credit rating agencies introspection inferrence … · 2012-07-09 · the pakistan credit rating...

MAY 2011

The Pakistan Credit Rating Agency Limited

CREDIT RATING AGENCIES INTROSPECTION, INFERRENCE & INSIGHTS

CONTENTS Sections Title Page

1 Do Credit Rating Agencies (CRAs) Really Add Value? 1

2 Rating the RATERS…. 1

3 Credit & CREDIBILITY… 2 – 5

4 The Default EXPERIENCE 6 – 10

5 The Bond Market – NEXUS OF RATINGS’ GROWTH 11 – 13

6 PACRA – CARRYING THE ONUS OF LEADERSHIP 13 – 16

7 The WAY Ahead 16 -


CREDIT RATING AGENCIES –

INTROSPECTION, INFERENCE &

INSIGHTS

JUNE 2011 Page 1 of 17

PACRA SPECIAL COMMENT www.pacra.com

1 DO CREDIT

RATING

AGENCIES

(CRAS) REALLY

ADD VALUE?

Let’s assume:

What if – No

CRAs

existed….

1.1 Whether CRAs ADD any real value to the arena of risk assessment? The

answer to this question can best be „worked back” from considering the corollary –

What if no CRAs existed?

1.2 In one way or the other, credit assessment of borrowers is an exercise

undertaken by entities other than CRAs too – lenders, underwriters, regulators and

individual investors. It is, thus, not the exclusive domain of CRAs. However, CRA

opinions do have “unique” intrinsic characteristics unmatched by the others:

1.2.1 A truly independent, third-party opinion: CRAs are specialized entities set up

for the express purpose of providing a credit opinion. These opinions are widely made

available to the general public investor community free of charge.

1.2.2 Comprehensive and transparent opinion: A CRA‟s opinion, assigned on an

ordinal scale comprising ten rating categories, is definitely more comprehensive in

contrast to, let’s say, an auditor‟s binary (unqualified versus qualified) and generic

opinion. Also, the CRAs make their rating rationale public imparting great

transparency to their opinion. Again, taking audit as a comparable, the auditors‟

management letter is not a public document.

1.2.3 Easy-to-understand, standardized and comparable opinion: CRAs are

required to make their methodologies and criteria public. Hence, their opinions are easy

to understand, uniform and standardized and also comparable across CRAs on the basis

of how comparable their respective criteria is.

1.2.4 Quasi – regulatory role of CRAs: CRAs are quasi-regulators in the sense that

their ratings do take into account complete compliance with the law as a rating factor.

Furthermore, through their detailed rating rationale commentary / report accompanying

each opinion, CRAs, over a period of time, are instrumental in implicitly guiding firms

towards better governance and financial and business conduct.

1.2.5 Support to regulators in managing systemic shocks: It is true that the recent

global credit crisis has leveled allegations on CRAs as to their role in exacerbating

systemic shocks. However, credit ratings, generally, lend a element of confidence, if

they remain stable, and are an effective mitigant to containing the herd-like, panic

driven behavior of investors, that usually precipitates a systemic shock.

1.2.6 Channelizing the flow of funds: CRAs provide two unique services to the

market, by announcing their ratings publicly: (i) CRAs increase the precision of public

information for the market participants, and (ii) hence, make coordination amongst

investors easier. This facilitates channelization of funds in a more rational and

informed manner.

2 RATING THE

RATERS….

How PACRA

measures up

against CRA

Evaluation

METRICS…

2.1 There are three evaluation metrics for rating a CRA‟s quality:

i. Independence: Independence is determined by how unbiased,

impartial and objective the CRA opinion really is. Independence for a

CRA has two key dimensions: (i0 internal independence; and (ii)

external independence.

ii. Transparency: How understandable, standardized and comparable the

opinion is determines how transparent it is.

iii. Impact: How much of an impact a CRA exerts in terms of its ratings

and rating actions for risk pricing by lenders is another key evaluation




INSIGHTS



metric

PACRA AND THE CRA EVALUATION METRICS:

(i) Ensuring independence: An objective opinion is a function, mainly of

independence.

Internal independence: PACRA follows a rating process

where the opinion starts evolving at the level of an analyst, and

progressing through rigorous deliberation, culminates into a

rating committee (RC) comprising professionals of high caliber.

The opinion formation process is fully documented at every stage.

Furthermore, PACRA has an organizational structure that

effectively minimizes the potential for conflict of interest. The

BoD and the management are completely separate and the board

members have no role / influence in the rating process or the

formation of rating opinion. Also, there are operational firewalls

between the development team and the rating team.

External Independence: PACRA has business practices

that facilitate external independence. One such practice is arms-

length dealings with all existing and potential clients in matters

such as fee negotiations, gifts etc. Moreover, related entities

(subsidiaries, associates, PACRA directors / shareholders owned

entities) are not rated by PACRA as a matter of policy.

