Credit Rating Agencies' Business Model

8 Jan 2020 Read 1024 Views

If you pick up a business newspaper, you will find the name of at least one of Fitch, Moody, or S&P. In fact, in the recent news associated with Indian slowdown, you would see GDP forecasts by Ind-Ra, ICRA, or CRISIL at least once in every quarter.

They are all known as 'credit rating agencies.' Their job is to provide ratings to certain bonds and papers issued. We will talk in detail about what they do, why it is crucial, and how just assigning a number to everything is result in windfall profit-making business.

The Borrowing Market

Many times, we have discussed before that enterprises accumulate debt from the market to expand. For taking debt from the market, they issue an instrument called 'Bond.' The investor buys the bond that promises certain returns on maturity and interest (coupon) throughout the holding period. In a matter of time, they are supposed to repay the amount on maturity of the bond. So long story short, you loan an amount to the enterprise, and the enterprise has to pay it back to you someday.

Now, what would happen if the enterprise fails to pay back the debt and bankrupts! You lose all the money you invested.

The question underlying is, can one foresee the future of the enterprise before investing? It is relatively easier in cases of IPO, which are much-publicized for retail investors, and you may track the shares over an exchange. Bonds are mostly traded over the counter. The information available is less, and that is too complex.

Here comes the 'Credit Rating Agencies.'

Job Description

As told, the information available is less and complex. The Securities Board in the entire world has mandated all enterprises to get their bonds and other credit instruments 'rated' before floating it to the public.

This 'rating' is done by Credit Rating Agencies (CRAs). Their job is to analyze the information given by an enterprise and see if they can repay the amount they plan to borrow. They provide a better sense to investors, whether it is a good debt instrument to invest.

The Impact

It is just like how students are rated in schools. The one with higher marks gets a better grade. Similarly, the bond that makes a realistic promise, owing to coupon value and company capability to repay, gets a better grade.

In short, the rating of a bond is a clear reflection of if the company will be able to repay its creditors. When a bond gets a good rating from a credible CRA, people trust that their invested money will be repaid. More people would want to buy the bond. Therefore, a good rating is a good advertisement for the enterprise.

Also, if the rating is poor, the investors would ask better returns, like a higher coupon rate, before investing.

The Revenue Model

The CRAs study the entire statistics and provide it to people. How organizations like Fitch, Moody, and Standard and Poor (S&P) became finance giants, the ‘big three’ by just providing ratings to debt instruments?

The answer lies in the government rule to mandate any debt instrument to undergo rating before floating to people. The company has to share its relevant data with the CRA to get this rating. This means that every enterprise will have to pay them some amount for analyzing their company data. CRAs would rate on the basis of this data and make this rating public.

This model is called the ‘issuer-pay model.’

There was a ‘subscription model’ prevalent until the 1970s, but is much unpopular now. Under this model, the company would keep rating instruments of an organization but would not open it to the public. Since now, investors want more transparency; this model is near obsolete.

Some CRAs have also moved to new ventures related to company reports and investments.

The Oligopoly

What drives the business is the oligopoly of reputed CRAs. You would notice that though it is mandatory to get some debt instruments rated, one would not trust rating from anyone. What would happen if a company opens its own CRA and then rates its instrument as best graded?

Here comes the matter of reputation and credibility. Some organizations over the years have gained this, and they have become an unofficial oligopoly. This is simply because investors would like to hear a known name than a new one. If I say you are a good investor, some stranger might not believe this. How about Warren Buffet says the same about you? The world would go gaga after you.

Hence, Fitch Moody and S&P are renowned as 'big three.' They enjoy unparalleled trust from investors. The issuers want these names should rate highly to their instrument and attract a large number of investors. Their establishment nears 100 years. New names today cannot even think about getting into this market.

Indian market is though new and underdeveloped in debt instruments. RBI and SEBI mandate any debt instrument over ₹5 crores to be rated by a CRA. Hence, India is seeing these old CRAs now gaining a foothold in India as well. CRISIL (a subsidiary of S&P), ICRA (a joint venture with Moody), and India Ratings (Ind-Ra, Fitch subsidiary) are India's potential 'big three.'

The Issues

There is nothing rosy in finance. There have been several controversies related to the CRAs. Firstly, the rating provided by them is subjective. Investors do not have any access to company documents, only CRA has. The basis of rating is much opaque. Secondly, the CRAs have failed in recent times. One example is the 2008 subprime crisis, where even substandard loans were rated good.

In India, we have seen a new term, coined 'Rating Shopping.' As per Indian laws, a company may either accept the rating or go to other CRA. Since nobody wants to lose business, the accusations are that ratings are awarded to keep the issuer happy. In addition, insiders of CRAs have been regularly accused of helping companies to manipulate information for favorable ratings.

It seems like opacity is much bigger a problem in the financial and fiscal domain indeed.

The Closing Word

CRAs are the forensic department of the financial world. They analyze the data of companies that are not available to others. People trust their verdict before investing. They are not directly part of the business but are inseparable with it. Hence, their credibility is paramount not just for their business but for the health of the entire financial system. The murky issues should be sorted in favor of everyone.

About the Author: Vivek Tiwari | 62 Posts

Vivek Tiwari is a Software Engineer and a Data Scientist who hopelessly fell for Economics. His plans to move to Finance might now save mankind from his IITJEE selection story.

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