Credit Rating Companies: When competition undermines quality

Infographic: TBS

A credit rating is an independent assessment of the ability of a corporation or government to repay debt, either in general terms or with respect to a specific financial obligation. It estimates the level of risk involved in lending money to a business, government, or government agency. 

A high credit rating indicates that the bond issuer is likely to repay its debts to investors without difficulty, while a low credit rating suggests the opposite.

Globally, the three major rating agencies are Standard & Poor's, Moody's, and Fitch Ratings, all based in the United States.

In 1996, the Bangladesh Securities and Exchange Commission (BSEC) introduced the Credit Rating Companies Rules to safeguard investors in debt securities and public share offerings. These rules provide a legal framework for regulating credit rating companies, outlining their operations, and detailing the responsibilities and commitments of their analysts.

Currently, eight credit rating companies (CRCs) are operating in Bangladesh. Initially, two domestic credit rating agencies (DCRAs) were registered by BSEC after 2002 and later accorded the status of external credit assessment institutions (ECAIs) by Bangladesh Bank. 

The remaining six CRCs were registered between 2010 and 2012. Subsequently, Bangladesh Bank provided acknowledgment for their operations through ECAI status, aligning their rating notches with risk weights. Administratively, all CRCs report to both BSEC and Bangladesh Bank, but the primary regulatory role lies with BSEC. 

For measuring the creditworthiness of an entity, CRCs follow a model-based assessment method in conducting creditworthiness of the clients. In this regard, each CRC has a technical collaboration with a foreign credit rating company for technical know-how. 

Subsequently, all CRCs have developed their either with collaboration with Technical partner or own customised methodologies for rating various sectors, including SME, Corporate, Bank Loan Rating (BLR), Financial Institutions (FI), Power Plants, NGOs, Bonds, Commercial Papers, Brokerage Firms, Asset-Backed Securities, State-Owned Enterprises, General Insurance, Life Insurance, and Projects. 

The assessment process based on the model approach consists of two broad segments: (i) the quantitative part, and (ii) the Qualitative part. The Quantitative part involves financial statement analysis of the client, using ratio analysis, horizontal analysis, and vertical analysis. 

Additionally, in the quantitative part, bank loans hold an indispensable place, considering both funded and non-funded loan positions, repayment history, loan classification status, and transaction behavior as reflected in bank statements. 

On the other hand, the qualitative part considers factors such as ownership structure, governance, management independence from the Board of Directors, succession planning, systems and controls, workforce, nature of the business, and inherent risks when assigning ratings.

Ironically, since its inception, CRCs have been engaged in fierce competition with each other to sustain themselves in the market. This is due to the presence of eight companies operating in the small-scale financial market of Bangladesh. 

The Bangladesh Securities and Exchange Commission (BSEC) has enrolled eight companies, which is disproportionate to the size of our financial market. In comparison, India has seven, Pakistan two, Vietnam four, Japan one, Thailand one, and Malaysia two. 

With respect to peer countries, Bangladesh has the highest number of CRCs. CRC must function as a credit standard measurement organisation, ensuring a high level of professionalism among analysts and maintaining uncompromised quality in assessments. 

Unfortunately, many companies in Bangladesh operate with a profit-driven focus, often compromising the quality of their ratings. Additionally, the lack of demutualisation (separation of Management from the Board of Directors) creates a conflict of interest that affects the impartiality of the assessment. When board members also hold management positions (such as CEO, Executive Director, or in an advisory role), it undermines the professional integrity of the analysis.

In assessment, the Analyst Team prepares credit rating reports by collecting information from clients, Audit firms and Banks. However, the data provided by these sources is sometimes asymmetric or overstated. Similarly, the financial reports submitted by auditors or banks often consist of management reports that do not accurately reflect the entity's actual performance. 

In project ratings, the project profiles prepared by clients or banks are often filled with exaggerated hypothetical data, or misstating material facts. As a result, due to the low quality of the data, the assigned ratings can misguide the opinion. Data integrity thus becomes a significant challenge for analysts in justifying the actual scenario of the client.   

The credit rating transition matrix shows the migration of non-financial corporate entities from one rating category to another. According to the Bangladesh Bank Financial Stability Report from 2014 to 2019, the Credit Rating Transition Matrix revealed that approximately 90%-100% of ratings remained within their limits, indicating consistency in the ratings assigned by the CRCs in subsequent years. 

However, if the transition matrix was stable, it raises the question of why Non-Performing Loans (NPLs) reached their highest levels in history, accompanied by a significant provision shortfall. On the other hand, excessive migration, particularly the frequent downgrading of entities in the matrix, suggests a potential threat to economic stability. 

The reliability of such ratings depends on the accuracy of the assessment processes employed by the credit rating agencies. However, this analysis is subject to survivorship bias. Therefore, the assessments conducted by CRCs in Bangladesh have likely overstated ratings and shown poor credibility, which adversely impacted the asset quality of the banking sector in the last decade.

Furthermore, the collusive practices among Banks, clients, auditors, and CRCs have caused significant harm to the risk assessment process in credit rating. Although Bangladesh Bank encourages the use of independent assessors from ECAI-accredited CRCs for a true reflection of entities, the reality is different. 

According to the Risk-Weighted Assets (RWA) approach guidelines and BASEL-III implementation by Bangladesh Bank, ECAIs are accredited to provide a comprehensive measure for assessment. However, in practice, CRCs have exploited the RWA guidelines, along with survivorship bias, to exaggerate ratings and make misjudgments, raising serious concerns about their irresponsibility.          

By and large, the CRC industry of Bangladesh urgently needs a major policy overhaul to ensure sustainability and quality assurance. In this regard, BSEC and BB must play a regulatory role in enforcing stringent rules for accountability. Default studies, stress testing, and assessment models must be redesigned following international best practices. Additionally, license cancellations and exemplary fines for compromised ratings should be strictly monitored. 

The CRC industry of Bangladesh will have a long way to go to achieve quality ratings.

Sketch: TBS

Md Mehdi Hasan Khan and Md Kamrul Hasan are currently pursuing Certified Internal Auditing Program with Institute of Internal Auditor, Bangladesh

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.