(ii) Facilitating transparency: All PACRA non-confidential ratings

are publicly disseminated. Furthermore, PACRA also makes its

summary rating report available in the public domain. All PACRA

rating methodologies are in the public domain and ratings are routinely

validated against any changes in such methodologies.

(iii) Generating impact: PACRA‟s ratings are considered to

effectively communicate risk as they are highly sought after by lenders

in order to price their loan books.

3 CREDIT &

CREDIBILITY

“Unbiasedness”

of OPINION

Conflicts of

interest

Predictive ability

of ratings

3.1 A credit rating is essentially just a piece of information – an opinion - about the

likely capacity of the entity / issuer to pay interest and repay the principal. Credibility is

this opinion‟s cornerstone, believability its crux. Not only is a CRA scrutinized for any

actual lapse resulting in rendering a dent to its credibility but a mere perception of

diminished credibility is, at times, enough to tarnish the value of a CRA‟s opinion.

3.2 Scouring the CREDIBILITY MAZE brings into focus the following premises.

With special reference to Pakistan‟s credit ratings industry, these are as follows:

How unbiased the OPINION really IS?

Conflicts of interest – An exercise in manageability

Commenting upon the “signaling value” of ratings

3.3 How unbiased the OPINION really IS? In the aftermath of the global credit

meltdown, the most prominent alleged indiscretion attributed to creating a bias in the

major CRAs‟ opinions is the phenomenon of Rating Shopping. From the point of view

of the CRA, rating shopping is described as a business practice, whereby the CRA,




INSIGHTS



knowingly, lowers its standards and adopts a less stringent methodology to afford

higher credit ratings to entities / issuers. The underlying aim is to grab and maintain

larger market share. The pertinent question is, whether such a practice has maligned

the ratings industry in Pakistan or not. The answer would have a direct bearing upon

deciding how unbiased the opinion of the domestic CRAs (DCRAs) really is.

3.3.1 It is noteworthy that difference in the opinion of DCRAs, per se, does not

imply that any bias has necessarily been woven into these opinions. Examining such

opinions against their relevant methodologies can validate this statement. Historical

experience, thus far, points to evidence that substantiates, beyond a reasonable

modicum of doubt, the non-existence of rating shopping being practiced by any of the

two industry participants. Let history speak for itself:

i. Analyzing Dual Ratings: Though, no such mandatory requirement

exists, there are numerous instances of one entity / issuer being rated

by both the DCRAs in Pakistan. An examination of such ratings

indicates little difference in the opinion of the two raters for the same

entities / issuers. However, DCRAs have still facilitated diversity of

opinion as they afforded the market two independent opinions on the

same issuer. The fact as to why most dual ratings between DCRAs are

the same may be attributed to the fact that, in Pakistan, most issuers

maintain a simple capital structure, tantamount to a plain-vanilla asset.

Research indicates that diversity of opinion, generally, is witnessed for

complex assetsi.

ii. Analyzing Switch Ratings: Listed TFCs cannot switch between CRAs

during their tenor without seeking prior approval from SECPii.

However, there is no regulatory impediment present for privately

placed TFCs and entities / issuers switching between CRAs.

Notwithstanding though, there aren‟t many switch ratings (during the

last three years from 2009 - present) to indicate that either the CRAs or

the entities / issuers undertook “rating shopping”

REFER TO Annexure A: DCRAs facilitating Diversity of Opinion

HOW TO FACILITATE THE UNBIASEDNESS OF THE RATING OPINION

i. PACRA Practices: PACRA has practices (both existing and those

planned to be undertaken in a gradual manner) that serve to facilitate

an objective opinion:

Documented and disclosed criteria / practices: All

PACRA ratings conform to the documented criteria and

practices that are disclosed in detail on the official website.

No objection letter for switch rating mandates:

PACRA is shortly finalizing a policy, whereby, it solicits a

no-objection letter (to be furnished by the other rating

agency) from the entity / issuer, if it happens to switch to

PACRA for the rating mandate.

Sending the rating report to the board: as an

intended practice, PACRA is to send a copy of the rating

report to the chairman of the enmity / issuer‟s board.

PACRA considers such practice conductive to enhancing




INSIGHTS



the governance structure of the entity / issuer.

ii. Regulatory Support: For facilitating independence industry-wide,

PACRA seeks regulatory support in the area of disclosures:

Broader disclosures: PACRA proposal is to broaden

disclosure requirement for DCRAs to specify (by name, title

and release date) in the Client Credit Rating Report which

methodologies / criteria have been used to reach the

particular rating opinion.

Preliminary / unused final ratings: PACRA

proposal is to require mandatory disclosure by the entity „

issuer of any preliminary / unused final ratings (in the

prospectus) in cases where the entity / issuer makes a

securities offer to the general; public.

