March 15, 2004

Credit rating agencies constitute an essential resource for lenders, investors and borrowers in the fixed-income market.

Their ratings are a distillation of information to determine the risks an investor would face in lending to a particular country, corporation or government.

The recent bout of corporate failures globally has placed rating agencies under the same spotlight as auditing firms, as their business models are scrutinised for flaws.

There are two models used by these agencies to generate income. The most common - which is used by the three largest rating agencies, Moody's, Standard & Poor's and Fitch - is to charge issuers for ratings which are then available either free of charge or at nominal cost

The agency has unfettered access to the internal information required to conduct its research.

Maintaining credibility within the investment community keeps the ratings as impartial as possible and, of course, this reputability is what keeps clients on board.

Barriers to entry in this industry are understandably high and the smaller and relatively unknown agencies are seldom invited to provide a rating for issuers.

Agencies do produce unsolicited ratings, without access to internal information, with a view to building up a reputation.

The announcement of an unsolicited rating can have far-reaching and often undesirable effects if the reader is unaware of the nature of the rating or the agency's relationship with the issuer, something that is not obligatory to disclose.

Such a rating was recently published on the SA Land Bank by a relative newcomer to Africa. This credit rating company downgraded the SA Land Bank from AA- and A1+ to A+ and A1, based on what seemed to be an accurate and reliable analysis. 

An upgrade or downgrade can mean that investment managers must rebalance their holdings to comply with the prescribed limits, as per client mandates and the Collective Investment Schemes Control Act (Cisca).

Both prescribe a maximum holding depending on the credit quality of the institution. In addition, Cisca restricts money market investments in an A1-rated institution to a maximum holding of 20 percent (A1+ = 30 percent maximum). Where more than one rating exists, the lower rating applies.

The Land Bank downgrade failed to disclose that it was an unsolicited rating based on a limited understanding of the bank's activities.

Further investigation revealed that it did not qualify as a downgrade or even a rating as per Cisca's definition, by which a credit rating is conducted at the request of the issuer of an instrument by a rating agency with unrestricted access to all confidential and other sensitive information, including management interaction. The rating must be publicly disclosed.

The downgrade was misleading and flawed in all aspects of the Cisca definition. The rating company acted without any access to the Land Bank's confidential and sensitive information.

Can the impartiality of an unsolicited rating add more value than that of a solicited rating agency?

It would appear not in this case, as the Land Bank's year-to-date unaudited results show a return to profitability levels with an adequacy ratio that is above the Reserve Bank's guideline for banks. All in contradiction of the unsolicited assessment.

Fitch - the Land Bank's certified rating house, with unfettered access to all information necessary to make an accurate, reliable and informed credit rating, affirmed the Land Bank's rating in December as long-term AA- and short-term A1+.

Yondela Ndema is compliance and legal officer at Abvest