In the wake of the global financial crisis, rating agencies — firms that grade the creditworthiness of companies and governments, among others — have come under fire. Because they are funded by the very debt issuers they rate, questions have been raised about their impartiality: Are they truly independent, or have they sometimes turned a blind eye toward risky businesses? In an interview with India Knowledge at Wharton at the Wharton India Economic Forum earlier this year, Roopa Kudva, South Asia regional head for Standard & Poor’s and managing director and CEO of S&P’s Indian subsidiary CRISIL, offered her perspective on what role rating agencies play in the marketplace, why they should still be funded by issuers and what they can do to help mitigate potential conflicts of interest.
An edited transcript of the interview appears below.
India Knowledge at Wharton: You are managing director and CEO of CRISIL and regional head for South Asia for Standard & Poor’s. Tell me a little about what you do in that role.
Roopa Kudva: As CEO of CRISIL, I head a global analytical company. We are India’s largest rating agency. We are also the leading provider of research and analysis to the world’s largest banks and leading corporations. We work with them in the areas of equity research, derivative research, fixed income research, etc. In addition, we also have a policy advisory business that works with governments in India and in 22 other emerging market countries in the area of infrastructure privatization.
India Knowledge at Wharton: In general, ratings are a summary picture, right? What role do they play in the markets? Why are they needed?
Kudva: A rating, very simply put, is an opinion — an independent opinion — on the degree of risk involved in timely payment of principal and interest on a debt instrument. So the value that ratings add is, first, by virtue of their independence. They are not expected to be a substitute for investors’ or banks’ own due diligence and analysis. But they are an additional opinion that provides insight.
What ratings help markets do is price risk. Ratings help markets get benchmarks across a range of companies, across industries, across sectors and across countries. So they play a very important role in improving the transparency in markets, in helping pricing and in ensuring comparability across a global market.
India Knowledge at Wharton: Are there differences in how ratings are determined in different parts of the world?
Kudva: Yes. Typically it would depend on whether you’re looking at a global rating agency like Standard & Poor’s or a national rating agency like CRISIL. For Standard & Poor’s, the rating methodology and the rating processes are designed to ensure comparability of ratings globally. So Standard & Poor’s rates entities on a global scale, which is common across the world.
When you come to national rating agencies like CRISIL, we rate companies on a national scale. And the assumption in our ratings is that the government of India, in its capacity as a sovereign, is AAA. The purpose of a national-scale rating is to provide analysis and insight, to rate rupee-denominated debt raised in India for Indian investors. Global ratings and national ratings have different roles to play, and they can coexist.
India Knowledge at Wharton: Ratings have been criticized of late as having been a factor in the recession. Are they truly independent? How would you counter that assertion?
Kudva: Yes, indeed there has been a lot of debate and discussion about the role of rating agencies in the global financial crisis. And I will take this question in two parts. One is: what have been our learnings from what happened? And two: I’ll address some of the fundamental issues that keep coming up about conflicts of interest that rating agencies face.
In terms of what have been our learning at CRISIL, I think one of the things we saw — and one of our takeaways from the global financial crisis — is that it is very important for rating agencies to be, one, transparent about the assumptions that go into the analysis and, two, to communicate continuously to the market and to the investors as to what their thinking is. What have we done after the global financial crisis? We have considerably stepped up our conversations and our dialogue with the investor community. We make sure that we talk a lot about our criteria and our analytical process, so that people have a deeper understanding of the same. And we make sure that we keep our portfolio under surveillance so that we are sending out timely alerts to the market.
On the issue of conflict of interest in rating agencies, the main issue is really that the conflict exists because issuers pay rating agencies to assign them ratings. The question is: are there any other business models that are superior? What people tend to underestimate is that the biggest advantage of an issuer-based model is that it allows ratings to be available free of charge to investors across the world on a whole variety of companies. If there were only investors paying for a rating, then only those investors who paid for the rating would actually get the rating. And what that would mean is that this whole transparency that rating agencies bring to the markets by putting out comparable information on so many companies would not be available. The greatest benefit of the issuer-based model is that it increases availability and transparency and makes available ratings free of charge to investors across the world.
Now, having said that, does a conflict exist? It does. And therefore, just like conflicts in every other part of financial services, they have to be managed. How do rating agencies manage the conflict? We at CRISIL, for example, have a very clear separation between business development and commercial issues, as well as analytical issues. An analyst’s compensation is in no way determined by the rating assigned or by the amount, by the quantum of debt rated or any such parameter. The ratings themselves are assigned through a multilayer process and through a committee process, so that no one individual can bias the rating in any particular manner. So there are several checks and balances that are put in place to manage the conflict. And I think that is something rating agencies take very seriously, because at the end of the day what they have to ride on is only their reputation.
India Knowledge at Wharton: When a rating agency upgrades or downgrades the debt of a country, what effects or implications might that have on the marketplace?
Kudva: I think the same effect that it has when a rating agency upgrades or downgrades the rating on a corporate or on a bank or on a municipality. A rating upgrade indicates that the probability of default or the degree of risk is lower than it was earlier. And a downgrade indicates that the degree of risk is greater than it was before the downgrade happened. What that typically tends to affect is the price at which the entity can borrow. So, generally, rating changes do have an impact on the cost of borrowing. In some markets they could also affect the availability of funding to a particular issuer or entity.
India Knowledge at Wharton: You have a background in statistics. What got you interested in working in ratings?
Kudva: Well, I went to business school, and after that clearly a career in finance was something that was very appealing. What has really inspired me to stay on for so long in a company like CRISIL is actually the role that we take in making markets function better. The culture we have in the company is a true meritocracy where you’re encouraged to think, you’re encouraged to debate issues, bear the power of what you see — and the idea is more important than who you are. I think it’s that culture really, and it is the impact that we have on markets, that has kept me here for so long.
