A business model for rating agencies: learning from the CRISIL experience

Roopa Kudva Managing Director and Chief Executive Officer CRISIL

June 16, 2010

Key Messages
Measures of effectiveness of business model for credit ratings
High-quality and accurate credit ratings Widespread availability of credit ratings

Three possible models

Each has advantages Each also has potential risks

The issuer-pays model has worked well in India

The market lacks organized large bond investors As in any model, strong safeguards and processes are needed to manage conflicts of interest
India benefited from its strong regulatory framework

Other lessons from CRISILs experience

Bond rating revenues may need to be supplemented through complementary businesses Ratings not being the sole source of revenues or profits helps rating agencies to maintain their independence
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Presentation Flow
Background: what credit ratings are The framework for evaluation An evaluation of the business models
The issuer-pays model The investor-pays model The government-pays model and its variants

How CRISILs model evolved

The challenges of being a pioneer The need for revenue diversity

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Background: What Credit Ratings Are

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What Credit Ratings Are

Alphanumeric symbols indicating a scale of creditworthiness for a security, issuer, or borrower
AAA, AA, B, etc.

Usually indicate probability of default or expected loss Not recommendations to buy, sell, or hold rated securities
Other considerations would enter into the decision, e.g. price, investors preferred risk profile

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Why Markets Need Credit Ratings

Not all investors have the ability or resources to carry out a thorough credit analysis of all available debt securities
Broadens the investable universe for the average bond investor

Allows large numbers of issuers to competitively access funding at a low transaction cost A rating is an easy-to-understand opinion from an independent party
Establishes a common currency across market participants Allows specification and measurement of capital adequacy and capital allocation in a transparent manner

Publicly available credit ratings add to the information and research available about companies and securities
Allow market participants to make better-informed decisions
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The Framework for Evaluation

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What to Look for in a Business Model

Credit ratings should be of high quality, and should be accurate
Should accurately measure creditworthiness Should be the product of a strong and independent process

Ratings should be widely available to all market participants

The principal benefit of ratings today is that they are freely available to the market as a whole This benefit would be lost if ratings were available by subscription only Smaller investors would be hit the hardest

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The Models Examined

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The Issuer-pays Model

Benefits:
Free availability of ratings. Investors can compare the credit quality of a wide array of instruments, choose the ones that best fit their risk preferences, and continuously monitor the credit quality of their investments Access for rating agencies to high-quality information Keeping the cost to the system low

Potential risks:
Potential for conflicts of interest. Strong mechanisms are needed for managing these, including
Multilevel rating processes Strict separation of the analytical and marketing functions Delinking compensation from level of ratings

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The Investor-pays Model

Benefits:
Freedom from possibility of issuer pressure

Potential risks:
Conflicts of interest in the opposite direction. Rating agencies could face pressure from investors to give lower-than-warranted ratings so that yields can be higher, and to not downgrade once rated so that mark-tomarket losses can be avoided Dependence on public information for ratings, given the absence of a relationship with the entity being rated Taking ratings out of the public domain, since ratings would be available only to investors who agree to pay for them

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The Government-pays Model (and its variants)

Benefits:
No structural incentive for bias in either direction

Potential risks:
Moral hazard. Ratings that are paid for by government or regulators can be seen to have an official approval or even amount to a payment guarantee Guaranteed business for rating agencies. Since government cannot be seen to be favoring any party, all empanelled agencies will be guaranteed business, removing any incentive to demonstrate analytical rigor or to update and improve criteria and processes

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Which Model Works Best?