3.4 Conflicts of interest – An exercise in manageability: CRAs are alleged to

suffer from an intrinsic conflict of interest, namely, the very clients, whom they rate,

pay them. This business practice, referred to as issuer-pays model, is predominant

amongst almost all major CRAs since the 1970s. However, despite all criticism, in the

foreseeable future, it seems to be the preferred business model for CRAs, issuers and

investors alike.

3.4.1 A deeper reflection into the working of the issuer-pays model makes it clear

that this business practice actually requires CRAs to manage the inherent potential for

conflict of interest. The model has virtues, unmatched by its alternative, the investor-

pays model:

Long-term, continuous and diverse availability of rating opinions: The

only users of ratings that can ensure the long-term, diverse (a large enough

number of rating opinions within each sector to ensure relative

comparisons) availability of a rating opinion are the issuers themselves.

Hence, an issuer-pays business model has greater staying power as far as

sustained information on credit quality to all other users of ratings is

concerned.

Free-of-charge availability of a rating opinion in the public domain:

The investor-pays model may lead to information gaps and asymmetry, as

the opinion is only available to those users who subscribe to the services of

the CRA. The issuer-pays model makes it viable for CRAs to make their

rating opinions available in their public domain without a price tag attached

to them.

Quality of information: Issuer participation could be ensured at a

higher level within the issuer-pays model. The primary criticism against the

alternative model is that the rating opinion is based solely on public

information or low quality secondary-source non-public information

regarding the issuer.

HOW TO FACILITATE MANAGEABILITY OF THE CONFLICTS OF INTEREST INHERENT IN

ISSUER-PAYS BUSINESS MODEL FOR CRAS

i. PACRA Practices: PACRA undertakes following practice(s) to manage any




INSIGHTS



existing or potential conflict of interest:

Voluntary disclosure of compensation structure: PACRA

discloses its fee structure in detail on its official website.

3.5 Commenting upon the “signaling value” of ratings: “Signaling value” refers to

the predictive power of ratings – how accurately they can forecast default. CRAs are

the only institutions that incorporate non-public information into their ratings and then

publicly disseminate them to the general public. The main reason why their ratings are

considered prospective is the presence of such information.

3.5.1 Reality Check - Limited predictive ability of ratings: Reality for most CRAs,

including the DCRAs, during the recent credit crisis, has been different. Ratings have

acted as laggards to credit events, even default, showing limited predictive ability. The

reality check has borne out the fact that apart from issuer-solicited non-public

information, ratings also require to be validated based on economic shocks and rating

behavior at extremes of the business cycle.

HOW TO FACILITATE THE PREDICTIVE POWER OF RATINGS

PACRA practices: PACRA undertakes following practices to ensure that its

ratings remain prospective:

i. Quarterly surveillance exercise: PACRA conducts a quarterly surveillance

exercise to elicit first-hand information on all its clients even before the

annual update comes due. The exercise has been refined of late to include

a surveillance criticality scale being applied to pick up clients that may

require a review of ratings mid-year due to any material change in credit

quality.

4. THE

DEFAULT

EXPERIENCE

Putting default

into

perspective

Default

experience –

international

and local

ratings

4.1 Default statistics are a recognized performance barometer for a CRA. The

occurrence of a default, thus, is synonymous to catastrophic failure as far as a CRA is

concerned as it results in its opinion “ceasing to exist”. Hence, if CRAs were to have

their way, there wouldn‟t be any defaults. Nonetheless, despite all good intentions and

efforts, defaults arte part and parcel of the game. The best CRAs can do is to recognize

defaults as the silver lining around the cloud – utilizing them to draw insights and

employing these in strengthening the quality of their rating process.

4.2 PACRA has a comprehensive definition of default. Defaults occurs when: (i)

there is missed payment(s) on contractual obligations, that remain unremedied beyond

the grace period, (ii) corporate guarantee is dishonored, (ii) bankruptcy is filed, (iv) a

forced restructuring takes place, and (v) lenders‟ forbearance is exhausted.

PUTTING THE DEFAULT EXPERIENCE – IN PERSPECTIVE

4.3 The default experience of any CRA, in order to be understood in its true sense,

needs to be put into perspective first. Such positioning is furnished by considering the

following:

4.3.1 Limitations of default statistics

4.3.2 National Ratings and Sovereign Risk




INSIGHTS



4.3.1 Limitations of default statistics: In PACRA‟s and Pakistan‟s context,

there are two capping factors that undermine the: (i) generalizability, and (ii) the

representativeness of the default numbers:

(i) Relatively small and concentrated ratings universe: The size of the

rated universe viz a viz the total universe of existing (all those entities /

issuers rated by PACRA and other rating agencies) and potential

entities / issuers to be rated in Pakistan is very small – a mere about

less than 15% (this figure is an estimate reached at by taking into

account the listed companies (642) and those rated corporates (public

ratings only) by either of the two DCRAs. Hence, it does not qualify as

a representative sample, thus, failing to present a true reflection of the

credit quality in the economy. Furthermore, about 90% of PACRA‟s

ratings have always remained concentrated in the investment grade

categories. Due to such concentration, defaults emanating from

investment grade categories, necessarily, do not indicate lack of

ordinality for PACRA‟s ratings.

