India’s Financial Economy: Post 8

The Government’s Budget for FY22 has been well received by all segments of commentators despite the trepidations in the bond market. Equity markets seems to suggest that we are in the beginning of the next capex cycle.

Today we will talk about an essential piece for a healthy capex cycle in India; a key link between capital formation and the financial markets. I’m talking about the Credit Rating Industry. I believe that a robust credit rating ecosystem is essential for India to make the most of the upcoming capex cycle. I will demonstrate to you that this essential link is broken in India. We will talk in depth about the repercussions of this both to the real sector and the financial economy.

Comparison of key Rating Metrics

We start our discussion by looking at some key metrics to access the efficacy of Credit Ratings in India by comparing them to some global benchmarks. Here we are comparing the ratings experience of an Indian CRA with a Global Peer. Interestingly the Indian CRA is a subsidiary of the Global CRA, thus the ratings standards for these two organizations cannot be that different. We will evaluate two key metrics.

1. Default Rate: This is defined as the fraction of companies in each rating category that have defaulted in a 3 year time period. For Indian CRA this is metric is for the period FY10 to FY20. While for the Global CRA it is calculated over CY81 to CY19. We see that the default rates for the Indian CRA are higher across all categories. For ratings below AA, Indian CRA’s default rates are a multiple of that of the Global CRA; in some cases by a factor of 15–20X.
2. Ratings Transition Rate: Ratings Transitions is a study of the fraction of ratings that move across categories. Over here the number I have provided against each rating category is the total of all transitions over a 1 year timeframe: basically what fractions of ratings issued in each category change in a 1 year timeframe. We already know that Indian ratings have a higher default than those of Global peers. A lower transition rate simply indicates that rating agencies are in India aren’t actively monitoring the instruments that they are rating. I want to also state that the Global CRA’s data is naively adjusted for a mid-period change in rating agency.

It’s important to recall that the Indian CRA’s data excludes the Global Financial crisis and I’m quite certain that had that period been included in this analysis, the default rates would have been even higher.

Impact on Banking Sector

Ratings has serious implications for the banking sector. Under the Standardized Approach for calculation of Capital Adequacy under Basel II norms, Banks have to assign a 100% Risk Weight to corporate loans that are not rated. Risk Weight varies with the Rating for loans that are rated by Credit Rating Agencies on a solicited basis. This goes all the way from 20% weight for AAA rated entities to 150% for BB entities. Thus there is a strong incentive given to banks to rate their corporate loans and indeed since 2009 this has become the norm in the banking industry in India.

In this context I would like to draw your analysis to a study conduced by RBI in 2017 in their Working Paper 06/2017. When the Bank of International Settlements arrived at the Basel frameworks for risk based Bank Capitalization, they also suggested reference rates for different rating categories which would confirm to the equity capitalization methods that are recommended. This study the RBI shows that the cumulative default rates for Indian agencies are above the reference level of benchmark CDRs, especially for rating grades below AA, where the major concentration of borrowers exist. This implies that the capital allocated by banks to corporate loans on the basis of Credit Ratings could be lower than the actual capital required basis the true default experience of these loans.

In 2020 RBI did another study on the intersection of Credit Ratings and NPA. In this study they have mapped the data on NPAs maintained in RBI’s database of large corporate borrowers (CRILC) with historical credit ratings data on these corporate group from Prowess.

I want to draw your attention to a few takeaways from this study:
1. About 12% of the NPA exposure from CRILC was rated as investment grade by at-least one CRA a quarter before slipping into the NPA category.
2. These Investment Grade borrowers became an NPA in the books of the bank in just11 months (on an average)
3. After becoming delinquent in the books of the bank, most of these investment grade corporates were downgraded to Sub-Investment grade with a delay of 5 months
4. The study also found that there is a significant divergence between ratings assigned to bank instruments and that by CRA on the corporate entity. Some 14% of loans were found to be in investment grade as per CRILC but were in default at a corporate level as per the Prowess database.

Impact on Corporate Bonds and Mutual Funds

Corporate Bonds are highly illiquid in India. I’m citing two studies by RBI (one each in 2018 and 2020) which state that 96% of primary bond issuances of Indian Corporates is through private placement. Although I couldn’t find any recent study on the secondary market for corporate bonds, I consider the above as a clear sign that the secondary market for Indian Corporate Bonds are highly illiquid. Recent episodes with the debt portfolios of various Mutual Funds houses in India also indicate that secondary markets are not liquid for Corporate Bonds that are rated below AAA.

