A Market Built on Not Knowing
Every market assumes both sides roughly understand what is being traded. The bond market enjoys no such comfort. A company issuing debt knows its own balance sheet with a precision no outsider can match. It knows which receivable will never arrive, which subsidiary is quietly being kept alive by another, which repayment is being met with fresh borrowing rather than cash from operations. The investor knows what the company has chosen to publish, filed on time, in a format designed by people the company pays.
George Akerlof's 1970 paper on the used car market gave this problem its name. When buyers cannot distinguish good from bad, they price for the average, good sellers withdraw, the average deteriorates, and eventually the market unravels. Applied to debt, the logic is severe. If lenders cannot tell a solvent borrower from a doomed one, they charge everyone the doomed rate, and the solvent borrower stops issuing.
Economics offers an elegant repair. Insert a third party whose entire commercial value rests on being right about the other two. Let it examine the books, assign a grade, and stake its reputation on that grade. Reputation becomes the collateral. Get it wrong often enough and nobody buys your opinion again.
This is the credit rating agency, and on paper it is a beautiful institution. In practice it introduced a second asymmetry roughly as large as the one it was hired to close, and then charged rent on it.
The Small Matter of Who Signs the Cheque
Ratings were once sold to investors. Subscribers bought the manuals, the agencies wrote for them, and the incentive ran in the correct direction. That arrangement collapsed in the 1970s, partly because photocopiers made subscription revenue difficult to defend. The industry migrated to the issuer-pays model, in which the company being judged retains and compensates the judge.
Consider what this does to the incentive structure. The agency's revenue depends on issuance volume. Issuance volume depends on issuers choosing that agency. Issuers choose the agency that is likely to be generous, and since a preliminary conversation costs nothing, they can canvass opinion before committing. The polite term is rating shopping. The result is that competition among agencies, normally the thing that disciplines a market, here degrades quality. More referees simply means more chances of finding one who likes you.
None of this requires anyone to be corrupt. It requires only that analysts, over years, absorb which kinds of judgements generate friction with the commercial side and which do not. Institutions do not need instructions to learn what is unwelcome.
Case Study: Twenty-Five Days in 2018
Infrastructure Leasing and Financial Services was, for three decades, the least controversial name in Indian infrastructure finance. It was systemically important, quasi-official in character, and shareholder-listed to a roll call of institutions that do not ordinarily associate themselves with disasters: LIC held over 25 per cent, Japan's ORIX around 23 per cent, the Abu Dhabi Investment Authority, HDFC and Central Bank of India between them a further 29 per cent.
It was also enormous and largely unreadable. As of October 2018 the group comprised 348 entities. Forensic auditors would later count 24 direct subsidiaries, 135 indirect subsidiaries, six joint ventures and four associates. Its consolidated borrowing as at 31 March 2018 exceeded ₹91,000 crore. The opacity was not incidental to the business, it was the architecture of it.
The agencies rated this structure AAA, the highest grade available, and those ratings held until June 2018.
This was not for want of visible warning. In a March 2018 note, ICRA acknowledged that the company was very highly leveraged, with a debt to equity ratio above 13:1, while praising its experienced management and infrastructure track record in the same document. India Ratings had assigned a negative outlook to IL&FS Transportation Networks in June 2016, an action that conventionally signals a downgrade within twelve to eighteen months, and then took no rating action at all for the following twenty months.
The unravelling, when it came, was brisk. ITNL defaulted on commercial paper and had its long-term borrowings cut to sub-investment grade in July 2018. The agencies nonetheless maintained good short-term grades on ITNL's paper and reaffirmed the parent's top rating. In August 2018 IL&FS was moved from AAA to AA+, a single notch, the rating equivalent of clearing one's throat. On 8 September it went to BB, junk, with commercial paper at A4. On 17 September, after the group had defaulted on commercial paper and inter-corporate deposits due on 14 September, it was cut to D.
AAA to default in roughly twenty-five days. At the moment of that final downgrade, the securities carrying these ratings amounted to ₹11,725 crore rated by ICRA, ₹16,270 crore by India Ratings and ₹20,942 crore by CARE.
A rating is meant to be a forecast. This one functioned as an obituary.
Why Anyone Believed It
The instinctive response is that professional investors should have done their own work. Many were not permitted to. Ratings are not merely advisory in India, they are wired into the regulatory plumbing. Bank capital requirements scale directly with the borrower's rating, with risk weights notched at 20, 30, 50, 100 and 150 per cent, so a AAA borrower consumes a fraction of the capital a BB borrower does. Insurance and provident fund mandates restrict holdings by rating grade. Debt mutual fund schemes are constructed around them.
When IL&FS collapsed, debt schemes at HDFC, UTI and Aditya Birla Sun Life were caught holding exposure to group special purpose vehicles. The state had, in effect, outsourced credit assessment to three private firms and then instructed the entire savings system to defer to the answer. That is not investor laziness. That is a regulator manufacturing demand for a product whose incentive structure it declined to examine.
What ₹1 Crore Buys
SEBI's verdict, when it arrived, was unusually blunt for a regulator. In December 2019 it found that the default had occurred through what it described as "lethargic indifference and needless procrastination and laxity" on the part of the agencies, and fined each of ICRA, CARE and India Ratings ₹25 lakh.
Twenty-five lakh. Against tens of thousands of crores of mispriced paper.
The regulator subsequently agreed that this was inadequate, and in September 2020 raised the penalty to ₹1 crore each, noting that a rating agency functions as a financial gatekeeper and that the earlier order had failed to weigh investor losses. One crore, set against ₹20,942 crore of CARE-rated securities, is a penalty of roughly five thousandths of one per cent. As deterrents go, this is closer to a parking ticket than a sanction.
The Repairs, and the One Nobody Made
SEBI's substantive reforms were sensible. From November 2018, agencies were required to analyse issuer liquidity deterioration, account for asset-liability mismatches, and treat sharp deviations in bond spreads as material events. From June 2019 they had to publish standardised probability of default benchmarks, disclose liquidity as superior, adequate, stretched or poor, and include an explicit rating sensitivity section identifying what would trigger a change.
Every one of these addresses methodology. Not one addresses payment. The issuer still selects the agency, still pays the agency, and still holds the option of not returning next year. The referee's methodology has been improved considerably. The referee is still on the home team's payroll.
Information asymmetry was never eliminated in Indian credit markets. It was relocated, professionalised, and given a rating scale.