Rating Penetration in Pakistan

Listed

Companies

(KSE)

Listed & Rated Corporates (Non-financial companies)

(DCRAs‟ Public Ratings)

642 72 (11%) PACRA 40

Dual Ratings 4 JCR-VIS 21

(ii) Default study with limited representation: PACRA‟s default

study, registering either nil defaults or a low single-digit default rate is

not representative. This is attributed to the concentration of ratings

into investment grade categories, as explained earlier, which are less

likely to default.

4.3.2 Sovereign Risk and National Ratings: When reflecting on the

performance of CRAs, it must be borne in mind that sovereign ratings reflect the risk of

an operating environment. Hence, a AAA rated entity on a national scale of a country

rated B would have a higher default likelihood as compared to a AAA rated entity on

the national rating scale of a country rated, let‟s say, AAA. Moreover, when country

risk increases to a substantial level, even the highest-rated entities may be at risk of

temporary default. The period following FY08 witnessed the worst recorded global

meltdown and deteriorated economic environment in Pakistan. This is reflected in the

sovereign ratings, where there are three consecutive downgrades. So severe was the

downturn that it precipitated a run on the market, which resulted in an unusually

unprecedented closure of Pakistan‟s stock market for about 100 days. This was

indicative of a toughening economic environment and high risk of default across ALL

rating categories that was eventually reflected in the credit ratings and the defaults that

took place for DCRAs in Pakistan.




INSIGHTS



INTERNATIONAL DEFAULT EXPERIENCE - A COMPARATIVE ANALYSIS

4.4 CRAs, around the globe, have witnessed a paradigm shift in credit trends.

Actually, the recent global credit turmoil, beating even the great depression in terms of

its severity, has brought home an unsettling truth for all CRAs to contend with – the

“investment grade category” is not as “downgrade & default resistant” as previously

thought.

4.5 2009 happened to bring the worst in terms of the default experience and

default activity, worldwide, set new precedents. In Pakistan, the impact was delayed till

2010 and is seen continuing in 2011. However, internationally, the default activity is

seen bottoming out in 2010:

INTERNATIONAL DEFAULT EXPERIENCE

DEFAULT RATE PERIOD: 2009 & 2010

Default Metrics Rating Agency

2009

CRA S&P Moody‟s CRISIL RAM PACRA JCR-VIS

Sovereign Risk USA: AAA India:

BBB-

Malaysia

: A- Pakistan: B-

Annual default Rate (%)

(No. of defaults)

4.04

(265)

5.40

(261)

2.50

(43)

1.60

(3)

0.00

(0)

0.00

(0)

2010

CRA S&P Moody‟s CRISIL RAM PACRA JCR-VIS

Sovereign Risk USA: AAA

Outlook: Negative India:

BBB-

Malaysia

: A- Pakistan: B-


(No. of defaults)

1.14

(81)

1.30

(57)

2.10

(68)

0.00

(0)

5.56

(4)

1.30

(57)

2011

CRA PACRA JCR-VIS

BB- BB-

B+ B+

B B

B- B-

CCC+ CCC+

CCC CCC

CCC- CCC-

CC CC

C C

SD / D SD /D

Jul-07 Nov-07 May-08 Oct-08 Nov-08 Dec-08 Aug-09 Nov-10

Source: S&P

Pakistan Soveraign Rating History




INSIGHTS




(No. of defaults)

5.56

(4)

AS RATINGS FELL - HOW THE DCRAS’ FARED ?

4.6 In Pakistan, the global meltdown had a spillover effect. Corporate credit

quality, already beseeched by a tough local operating environment, came under intense

pressure and defaults and multinotch downgrades were encountered by both the

DCRAs.

4.7 The majority of defaults for DCRAs occurred in the investment-grade

categories, merely due to the fact that the rating penetration in Pakistan is still very low

and mostly, only larger issuers get themselves rated. Such issuers generally enjoy good

credit quality under a normal operating environment. However, some of these, despite

being originally rated by DCRAs in investment-grade categories, could not withstand

the severity of the recent economic shock and succumbed to default.

REFER TO Annexure B: DCRAs’ Default Experience

4.8 PACRA has prepared TRANSITION TO DEFAULT Summary Reports

for all its defaulted ratings that explain in detail the trajectory adopted by the ratings

right from the time they were initially assigned till the time, the rating ceased to exist.

