Insights Squaring The Asset Quality Circle Suresh Kumar

13 March 2002

"In the race for excellence, there is no finishing line", are the famous words of Dubai's Crown Prince; which will ring loud and clear to everyone in the Emirates in their quest for quality. Until now, be it the Dubai Quality Awards or the Dubai Quality Group's activities have pretty much been confined largely to operational excellence i.e. quality in terms of customer service processes and procedures. This is understandable as these functions lend themselves to easy and effective assessment in terms of definable and quantifiable standards. High operating quality will no doubt, enhance the credit-worthiness and the quality of the assets and investments and these are inter-related even if not, inextricably. On the other hand, credit and asset quality issues tend to have financial impact and their appraisal becomes complex. Only the brave will perhaps institute awards for credit quality! Indeed as of now, there are no Balridge or Six Sigma Awards that measure credit quality; as far as I am aware! The nearest measurement of credit quality are reflected in the credit ratings issued by the likes of Moody's and Standard & Poor's (S&P). Generally, those companies and countries that seek to raise money in the global capital markets, solicit credit ratings. In some instances, agencies such as Moody's and S&P as indeed the Cyprus-based Capital Intelligence would voluntarily assess and announce ratings i.e. on an unsolicited basis.

'Independent' credit or asset quality assessment has therefore, very much been, the preserve of the rating agencies. Over the years, they have expanded their activities to include equity gradings for different types of publicly traded / quoted equity exposures. They also assess the credit quality of special purpose vehicles (SPVs) and other debt issues such as commercial paper as well as a whole host of stand-alone arrangements. Interestingly, such special structures have enabled companies that may not, on the strength of their own financial statements, justify higher ratings, to be placed a few notches above their sovereign ceilings.

This form of credit enhancement may also be achieved through measures such as escrow accounts, whereby the entity's receivables in a foreign currency are kept outside the home country of the corporate or the entity. Similar is the situation where the collateral security offered is of such a superior quality as to warrant higher ratings. The agencies rigorously review the watertight arrangements to be put in place in this region to preserve the collateral value and upon comfort, confirm any superior ratings of these structures. For instance, some regional issuers from the emerging markets do offer asset or mortgage backed securities, where the underlying securities say from the U.S. market, are of a very high credit quality. These are of course the more exotic versions.

The "run of the mill" financial requirements are adequately met by the likes of Dunn & Bradstreet who provide access to corporate financial information and in certain instances, ratings too. Some also offer to assist in the collections of receivables, both overdue and otherwise.

Going forward, the BIS capital adequacy norms for financial institutions are expected to change dramatically, by about the year 2005. Although the Basle Capital Accord will require banks to allocate capital on the basis of the riskiness of their activities and not merely on the basis of their collateral or asset quality, these effectively cover operational, credit and market risks. In this regard, it is feared that most of the emerging markets will fall in the 'high-risk' credit quality bracket, requiring higher capital allocations than of now and thus choking off a good amount of credit supply in the international banking system. This may force banks in the emerging markets to seek confirmation of their guarantees and letters of credit from banks in the OECD / better rated countries. Inevitably, this will push up the cost of banking / lending transactions because all such perceived risks will be reflected in pricing. Therefore it would become particularly important that financial institutions and indeed corporates choose and deal with appropriate counter-parties of good credibility and credit-worthiness. This is where research and rating agencies come into play. In a number of countries in this region, there are good, family run businesses but who are poor in meeting financial disclosure standards. Many of them will have to now "loosen their balance-sheet strings" i.e. actually provide adequate information or else risk being rated inappropriately.

Good companies the world over will and should voluntarily subject themselves to rating discipline. Hopefully they can trigger a 'demonstration effect' i.e. if they get good ratings and are able to command better pricing in the international market place, then others will be more than eager to obtain a similar competitive advantage. This region also needs good data and deeper sectoral analysis covering the various economic segments, so as to determine where a particular company stands in its industry segment and where and how they are exposed to risks that could alter their financial status.

Ultimately, all ratings are as much based on the current financial performance of the entities, as on a forecast of their prospects. Here the crystal ball syndrome does come into play and rating agencies can only exercise a reasonable judgement and cannot play 'God'.

Some argue that credit rating agencies have now been given so much authority and importance in the markets that if they sneeze, the particular market segment may catch a chill! If they were to even raise their eyebrows a little bit by way of a credit watch or a potential downgrade signal, this move may send shivers down the bond markets; especially if that particular company's debt is trading actively and it begins to lose value. Rating agencies have been criticised during the Asean crisis for panic creation and for being behind the information curve and for their multiple downgrades, within a span of a few weeks; as it happened in Korea. They have also been faulted for not accurately predicting the Russian and the more recent Latin American crises.

The last straw on the camel's back appeared to have been that of the Enron fiasco, where the rating agencies were found to have retained an investment grade rating for the company, only days before it collapsed under the weight of its wrongdoings. Of course, rating agencies cannot uncover fraud and chicanery anymore than the auditors can. Indeed much less; as they do not see or scrutinise the entire financial records of an entity. Often, they have to make very discreet and intelligent enquiries to uncover and unfold what the underlying picture is. Much hype is naturally vested in the client presentations made to rating agencies and they are required not to miss the wood for trees.

That is where lies the quality of rating analysts and the composition of the ratings committees, their independence and multi-faceted experience are critical. While assessing the performance of similar entities, they will be able to identify the 'odd ones'. It is their considerable exposure across the industry spectrum that tests and hones their wisdom and judgement and this is what credit or asset quality gradings and ratings are all about. Ultimately ratings are only a little more than snap shot pictures and are valid for short points in time and are naturally subject to periodic reassessment and reaffirmations. It is in this context, that one also welcomes the stated objective of the Dubai International Financial Centre (DIFC) to facilitate the establishment of credit rating agencies.

Research and rating agencies do perform useful anchor roles in the development of financial markets. It would be wise for the authorities in the emerging markets to encourage these agencies to ensure independence objectivity and lively competition. In a sense, the rating agencies are like doctors, who are expected to adhere to the Hippocratic Oath and make diagnoses to promote good healthcare and not prescribe medicines and surgeries when not warranted. If however their fees are dependent on scaling up such activities, then much harm can be done. This is where the commercialism and market discipline alone cannot hold good and the regulators would need to step in and independently monitor the consistency, the aggressiveness or otherwise and the track record of the research and rating agencies. If research and rating agencies are found to have fallen foul or short of desired standards, they are unlikely to get on-going business. Such a cluster of professional agencies comprising lawyers, auditors, rating agencies and regulators will augur well for the development of capital markets in this region. Bond and debt instruments require rating agencies and would as a result act as good shock-absorbers for excessive exuberance in the market place.

(The author (sureshk@emiratesbank.ae) is a General Manager in Emirates Bank Group. The views expressed in this article are not necessarily shared by the Bank.

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