Modern financial markets have overwhelmingly used the issuerpays model The investor-pays model fell out of favor during the 1970s, although there have been efforts to revive it The government-pays model variants have so far not been tried except in pockets; too early to say if it works Each model has its strengths and weaknesses, and there is room for all three to coexist

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The CRISIL Story: How It All Happened

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CRISILs Growth from 1994 to 2009

Rev INR Mn 6,000
Total Rev Int Rev PBT
1,875

PBT INR Mn
2,075

2,500

5,000 4,000 3,000 2,000

314 355 802 1,106

2,000

1,500

1,000

1,000
54 86 120 127

154

208

192

127

272

268

281

500

1994 Total Rev Int Rev PBT 90 1 54 1995 126 0 86 1996 183 3 120 1997 238 2 127 1998 323 3 154 1999 364 12 208 2000 340 4 192 2001 441 20 127 2002 685 40 272 2003 714 37 268 2004 854 143 281 2005 1,193 365 314

2005 (9M)* 1,405 660 355

0
2006 2,873 1,705 802 2007 4,043 2,629 1,106 2008 5,146 2,823 1,875 2009 5,603 2,911 2,075

Year Headcount

1994 141

1995 161

1996 191

1997 182

1998 205

1999 197

2000 202

2001 368

2002 370

2003 394

2004 496

2005# 638

2005^ 1155

2006 1484

2007 1750

2008* 1956

2009 2164

#Up to 2005 CRISILs reporting year was April to March ^2005 was a nine month year from April to December 2005 *Majority stake in Gas Strategies sold on 10th Dec 2008
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The Beginning: Credit Rating? Wont Work in India!

No bond market Directed lending Absence of market-determined interest rates Zero interest from global rating agencies Grudging acceptance from domestic issuers and investors What CRISIL Did Built credibility
Ensured that opinions put out were independent, objective, and reliable

Developed awareness
Outreach with regulators, borrowers, users, intermediaries

Entrenched itself to benefit from the growth that it anticipated

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1991 2001: Building a Robust Business

Rapid economic growth post liberalization, followed by a slowdown Deterioration in corporate credit quality Collapse of many nonbank lenders These were anticipated by a spate of downgrades from CRISIL Credit Rating agencies in India were regulated starting 1999

What CRISIL Did

Refused to dilute standards despite loss of business
Market share in ratings plummeted below 40% CRISIL believed that business would eventually come back if it continued to put out credible ratings, focused on criteria and processes Focused on key intermediaries and investors, to address the move to private placements

Incubated and built up infrastructure policy consulting business

Growing competition, shallow market in ratings

Moved strongly into research

Acquired Indias leading industry and company research provider

Initiated global tie-up to access best practices, attain scale

MoU with S&P (later evolved, through an equity investment, into a majority holding)

Went public
CRISIL has never borrowed Comfortable with transparency and exposure that a public listing entails
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Timely Rating Changes: Rating Actions and Market Share

Rating changes and market share
1.2 71 1.0 59 60 69 65 72 70 70 80

Modified Credit Ratio

0.8

50 0.6 1.1 0.4 0.7 0.6 0.2 1.1 0.9 0.9 1.0 0.9 1.0 1.1

40 30 20 10

0.0 FY 1995 FY 1996 FY 1997 FY 1998 FY 1999 FY 2000 FY 2001 FY 2002 FY 2003 FY 2004 Modified Credit Ratio Market Share in ratings business (%)

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Market Share (%)

48

50

2002 Today: More Diversification, Explosive Growth

Rating actions in the 1990s built up CRISILs credibility in the credit ratings space
CRISIL today is the unquestioned leader in the Indian market

Opportunities: application of Basel II guidelines, growing sophistication of SMEs

Opened up a huge market for ratings

Indias rating agencies and its CRA regulations have served the market well
Subprime crisis and its fallout have had relatively little effect on the industry in India

Rapid evolution of Indias markets and capabilities have opened up myriad business opportunities

What CRISIL Did

Adhered strongly to values, reinforced processes Focused on outreach and transparency in ratings business
To maintain franchise with investors, regulators a key source of competitive advantage

Stayed hungry for growth

Acquired and built up Irevna, now the leading knowledge process outsourcing player in the financial space Set up research and analytics offshoring for Standard & Poors Aggressively created market for independent equity research and funds research
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www.crisil.com www.standardandpoors.com

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