These publications are available on PACRA‟s website. For illustrated Default

Timelines on each defaulted rating:

REFER TO Annexure C: Default Timelines

HOW TO FACILITATE OPINIONS THAT CAN STAND THE TEST OF TIME

i. Maximizing the information content of ratings: Ratings are opinions

based on facts and assumptions. These opinions have gone wrong in

the past and the future is not going to be any different. However, as

PACRA introspects upon its default experience, its key consideration

is to maximize the value of its ratings, no matter, where they stand on

the rating scale. The valuse of any CRA‟s opinion stems from two

dimensions:

How steadfast they are through the passage of time

How valuable these are in terms of information they

provide at a particular point in time

PACRA, while taking several diverse steps to improve the

perseverance of its opinions, is also, becoming imparting major focus

upon improving the information content of its rating opinions. (i)

Sector alerts, (ii) interim updates on the client (whenever there

arises a material question upon credit worthiness), (iii) demanding

greater issuer participation, (iv) quarterly surveillance of all

clients based on a surveillance criticality scale are just some of the

macro measures taken to address the situation.




INSIGHTS



5. THE BOND

MARKET –

NEXUS OF

RATINGS’

GROWTH

A SCANTY

Landscape

Pertinent Issues

5.1 Growth in the bond market is the NEXUS of ratings‟ business growth. In fact,

when PACRA was established back in the 1990s, expectations for the bond market

taking off in Pakistan were at full throttle. One reason or the other, these never

materialized.

5.2 Until today, the bond market in Pakistan is scanty, as best, as compared to

regional markets.

5.3 The corporate bond market in Pakistan is as follows:

Corporate Bond Market in Pakistan

Total debt Raised 1

Total debt Outstanding 2

Instruments Issues (Nos.) PKR (in Bln)

Listed TFCs 111

38

115.841

66.106

Privately-placed TFCs (PPTFC) 66

48

113.184

87.811

Sukuk (including Govt. Ijara

Sukuk)

57

55

282.054

224.474

Commercial Paper (CP) 30

1

14.862

1.00

Total Debt Issues 264

142

525.941

379.392

Source: SECP 1 Total Debt Raised: As of March 31, 2011 2 Total Debt Outstanding: As of Dec 31, 2011

0 25 50 75 100 125 150 175 200 225 250 275 300 325 350 375 400

China

Hong kong

Indonasia

Japan

Korea

Malayasia

Philipines

Singapore

Thailand

Vietnam

India

Pakistan

Regional Debt Markets (% of GDP)

Govt (in %GDP) Corp (in %GDP) Total (in %GDP)




INSIGHTS



FUELING GROWTH….OFFERING OPPORTUNITY – PERTINENT ISSUES

5.4 PACRA views the following factor as impediments and roadblocks

constricting the growth of the debt market in Pakistan. In its own capacity, it highlights

the issues and proposes ways and means to gear up the growth opportunity for the debt

market in Pakistan:

5.5.1 What goes in the issuance of a bond? Two main considerations for a bond

issuer is: (i) turnaround time, and (ii) cost of issuing the bond. Both these

considerations are unfavorable to bond investors, at present and require the

regulators‟ attention.

5.5.2 Transparency in the secondary market: The bond markets, by virtue of being

populated by large institutional investors, preferring block trades, always lean

towards a “negotiated-deal” OTC structure. This is the case in Pakistan and other

regional and international markets. However, even an OTC structure could be

imparted transparency borrowing from the example of regional markets:

BATS – A dedicated debt market reporting and trading platform: Though, listing on organized exchanges of all bonds is desirable, the

importance of the OTC market for bonds cannot be denied. In regional

markets like India, Thailand and Malaysia, the automated trading platforms

integrated with the major local stock exchanges (on similar, but more

advanced, lines as Bonds Automated Trading System (BATS) have been

developed greatly to act as centralized, one-stop reporting platforms for all

listed and OTC bonds. The idea is to impart transparency to the secondary

market for bonds.

Complete yield-curve benchmarking: Such a platform should

provide price discovery for the entire yield curve by having money market

securities (the CP market) as well as government securities and corporate

debt.

5.5.3 Breaking free of the “investment grade rating‟ psyche: Investors have

traditionally exhibited stickiness with the “A-“ rated bonds despite the mandatory

minimum rating requirement being much lower - “BBB-‘iii

for issuing a TFC for

general public. In order to develop the bond market, this psyche of investors needs

to be modulated.

5.5.4 Generating the all-important liquidity: At present, the very short duration

allowed to mutual funds for redemption (a deterrent for mutual funds)iv and the

regulatory push for issuers to append a put option on retail bonds (a deterrent for

retail bond issuers)v strap liquidly in the bond market through discouraging

investment and supply respectively:

A longer redemption period for mutual bonds is proposed aligned to the

nature of underlying investment – cash funds versus bond funds

A staggered put option or no put option could be considered to

encourage retail bonds issue (by bond issuers) as such bonds are deemed to

widely increase liquidity in the market through retail sector participation.

5.5.5 Pricing benchmarks and mechanisms: At present the valuation of bonds is

carried out by the Mutual Fund Association of Pakistan (MUFAP). However, the

pricing is neither transparent in terms of its methodology, nor indicative of market

conditions. Lack of transparent valuation and pricing is a major deterrent to the




INSIGHTS



growth of the bond market and its illiquid trading and market making. PACRA

appreciates the recent attention SECP is paying towards materializing the concept

of developing an independent bond pricing agency (BPA) in Pakistan.

