Rating companies: when competition harms quality

Bangladesh’s credit rating industry faces credibility challenges due to conflicts of interest, data inaccuracies and an oversaturated market, prompting calls for urgent reforms and more regulation. strict.

A credit rating is an independent assessment of a company or government’s ability to repay its debt, either in general terms or in relation to a specific financial obligation. It estimates the level of risk associated with 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 main 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 Company Rules to protect investors in debt securities and public offerings of shares. These rules provide a legal framework for regulating credit rating companies, describing their operations and detailing the responsibilities and commitments of their analysts.

Currently, eight credit rating companies (CRCs) are operating in Bangladesh. Initially, two National Credit Rating Agencies (DCRAs) were registered by BSEC after 2002 and were later granted External Credit Assessment Institution (ECAI) status by Bangladesh Bank.

The remaining six CRCs were registered between 2010 and 2012. Subsequently, the Bangladesh Bank recognized its operations through ECAI status, aligning its ratings with risk weights. Administratively, all CRCs report to both BSEC and Bangladesh Bank, but the primary regulatory role rests with BSEC.

To measure the creditworthiness of an entity, CRCs follow a model-based assessment method to determine the creditworthiness of customers. In this regard, each CRC maintains technical collaboration with a foreign rating company for technical know-how.

Subsequently, all CRCs developed their own customized methodologies for rating various sectors including SMEs, Corporates, Bank Loan Rating (BLR), Financial Institutions (FI), Power Plants, NGOs, bonds, commercial papers, brokerage firms, asset-backed securities, public companies, general insurance, life insurance and projects.

The evaluation process based on the model approach consists of two main segments: (i) the quantitative part and (ii) the qualitative part. The quantitative part involves the analysis of the client’s financial statements, using ratio analysis, horizontal analysis and vertical analysis.

Moreover, quantitatively, bank loans occupy an indispensable place, considering both funded and unfunded loan positions, repayment history, loan classification status and transaction behavior such as it appears in bank statements.

On the other hand, the qualitative part takes into account factors such as ownership structure, governance, independence of management from the board of directors, succession planning, systems and controls, hand work, the nature of the business and the inherent risks when assigning scores.

Ironically, since their inception, CRCs have been competing fiercely with each other to survive 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 listed 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.

Compared to peer countries, Bangladesh has the highest number of CRCs. The CRC must function as a credit standards measuring body, ensuring a high level of professionalism among analysts and maintaining uncompromising quality in assessments.

Unfortunately, many companies in Bangladesh are profit-driven, which often compromises the quality of their ratings. Additionally, the lack of demutualization (separation of management from the board of directors) creates a conflict of interest that affects the impartiality of the evaluation. When board members also hold leadership positions (such as CEO, executive director, or in an advisory role), it undermines the professional integrity of the analysis.

During the assessment, the team of analysts prepares credit rating reports by collecting information from clients, auditing firms and banks. However, the data provided by these sources is sometimes asymmetrical or overestimated. Similarly, financial reports submitted by auditors or banks often consist of management reports that do not accurately reflect the actual performance of the entity.

When evaluating projects, project profiles prepared by clients or banks are often filled with exaggerated hypothetical data or misrepresented important facts. As a result, due to the low quality of the data, the ratings assigned may be misleading. Data integrity thus becomes an important challenge for analysts when it comes to justifying the customer’s real-world scenario.

The credit rating transition matrix shows the migration of non-financial companies from one rating category to another. According to the Financial Stability Report of Bangladesh Banks 2014-2019, the credit rating transition matrix revealed that around 90-100% of ratings remained within their limits, indicating the consistency of ratings assigned by banks. CRC in the following 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 large provisioning shortfall. On the other hand, excessive migration, particularly the frequent downgrading of matrix entities, suggests a potential threat to economic stability.

The reliability of these ratings depends on the accuracy of the evaluation processes used by the credit rating agencies. However, this analysis is subject to survivorship bias. Therefore, assessments conducted by CRCs in Bangladesh likely overestimated ratings and showed low credibility, which negatively impacted the asset quality of the banking sector over the past decade.

Furthermore, collusive practices between banks, clients, auditors and CRCs have caused significant harm to the credit rating risk assessment process. Although the Bangladesh Bank encourages the use of independent assessors from ECAI-accredited CRCs for genuine consideration of entities, the reality is different.

In line with the guidelines of the Risk-Weighted Assets (RWA) approach and the implementation of BASEL-III by the Bangladesh Bank, ECAIs are accredited to provide a comprehensive valuation measure. However, in practice, CRCs have exploited the RWA guidelines, as well as survivorship bias, to exaggerate ratings and make erroneous judgments, raising serious concerns about their irresponsibility.

Overall, the CRC industry in Bangladesh urgently needs a major policy overhaul to ensure sustainability and quality assurance. In this regard, BSEC and BB must play a regulatory role by applying strict rules on liability. Default studies, stress tests and evaluation models need to be redesigned in line with international best practices. Additionally, license cancellations and exemplary fines for compromised ratings must be strictly monitored.

Bangladesh’s CRC industry will have a long way to go to achieve quality ratings.

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Sketch: SCT

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Sketch: SCT