It is time lenders too move away from total trust in External Credit Ratings, and start using external and internal ratings as two important but different lenses.
By Anil Kishora
Neither Mr Henry Poor nor Mr John Moody or, for that matter, Mr Fitch, whose information gathering and analysis on railroads, canals and other industries in the 19th and early 20th century America laid the foundations of ratings, would have imagined that one day their business of giving out ‘opinions’ on credit-worthiness would determine how much capital banks need to hold to support their lending. But, now that’s a reality. Basel norms mandate banks to maintain a certain ratio of capital to assets, risk weighted as per the ratings assigned by agencies like the ones founded by Messers Poor, Moody and Fitch.
Risk weights were expected to make the capital requirement risk sensitive and perhaps more ‘scientific’ compared to the rule of thumb, one-size-fits-all Basel-I thresholds. The approach, despite its merits, has its fault-lines; risk weights are based on ‘opinions’, that too formed by agencies that are paid by the entity being rated and the risk weights themselves are somewhat arbitrary. How do we, for example, know that a AA calls for a 30% risk weight and not 25% or 40%, unless our motto is ‘In Basel we trust’.
Given its infirmities, while the system is likely on course to move towards new hybrid approaches combining external ratings and internal models, the reliance on ratings for purposes other than what they were designed for continues to take its toll. The role of ratings in the global financial crisis a decade ago is well known. Nearer home in India, we have recently seen how ratings have migrated from Triple A to D in a matter of months. Ratings are said to be indicators of relative credit worthiness and that curtails their ability to reflect the inherent strength and restricts comparability across countries. Here’s a disconnect. Risk weights are uniform globally—a Single A credit in India attracts the same 50% risk weight that a similarly rated credit in Europe would, but the ratings themselves are not comparable.
It is also arguable whether ratings assigned by different agencies even within the same country are comparable. The system of risk weights has commoditised ratings, but the quality or specs of this commodity appear to vary across issuers. Can we standardise ratings? In other words, can we have ratings that are hallmarked? Just the way 22-carat hallmarked jewellery can’t have more than 2/24 parts of other than gold content, can the rating institutions be asked to rate with pre-fixed default bands attached to each rating grade?
Sebi’s new guidelines are probably a step towards such hallmarking. The Triple Rated cohort of companies is expected to deliver a benchmark default rate of zero over a two year horizon. A tolerance of 1% is permissible when default is measured over a three year period. This elbow room allows for unforeseen circumstances. Progressively, as we move from Triple A to Single A cohorts, the default rate benchmark stays at zero with the horizon getting shorter and the tolerance going up. This is in sync with the fact that the longer the tenor, the riskier it gets. This approach would certainly bring in tighter credit assessment, comparability of ratings across issuers, to an extent, even across countries and, of course, more scrutiny and accountability in light of disclosure requirements put in place.
No change is without implications and consequences. One view is that the new guidelines would moderate ratings and our country would have lesser number of Triple As and Double As. Some Single As might move to that holy band beyond which the junk territory starts. In a way, it helps us align with the jurisdictions which anyway have fewer companies rated at the upper end of the totem pole. USA, the birthplace of ratings, is left with just a few Triple As.
Why this dip in credit quality globally? In a single word, it is the piled-up debt that has dented the ratings landscape. Ballooning debt levels vis-a-vis cash holdings or expected accruals are not sustainable and certainly susceptible to any economic downturns, demand disruptions or liquidity blockages.
As a corollary to changes in rating benchmarks in India, some increase in banks’ risk-weighted assets with consequential elevation in capital charge is perhaps a given. In short, more capital requirement. Over a longer time horizon, however, banks should experience lower impairments and better stress test outcomes, with beneficial impact on baseline stress test related capital requirements.
Sebi has done its bit. It is time lenders too move away from total trust in external opinions called ECRs, or External Credit Ratings, and start using external and internal ratings as two important but different lenses, combined with detailed appraisal and assessments to look at credit quality of each and every loan proposal. In a fast growing economy, corporates often tend to not only spread their resources thin, but also latch on to debt-fuelled growth. Like a good tide lifts all boats, a booming economy often assures a pleasant P&L. In times of slow down and sinking demand, it is the strength of the balance sheet that counts for more. Headline credit labels, therefore, despite all the detailed and rigorous data crunching, have their boundaries!
(The author is DMD & chief risk officer, State Bank of India Views are personal)