In this context it is important to look at how Corporate Bonds in India are priced on a daily basis. Institutional investors such as Mutual Funds and Insurance Companies have to Mark to Market their portfolio as per existing regulations.

Most institutional investors get their pricing from solutions that are maintained by Credit Rating Agencies. The two key components in this pricing algorithms are:
1. Spread Matrix: This is essentially a yield based pricing matrix that assigns spread over Corporate and AAA instruments based upon the credit rating assigned to the instrument.
2. Polling: Agency calls holders of the instrument to seek 2 way quotes for the price of the bond.

Suffices to say that both these approaches to pricing of Corporate Bond instruments in India (in the absence of adequate secondary market liquidity) are subject to serious conflicts of interest. Credit Rating agencies who rate the instruments, use the same ratings to price the instruments. Credit Ratings agencies have both the issuer and the investor as their customers and both parties benefit by way of a stable and generous rating.

Why does this matter? For two reasons:

1. Mutual Funds are the largest allocators to corporate bonds in India. Most Debt Mutual Fund schemes that hold corporate bonds are open ended. This means that funds have outflows and inflows on an ongoing basis. Both entry and exit price allocations is done basis the pricing of the instrument provided by these agencies which is done basis these ratings. Ultimately imperfect pricing of these instruments hurt ordinary investors who do not earn the HTM return of the bond, which could be agnostic to the valuation approach used.
2. Investors in Corporate Bonds do not have the wherewithal and/or resources to monitor the corporates who borrow from them, unlike banks. Thus for them ratings serve as Early Warning Signals which can alert when the underlying debt service ability of the corporate is impacted. We also know that unlike Banks, Bond holders have thus far had limited success in recovering dues from delinquent borrowers (even when the bonds are secured). Thus a timely downgrade can give institutional investors an opportunity to exit such instruments and provide an arbitrage opportunity to players who have the resources to go through a long drawn recovery process.

Business Model of Credit Rating Agencies in India

Now lets come to the most important part. Whatever I have mentioned about thus far is well known to market participants and regulators. Then the question is why has the free market not rectified this problem thus far. In other words what is the market failure?

Lets first take stock of the basic business model and competitive landscape in the Credit Rating Industry in India.

Salient Metrics on CRA business model in India

A few takeaways from a study of the CRA Industry in India:
1. Oligopolistic Market: Slow growth market where top 3 players have 80% Market Share.
2. Lucrative Margins: Despite that margins are attractive for all players. Even smaller players earn 30% EBIT Margin in a business where there is no incremental capital requirement. EBIT Margin for the largest player is close to the Margins of Global CRA players who are an order of magnitude larger in size.
3. Evidence of Price Based Competition: In the last 5 years we have seen significant price based competition especially in the Corporate Bond segment. This is the main reason behind the stagnation in revenue and a contraction in Margins for most players.

In my opinion, the primary drivers of the market failure are as follows:

1. Monopsonistic Market: In India, outside of sovereign backed entities there are a handful of cooperate groups who dominate the Corporate Bond market. Since the revenue model of rating agencies is directly linked to fresh issuance of corporate bonds and ratings fees are paid by the borrowing corporate, a concentrated borrowers market increases the inherent conflict of interest in the business model.
2. High Entry Barriers: In India the SEBI requirement for registration of a new Credit Rating Agency is very steep. The promoter entity is required to have a capital base of at least 100 crore and the entity itself requires a paid up capital of 25 crores. As a result we see that all the 6 Credit Rating Agencies in India are backed by either Global Rating Firms or by entities controlled by the Government. This has prevented the entry of new players in the credit rating ecosystem.
3. Unhealthy Competitive Dynamics: Competitive intensity between players have increased in the last 5 years and there has been meaningful shifts in market share between these players. However this increase in competitive intensity has led to a deterioration in the quality of ratings across all players. A similar experience has been observed in the US in a study conduction by Bo Bocker et al, where they studied the impact on ratings quality of incumbents during the period which saw increased competitive intensity due to the entry of Fitch.

References

1. Risk-weighting under Standardized Approach of Computation of Capital for Credit Risk in Basel Framework — An Analysis of Default Experience of Credit Rating Agencies in India: RBI 2017
2. The Economics of Credit Rating Agencies: Francesco Sangiorgi et al, 2017
3. Efficacy of Credit Ratings in Assessing Asset Quality: An Analysis of Large Borrowers: RBI 2020
4. How did increased competition affect credit ratings? Bo Becker et al, 2017