PACRA, due to its long-standing experience in rating bonds, may play

an instrumental role in the establishment of such an institution. Also, in its

sole capacity or in collaboration with other institutions, PACRA may itself

establish a BPA in Pakistan

In order to avoid and manage any conflict of interest for a CRA also

operating as a BPA, the Malaysian regulator has provided some guidelines.

As per these guidelines issued by the Securities and Exchange Commission

of Malaysia (the pioneer in establishing a BPA with RAM - the major CRA

in Malaysia), a CRA is allowed to enter this business, ensuring

manageability of the ensuing conflict of interestvi

5.5.6 Looking up to the custodian – The Trustee Function: PACRA‟s experience

with bond trustees indicates that the custodial and fiduciary responsibility enodied

with the trustee function has room for improvement:

PACRA proposes closer performance monitoring of the trustee by the

regulator

In order to generate an independent third-parry opinion, a trustee

quality grading product could also be developed by PACRA on similar lines

as an asset manager or a real estate developer is graded

6. PACRA –

CARRYING THE

ONUS OF

LEADERSHIP

PACRA –

through the

years

Ownership &

Governance

Business &

Resources

PACRA - THROUGH THE YEARS

6.1 Pakistan‟s first credit rating agency, PACRA, came into being on June 15,

1994 as a result of a joint venture agreement signed between International Finance

Corporation (IFC)vii

, Fitch Ratingsviii

, and Lahore Stock Exchange.

6.2 At the time of its inception, the business of doing credit ratings was

unchartered waters in Pakistan. Young PACRA, thus, relied heavily upon its technical

partner, Fitch Ratings. However, the Agency was quick to assimilate knowledge, skills

and experience, hence; did not lose much time coming into its own. Nevertheless, the

technical collaboration with a global rating agency ensured that PACRA developed a

high quality rating process that remained intact even after the mutually agreed decision

to terminate the said arrangement.

6.3 Today, PACRA is recognized as a national rating agency by apex regulators of

the country, the Securities and Exchange Commission of Pakistan and the State Bank of

Pakistan. Moreover, eager to play a leading role in the regional context, PACRA is also

one of founding members of Association of Credit Rating Agencies in Asia (ACRAA).

6.4 Being Pakistan‟s premier rating agency, PACRA carries the onus of

leadership. It is poised to uphold its heritage and endeavors to play a psivotal role in

promoting industry best practices and facilitating market knowledge of the use and

benefits of credit ratings. PACRA‟s credit ratings reflect an independent and

professional opinion based on interaction with the client and the Agency‟s own pool of

extensive in-house database and know-how. In essence, PACRA‟s mission is to be

accepted as the leading credit rating agency in the country and the region through




INSIGHTS



highest standards of professionalism and ethics.

PACRA – GOVERNANCE & OWNERSHIP

6.5 Following the divestment of equity stake by Fitch Ratings and IFC in 2003,

Lahore Stock Exchange (Guarantee) Limited, with a stake of over 36%, is the principal

shareholder of PACRA. The remaining shareholding is distributed amongst a group of

professionals.

6.6 PACRA has a board comprising seven members. The majority of the board (5

directors) comprises independent directors. The board meets regularly and proactively

guides and reviews the management‟s strategy.

PACRA – BUSINESS & RESOURCES

6.7 PACRA provides a full range of credit rating services. This includes rating of

entities, bonds, insurer financial strength ratings for insurance companies, asset

manager ratings of asset management companies, stability ratings and star rankings of

mutual funds and grading of real estate developers. To date, PACRA has assigned over

one thousand fifty rating opinions. Its rating universe includes leading banks, leasing

companies, investment banks, insurance companies, asset management companies,

brokerage houses and a large number of industrial corporates operating in almost all

segments of the economy including energy, textile, fertilizer, cement, power,

communication, auto and allied, transportation, and technology.

SIZE OF PACRA CHARTS

6.8 Besides ratings services, PACRA also provides ancillary (non-rating) products

/ services – (i) international technical collaborations, (ii) analytics, (iii) third-party

training, and (iv) sector studies. In the realm of providing such products / services, any

existing and perceived conflict of interest is managed by PACRA through a

comprehensive policy on avoiding and managing conflicts of interest.

6.9 PACRA has recently entered into a technical agreement with National Credit

Ratings Limited (NCR) – a newly established CRA in Bangladesh. NCR has been

awarded the license to operate as a DCRA by Securities and Exchange Commission of

Bangladesh in June 2010. The company has also been recognized as an ECAI (External

Credit Assessment Institution) by Bangladesh Bank (the Central Bank of Bangladesh).

Under the technical collaboration agreement, PACRA provides technical support to

NCR in: a) setting up the rating business, and b) ongoing assistance.

