20 December 2018

Give credit where it's due

I have an op-ed piece in today's Economic Times which defends Credit Rating agencies from much of the criticism they are currently facing. Hiding the mirror does not make you more beautiful:



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It is easy to blame credit rating agencies for the current problems of the debt markets. But much of the opprobrium investors heap on them is undeserved. They are indeed behind the curve when it comes to critical information about defaults. But that is a design problem. The system is designed to fail investors. In tech jargon, it is a feature not a bug.

Clearly no one can sit on a computer inside a building and start getting visions of default. Rating agencies are no oracles of Greek mythology. Even oracles were somewhat overrated. Croesus, king of Lydia in 560 B.C., tested the oracles of Greece to discover which of them gave the most accurate prophecy. He sent out emissaries to seven sites who were each to ask the oracles on the same day what the king was doing at that very moment. Croesus proclaimed the oracle at Delphi to be the most accurate. He then consulted Delphi before attacking Persia, and according to Herodotus was advised: "If you cross the river, a great empire will be destroyed". Believing the response favourable, Croesus attacked, but it was his own empire that ultimately was destroyed by the Persians.

We have of course our companies, banks, NBFCs, mutual funds and many other borrowers and lenders who lend to each other on the basis of rated paper. Much of debt paper is traded and listed, though the listing is nominal. The rating is sought by the borrower, because most lenders insist on buying rated paper. Many regulators and internal charters prohibit investing in non rated paper. This is important, because the borrowers don’t really want a rating, they are expected to get it.

Move to the future when one of the rated paper defaults, the lender could be a bank, NBFC, mutual fund, insurance company or one of the many large investors. Before the borrower defaults on interest or principal, there are usually hectic parleys between the borrower and lender to resolve, restructure or re-define their relationship. Clearly, the lender wants its money back. But it is smart enough not to want egg on its face and even smarter, not to trigger other events which will make the borrower’s situation worse and thus repayment more remote. The borrower’s interest is of course not to disclose the default. As things go downhill, what is a little lie to your rating agency? Not a big deal. It’s merely a contractual violation.

What about the lender? Clearly the lender, wants to push the can down the road. In the case of public sector or even private sector bank, a restructured loan, is a good way to make an additional loan to enable the borrower to meet the interest payment. Voila, no non performing asset for a few years. The bank is healthy, but with an even bigger debt. Gamblers don’t often give up their game, they usually double up. This is a commercial lending equivalent. In addition, the current MD of the bank has a clean NPA record, and the problem is of a future hapless MD, who discovers this albatross across her neck. Thus the incentives at play, ensure that neither borrower nor lender inform the rating agency about the default. Borrower happy, check, lender happy, check, regulator also relatively happy with the NPA issues pushed down the road. Of course, it is not all black and white and all cynical. Many restructuring exercises are done in good faith and many of the companies which are given a lifeline, do indeed overcome the temporary liquidity crunch and pay back the money. Which gets us to the question of why not just do the restructuring above board, and inform the rating agencies of the issues. RBI’s concern does have some validity though. Financial intermediaries are highly leveraged and almost all of them including banks and NBFCs have by the nature of their funding, have an asset liability mis-match.

There is clearly a need to move a contractual arrangement between the issuer company and the rating agency, to a legal obligation to disclose. This would push much of the ‘adjustments’ bilaterally achieved into public domain.

Here, the vision of financial regulators come into play. While SEBI has been batting for prompt disclosure at the first sign of default, RBI has pushed back, believing this would cause panic in the market. Though SEBI’s circular of last year was indeed over-broad, as every delay or payment could fall within the scope of default, the absence of a new circular is problematic. RBI’s view that immediate disclosure of every default situation will cause panic is too simplistic. It assumes the marketplace is not smart enough to figure out the distinction between a short term liquidity crunch and a life threatening event for a company. Indeed, companies can while disclosing default explain its position, so that there is no run on the company. Similarly, the norm of immediate reporting can be relaxed to a few months, and subsequently tightened.

Just as an opaque system which pushes the can down for years, creates a larger problem for the successor, enables crony capitalism, makes for an uncertain position on what the networth of an organization is, an immediate reporting may cause panic. There is a need for an Aristotelian mean, where defaults are disclosed with a short cooling off period. And while we are at it, let’s stop blaming all problems on the rating agencies. Hiding the mirror does not make us more beautiful.

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