As far as I understand, Credit Ratings are a big deal in
other markets. There have been many research papers published on questions
like; do the credit rating actions have any impact on the stocks/market?, how
does the stock markets react to these ratings announcements, etc. Some have conducted event-studies to understand the
nexus between credit rating announcements (positive or negative) and the stock
performance on the listed markets. A paper by Magdalena Grothe of European
Central Bank themed, “Market Pricing of Credit Rating Signals” finds that “The results show that the effects of rating
actions on market prices are significant and depend on the current state of the
market. While during favourable market conditions rating actions are not
crucial for market pricing, they become very significant in the periods of
crisis”. Another study from our neighboring India suggests that credit
rating downgrades cause considerable negative reactions while upgrades tend to
result negligible positive response. However,
to my knowledge, it has not been an area researched in Sri Lanka.
Credit Ratings were a major subject of discussion in the
aftermath of the GFC. Credit Ratings Agencies (CRAs) were also
partly blamed as one of the contributors to the financial crisis. This video
from the famous 2010 documentary movie Inside Job gives you some thoughts which
were critical.
In this background, the
discussion moved further ahead with a search for better alternatives to conventional credit ratings. However, to-date I do not see any major alternative
gaining ground over conventional credit ratings which seem to prevail and
discussion seems to have tapered away. Interestingly enough, the ratings
agencies also have not come up with different solutions to counter the
arguments against them. (may be they think that the existing system works or
their business was not threatened as yet by any new methods suggested or by any
alternative providers like Invictus, INCRA and Trepp. However the chairman Mr Kamal Mustafa of Invictus claims that
couple of CRAs approached them to be acquired). This paper discusses in great
detail the drawbacks of issuer paid credit ratings, alternatives for issuer
paid credit rating agencies and resiliency of issuer paid CRAs.
In fact this post is not
going to be about the global credit ratings industry, but I wanted to look at
certain developments that have taken place in the Sri Lankan credit ratings
environment. Firstly, I will give a brief about the Credit
Ratings Industry in Sri Lanka.
One
million dollar industry
Currently, there are three recognized Credit Rating
Agencies (CRAs) in Sri Lanka. Fitch Ratings Lanka, Lanka Rating Agency and ICRA Lanka are those. These market intermediaries are regulated by the Securities
and Exchange Commission of Sri Lanka (SEC). Credit Rating is not a mandatory
thing in Sri Lanka though it is mandated if an issuer looks to raise money via
the listed bond market. Further, the investor community has also demanded rated
products making it necessary for issuers to obtain credit rating (entity as
well as instrument ratings) if they are to tap the securitized market,
commercial paper market, etc.
As shown in the figures on the table (the data were
extracted from Annual Reports of SEC) the industry has now grown to be a one
million dollar industry. Over the last three years, total revenue of the
industry grew from LKR35 million to LKR136 million. This is equivalent to over
90% annual growth rate. Even more noteworthy was the fact that the industry has
emerged profitable over this same period and the margins are pretty good at
around 34% PBT margin at present. Given the current activity level in the
credit markets in Sri Lanka, I expect the industry revenues to double in 2014.
This growth might come as a hurdle to maintaining integrity, independence,
quality of work, etc due to pressure from issuers.
Frictions
among issuers and CRA
In a new development in the ratings industry in Sri Lanka
there were differences in opinions between issuers and the rating agencies.
Consequently, Hayleys PLC and LOLC pulled out from the original agency and
contracted another one (RAM Ratings Lanka now known as Lanka Rating Agency in
the case of Hayleys PLC and ICRA Lanka in
the case of LOLC). It’s not the interesting thing, with the new contract
the issuers were able to gain the same rating back. Similarly, late 2014
Softlogic Holdings PLC got downgraded by Fitch Ratings Lanka and they were able
to regain the original rating from Lanka Rating Agency.
Thus, it appears to anyone that these subsequent ratings
are inflated (or the contrary may be true, i.e., the former’s rating is
deflated). Moreover, investors are left wondering who’s right or wrong, where the
process is heading, etc. In fact, from my experience I know that some investors
consider the ratings provided by these agencies as substandard.
I believe that either there is governance issues at corporate
level (both issuer and CRA level) and/or rating agencies do not possess the
required technical knowledge to understand the businesses and the industries
they are evaluating.
Market
seems to be ignoring rating actions
Another noteworthy thing about ratings actions is that
market seems to ignore the information contained in the ratings announcements.
This may be due to the fact that this was not new information to the market
and/or the market behaves totally irrational.
Technically, a rating downgrade means that the entity’s
risks have risen and as a result, from what I know, the investors required
returns are higher now. As a result the intrinsic value of the entity goes
down. Hence, theoretically this should result in a drop in price.
On 25 August 2014 (a week before rating downgrade)
JKH.N000 was at LKR243.00. As of 3 September 2014 it was at LKR249.50. On the
same date the Company got downgraded to AA+ from AAA by Fitch Rating Lanka. One
of my colleagues was asking me whether the share would come down due to this
bad news. (that was his reading of the market). I told him that it will go up
as the Lankan market behaves very erratically. As predicted, it kept moving up
and by 12 Sept 2014 it was at LKR259.50. See the price chart below.
Watch
out! The impact could be shocking
Recently, there has been a rapid growth in issuances in
the market. In 2013 and 2014, there were 30 and 24 listed debenture issuances
respectively on Colombo Stock Exchange. These issuances have raised a
staggering LKR131,258 million (c. USD1 billion) collectively. Growth in listed
debentures is known but the asset backed, commercial paper segments are not
known publicly. The size of this segment must also be significantly high.
As Dion Bongaerts of ECB quotes, “The IMF has estimated that the losses incurred on largely AAA rated
structured products amount to $3.4trln globally”. IMF has given a good
explanation as to what the systemic risks are of a rating crisis in a boom
cycle and a bust cycle. In a global context, IMF finds that there has been
about one rating crisis every three years in the twenty two year period before
2009.
Bottomline
CRAs are operating in
a for-profit market. Hence, there is always space for one agency to capitalize
over other as evidenced in Sri Lanka in the recent past. Frictions among issuer
and rating agency gives another agency a chance to poach the issuer. This will
always be the case as long as the ratings are issuer paid. Nevertheless, alternative
models have not yet been able to challenge the conventional rating form.
However a rating crisis can wield significant impact on the financial system. It is of utmost importance to avoid a rating
crisis in Sri Lanka. The systemic risks of a rating crisis can go even beyond
the losses incurred in the listed debenture market. Market participants can
also become contributors to a good rating culture by acting rationally. Thus,
news such as rating downgrade or even worse swapping CRAs to get the same
rating in a downgrade situation can be penalized by requiring higher returns to
commensurate with the higher level of risks.