PACRA – INNOVATION, IMPRVEMENT & REINFORCEMENT

6.10 PACRA has experienced significant growth in recent years and the

organizational structure has evolved to keep pace with the requirements of a fast

growing PACRA. With the rating team quadrupled within the last three years, support

functions such as information technology have been strengthened. A separate research

and analytics function has been set up. A business management function is present to

ensure monitoring of work execution in all divisions and generate MIS to aid the

management. Moreover, to promote standardization, PACRA has a dedicated criteria

function.

6.10.1 Organizational Reinforcement: PACRA has taken the following measures

to reinforce the organization in different spheres of activity:

i Ratings: Several support functions such as sector research,

criteria, model building and rating administration are developed at




INSIGHTS



PACRA to provide high-quality in-house support to ratings. Moreover,

inside the ratings department, the hierarchy has been strengthened

though organizing teams with senior analysts and assistant managers

coordinating with the team manager and supervising the junior analysts

ii Research and Analytics: This function provides ancillary (non-

rating) products / services for PACRA. The function is critical in the

sense that it provides diversification benefits for PACRA and reinforces

its brand equity. The idea behind this function is to capitalize upon

PACRA‟s decade-and-a-half accumulated expertise and knowledge for

venturing into risk-related spheres of activity.

iii Business Management: The Business Management Function is

essentially a MIS, monitoring, plan performance appraisal and data

management function. The function aids the management by

generating monthly and periodic MIS in various formats and across

dimensions. It also produces PACRA‟s proprietary intranet-based

publication PACRA DAILY and maintains a database of all ratings.

iv The RC: PACRA‟s RC has the full and final discretion of

assigning all ratings providing the final nod of approval to rating-

related decisions in PACRA. Employing a committee process, the RC

deliberates, develops and delivers a FINAL VERDICT - a completely

independent risk opinion. PACRA has two hierarchies in its RC. There

is the: (i) Apex RC and the, (ii) Team RC. The Apex RC is convened

to evolve a final rating opinion for: (i) Initial rating exercises, (ii)

critical rating exercises (involving significantly high risk of material

change in existing rating opinion and / or a default scenario). The

Team RC is convened to evolve a rating opinion on update-rating

exercises involving typical rating issues. There are permanent as well

as interim members joining both levels of the RC. PACRA‟s in-house

Apex RC is manned by three permanent members. These are: (1) The

Managing Director (MD), (2) the Chief Operating Officer (COO), and

(3) the Advisor. Both the MD and the Advisor are independent RC

members, whereas, the COO also has a major executive role as the

entire rating division terminates into him. Apart from these enduring

fixtures, the RC would have the participation of what are called interim

members. These are:

a) The lead analyst

b) Respective manager ratings, and

c) Either one of the other managers (not directly related to the rating

assignment at hand)

d) Manager Rating Criteria (sitting on RCs that relate to opinion on

criteria related issues, for instance, client appeals against ratings

assigned, recognition of default etc.)

The Apex RC is convened with the presence of at least one of the

permanent RC members along with a variety of interim members. The Team

RC, on the other hand, takes place with a Manager Ratings leading the RC as

its Chairman and may come up with a final rating opinion without the

involvement of the Apex RC. Hence, PACRA‟s RC, on both levels,




INSIGHTS



customarily convenes with five members in attendance. It has a quorum of three

members of which one has to be a permanent member for the Apex RC.

6.10.2 Strengthening the Rating Process:

i Criteria: Criteria at PACRA defines, develops and lays down

standards, policies and practices that govern the “how to” part of ratings

and non-rating businesses. The function is responsible for all criteria-

related activities that form the external face of PACRA in the domain

of policy and standards.

ii RE: This function is primarily responsible for developing rating

models. These rating models constitute the numbers side of the game –

financial statements analyses tools, scoring models. Detailed rating

programs accompany each of these rating models detailing a step-by-

step approach to execute the rating assignment through the utilization of

these models.

iii Training: PACRA has both in-house and external training

programs for strengthening its own human resource and to facilitate

investor education in the outside market. PACRA training courses

have been conducted in Bangladesh as well.

6.11 Multi-market knowledge: PACRA has a vision of facilitating the

development of regional credit rating industry. Thus, PACRA routinely researches and

studies international codes of conduct, credit rating industry regulations and rating

practices on regional and international markets. Moreover, PACRA‟s technical

collaboration arrangement with NCR of Bangladesh has given PACRA an opportunity

to study regional markets in depth.

7. CRUX OF THE

MATTER

For DCRAs –

Attaining a

critical mass

for sustainable

survival

For Investors -

RISK….must

be disclosed

…wherever

public funds

are involved

7.1 The crux of the matter is that an independent risk opinion is an invaluable tool

for investors, lenders and regulators. Despite its limitations, it is always better to have

such an opinion rather than having no opinion at all. As corporates grow in Pakistan

and explore more complex capital structures, the importance of expert credit risk

assessment increases manifold.

