings assigned by CRAs.
The rules on provisioning, and incentives on non-conservative risk assessment, will also need to be revisited accordingly.

– Reorient the regulations for CRAs to focus mainly on their governance and disclosure norms. It is neither the job, nor within the capability, of a regulator to assess the performance of a CRA. A free market of customers and analysts can do a more efficient function of the same.

– Encourage better discovery of risk assessments through alternate mechanisms. Credit derivative market is one, but not the only, mechanism. There have been several thoughtful pieces of work already done, which have highlighted the opportunities and challenges on this topic. This, in itself, deserves a separate discussion.

In summary, we need to freshly look at the CRA-based risk assessment framework. The fundamental conflicts in the same need to be eliminated and replaced with a market-based and sustainable framework.

-The author is associate professor and area head, Finance, SPJIMR

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