Rating agencies in India are witnessing a sharp rise in business as a result of the coming into play of the Basel-II norms which define the risk-related capital adequacy of banks.
These stipulate that a bank must provide capital commensurate with the implicit risk in its asset portfolio. If a bank gives a loan to an entity that carries an inadequate rating or no rating at all, then it must bring in sufficient capital to back that risky asset.
As a result, banks are rushing to get rated their small and medium business customers who enjoy credit above a certain level. The problem is that rating fees are determined by the amount which a business seeks to raise as debt and for which it is being rated.
In case of SMEs, this fee turns out to be quite small and the head of a rating agency has observed that the fee is typically not enough to meet the expenses involved.
Hence there is pressure to outsource the rating work for SMEs, and concern over the quality of such rating. This problem of quality, at a time of plenty for rating agencies, has a disturbing parallel with what happened in the US in the run-up to the current financial crisis.
The sharp rise in the number of structured products rated caused the revenues of leading rating agencies to jump. The quality of these exercises is today reflected in the vastly devalued status of those products.
Concern over the quality of rating for SMEs in India has now transformed into bigger posers: What is the state of the rating industry, what is the value raters bring, and what are the changes that need to be brought into the rating scenario in light of the recent experience of the developed markets?
Historically, Indian rating agencies suffer from a paucity of business because of Indian businesses' preference for equity has resulted in the small size of the debt market. Rating in India can come into its own when there is lot more of debt to be rated, creating enough volumes for the agencies. Rating practices in India also suffer from another drawback.
They still mostly use the methodologies developed in the west and these have not been shaped to take into account the peculiarities of Indian business practices.
Methodologies are also called into question when there is a sharp rise in the number of revisions, as has been the case since September last year.
The agencies say that although their models have provisions to anticipate course changes, the volatility that the economy has witnessed in the recent past is unusual, and was therefore not foreseen.
Do Indian agencies have the wherewithal to rate complex structured products, and should such products be allowed at all? The agencies assert that they do. What the regulator needs to do is not allow products that are excessively complex, lay down individual limits for exposure to complex products and define adequate capital requirements to mitigate the risks.
Finally, there is no answer to the question troubling the financial world: to avoid conflict of interest, who should pay for the rating -- the user, or the offeror? Or the state, as rating is in many ways a public service?