7.2 PACRA believes that RISK must be disclosed, wherever public money is

involved. Money exchange companies, real estate developers, hospitals and all

corporates issuing securities to the general public fall under this criteria. A regulatory

impetus is required to facilitate the DCRAs‟ approach into these as yet unrated sectors.

7.3 In international markets, specially, USA and Europe, currently, in the aftermath

of the global crisis, the trend is shifting away from regulator-imposed, mandatory

ratings. References to ratings also are being abandoned in favor of other credit quality

parameters in documents such as bond prospectus and marketing material of issuers.

However, those markets are mature with a high degree of rating penetration that had the

support of mandatory ratings by the regulator for the last several decades.

Expanding the Rating target market

Why is it important……..

For DCRAs For Investors

Achieving a critical mass to Free availability of a wide range of




INSIGHTS



sustain business credit risk opinions

i RATINGS SHOPPING AND ASSET COMPLEXITY: A THEORY OF RATINGS INFLATION; Vasiliki Skreta, Laura

Veldkamp, New York University, Stern School of Business; February 2009 – “When assets are simple, agencies' ratings are similar

and the incentive to ratings shop is low. When assets are sufficiently complex, ratings differ enough that an incentive to shop

emerges. Thus, an increase in the complexity of recently-issued securities could create a systematic bias in disclosed ratings, despite

the fact that each ratings agency produces an unbiased estimate of the asset's true quality”

ii SECP‟s Guidelines for the issue of Term Finance Certificates (TFCs) for general public, issued 20th November, 2002: Clause

12-xi-b CHAPTER IV / General Requirements / Credit Rating: “The issuer shall not change the Rating Agency without prior

approval of the Commission during the tenure of the TFC” AND SECP Directive under the Credit Rating Companies Rules,

1995, issued 17th February, 2005: Clause 4-a OTHER OBLIGATIONS OF (Credit Rating Companies) CRCs: “(The CRC) It shall

not accept a rating assignment where a client has prematurely terminated a rating contract with another credit rating company, unless

it obtains a written no-objection from the previously engaged credit rating company stating the reasons for cancellation of its rating

contract”

iii SECP‟s Guidelines for the issue of Term Finance Certificates (TFCs) for general public, issued November 20, 2002,

CHAPTER II Eligibility, Procedure and Contents of the Prospectus

iv Mutual Fund Redemption Period: 6 working days as per

v Put Option on Retail Bonds: Although, SECP Law is silent on the issue of a put option being a compulsory requirement for retail

bonds; the issuers are generally made to have such an option being offered to the investors whe hey approve SECP for the issue‟s

approval. In the past, the government of Pakistan (WAPDA Bonds and PIA Bonds) has mobilized retail funds without offering a put

option

vi Securities and Exchange Commission, Malaysia GUIDELINES ON THE REGISTRATION OF BOND PRICING

AGENCIES issued January 2006. “Shareholder requirement: Where a shareholder is a financial institution or a credit rating

agency that is able to exert significant influence over the applicant, there must be adequate segregation of management and

operational resources between the applicant and the financial institution or credit rating agency, as the case may be, to ensure full

independence of the operations of the applicant… Due process for bond pricing: Where a credit rating agency is also a shareholder

in the applicant, the applicant must only use publicly available credit information in arriving at the fair prices for bond issues rated

by that credit rating acy”

vii IFC: A member of the World Bank Group and the largest multilateral source of loan and equity financing for private sector

projects in the developing world

viii Fitch Ratings: The world‟s leading international rating agency. At the time of its inception, PACRA began with a technical

collaboration agreement with IBCA – a London based rating agency that was later on taken over by Us rating agency, Fitch, in 1998

and became Fitch-IBCA. Following the merger, the challenge was to raise Fitch-IBCA to a position alongside Moody's and

Standard & Poor's, the two US-based agencies that dominated the global market. A major step forward in meeting this challenge was

taken in April 2000, with the takeover of Duff & Phelps, the fourth largest rating agency and Thomson Financial Services Bank

watch subsidiary (specialized in financial institutions and ranked No. 5 in the ratings market, with a fairly strong presence in Asia.

On completion of these transactions, the four agencies were merged to form Fitch Ratings.

Analysts Humaira Jamil

+92 42 3586 9504

[email protected]

Shahzad Saleem

+92 42 3586 9504

[email protected]

Disclaimer:

PACRA has used due care in preparation of this document. Our information has been obtained from sources we consider to be

reliable but its accuracy or completeness is not guaranteed. PACRA shall owe no liability whatsoever to any loss or damage

caused by or resulting from any error in such information. None of the information in this document may be copied or otherwise

reproduced, stored or disseminated in whole or in part in any form or by any means whatsoever by any person without

PACRA‟s written consent. Our reports and ratings constitute opinions, not recommendations to buy or to sell

credit rating agencies introspection inferrence … · 2012-07-09 · the pakistan credit rating...

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