Are external ratings reliable? Describe the precautions to take when relying on external ratings. (5)
While external ratings are given prominence in the standardized approach, internal ratings are the core of the advanced approaches. A credit rating is an assessment by a third party of the creditworthiness of an issuer of financial securities. It tells investors the likelihood of default, or non-payment, by the issuer of its financial obligations. In fact, external rating agencies, wherever they exist, have a very responsible role to play in the ‘debt capital market’ of the economy. Usually, the companies that wish to approach the public ‘debt capital market’ ought to obtain ratings from at least two agencies. Only if the rating agencies assign a minimum investment grade, should they then go ahead with the debt issue. The agencies are supposed to keep in touch with developments associated with the debt issuer and revise ratings in the event of significant credit events. The ratings by these firms are captured by alpha-numeric notations, which are often stated to the shortest editorials that could be ever written. An example of a rating system is the Ratings
Over-reliance on external ratings
Basel II brought in a more prominent role for external ratings and accordingly, their ratings had begun to impact capital adequacy. The demand for AAA and AA rated securities (such as Collateralized Debt Obligations or CDO) were higher as Basel II required lesser capital adequacy on these categories (please see the chart in Section 16.3.3 above) and this might have acted as an incentive to get CDOs rated at AAA although inherently they were riskier. Sometimes credit decisions were primarily based on external ratings as it enjoyed the tacit support of Basel II. However, there were serious questions about the accuracy and value of credit ratings that played such an integral part in Basel II.
Another severe criticism was that the external credit rating agencies8 were not able to provide ratings that reflected the actual underlying risk and provided the markets with warning indicators of financial difficulties. The financial crisis saw swathes of downgrades and credit rating agencies were criticized for allowing their own commercial interests to cloud their rating judgment.
But how reliable are the external ratings? Can one skip internal ratings and rely solely on external ratings? The prudent answer is negative. The collapse of Enron, which still enjoyed investment-grade rating, just months before its bankruptcy, has eroded faith in the three big credit rating agencies in the US. As discussed earlier, external credit agencies in the US were subjected to severe criticism during the 2008 Credit Crisis because several AAA-rated Collateralized Debt Obligations (CDOs) defaulted. However, some comfort can be derived from the fact that such fiascos are uncommon, and the rating agencies improve their rating methodology with every such disaster. From a creditor’s point of view, unless it lacks resources, it ought to put in place a robust internal credit rating system to evaluate the credit risk. This is because of certain inherent defects in external ratings, which are explained below:
- Most external ratings are done at the time of debt issues by the obligors and usually fulfill a statutory requirement. In such cases, the ratings represent the quality of the particular debt issue. In other words, the rating is not representative of the credit risk of the obligor/customer, i.e., external ratings need not always rate the issuer or the company in full. Accordingly, it will not be a real reflection of the issuer rating. For instance, if a debt issue enjoys sound collateral, the external rating of the debt issue would be better than that of the customer/borrower rating. External rating is debt-issue oriented rather than borrower specific.
- The Stock Exchange Commission (US) and similar regulatory bodies prescribe certain minimum conditions to qualify for debt issues, which screen out almost the whole of the middle or medium market and smaller business segments. Hence, the ratings from external agencies are available only for large, usually listed companies. There will not be any external ratings available for obligors belonging to entities, not in a position to meet the eligibility (usually size) criteria.
- Conflict of interest. The agencies earn a substantial part of their income from the fees earned by providing rating services to the corporate sector. Since the fee is paid by the same entity that gets rated, critics have always pointed this out as a conflict of interest. It is not unusual to have two agencies come out with different ratings for the same obligor.