Credit rating, audits, and the African environment I

Credit rating agencies
Historically as well as in the present day, credit rating agencies have played an important and central role in evaluating the financial behavior of businesses and enabling loans. Nonetheless, they are vulnerable to criticism. There are question marks, too, over their ability to serve Africa and its developing world of business.
Conflict of interest
In a commercial context, a credit rating is a score given to a business or individual. It provides an estimate of that business or individual’s credit-worthiness. In other words, if a bank is asking the question “how safely can I give a loan to X?”, a credit rating agency attempts to provide an answer. However, since credit rating agencies are paid by the very institutions and businesses who they provide ratings for, it is widely believed that they are vulnerable to a conflict of interest.

Credit rating agencies are vulnerable to a conflict of interest.
Gaining a strong credit rating puts a business in a good position to gain favourable loan agreements. They are therefore motivated to get a high credit rating, and this may manifest itself in businesses seeking to employ credit rating agencies that will provide them with one. The outcome is that rating agencies may feel under pressure to provide charitable credit ratings in order to keep business and maintain their revenue.
Staff at Moody’s were pressured into giving favourable ratings in order to boost the agency’s revenue.
This conjecture is supported by a confession from William Harrington, a former senior president at Moody’s, one of the ‘big three’ worldwide credit rating agencies. In 2011, Harrington admitted that a conflict of interest does exist. He added that the compliance department at Moody’s “actively harasses analysts viewed as ‘troublesome’”, while “lenient voting” was rewarded. In other words, staff were pressured into giving favourable ratings in order to boost the agency’s revenue from big, loyal clients. Senior figures in the industry do, of course, deny the existence of a conflict of interest. The Chief Credit officer at Moody’s, Richard Cantor, insists that commercial activities and rating activities are “completely separated”.
Evidence of bias
While it is difficult to arrive at any concrete position as to whether or not credit rating agencies are corrupted by their inherent conflict of interest, a study by Baghai and Becker, reported by Money and Banking, looked at Indian agencies who are now required by law to disclose their sources of revenue and the corresponding amounts.

The findings of the study cannot be unequivocally extrapolated to a global scale. However, “financial institutions [in India] are relatively similar to those found in the OECD”, “the role of ratings in India is similar to their role elsewhere”, and the leading Indian rating agencies are majority-owned by the same big three agencies as globally. Therefore, Baghai and Becker’s findings do provide a useful insight into the dangers of the conflict of interest and support widespread scepticism surrounding the behaviour of credit rating agencies.
Clients paying for non-rating services were more likely to default on their loans within a year.
Ratings are graded AAA (highest creditworthiness), AA, A, BBB, BB, B, C, and D. With many agencies providing other, non-rating services, Baghai and Becker found that clients paying for non-rating services, and therefore contributing more to the agency’s revenue, generally received higher credit ratings by an average of 0.3 grades, or 3.75%.
They also found that “issuers tend to obtain higher ratings the more non-rating revenue they generate for an agency”. In other words, a general rule appeared: paying a credit rating agency more for non-rating services was conducive to getting a higher credit rating. Perhaps the most shocking revelation was that clients paying for non-rating services were more likely to default on their loans within a year. This clear bias (or rather, corruption) does not shine a positive light on the credit rating industry.
Difficulties in Africa
In order to create a score or rating, agencies look primarily at a business’s past performance history and its financial records. Africa, with its high number of young, emerging markets, which hardly replicate those in the West, is particularly unsuited to such a methodology.

Credit ratings neglect the importance of the informal sector to Africa’s economy. The International Labour Organisation reports that the average size of the informal sector as a percentage of GDP in Sub-Saharan Africa is 41%, reaching 60% in Nigeria, Tanzania and Zimbabwe. It also accounts for around 72% of employment in Sub-Saharan Africa.
Unbound by standard accounting practices, businesses in the informal sector usually do not posses the income statements, balance sheets and other financial reports that credit rating agencies use to generate a rating. As a result, an enormous and critical portion of Africa’s economy has limited access to credit.
Almost 40% of adults aged 18 to 64 in Nigeria and Zambia were starting a business or had been running one for less than 3.5 years in 2014.
Another clear problem posed by the the African context with regards to credit rating is the age of companies. Home to many emerging markets, Africa has a high proportion of young businesses. The future economic development of the continent is looking more and more reliant on startups. In particular, the dense market, startup culture (87% of the population believe they have the required skills and knowledge to start a business) and 4G network in Nigeria have enabled a rapid growth in the number of businesses in the country over the last few years. According to CNN, almost 40% of adults aged 18 to 64 in Nigeria and Zambia were starting a business or had been running one for less than 3.5 years in 2014.
Where credit ratings are concerned, these young businesses are often unable to prove their ability to withstand business cycles and stress scenarios. Rating agencies are also less capable of judging the earning power of such young companies. They do not have the necessary experience, and therefore evidence, under their belts.Credit rating agencies are simply unsuited to the particularities of Africa’s emerging economies.
Credit rating agencies are simply unsuited to the particularities of Africa’s emerging economies. We should look to new technologies in search of alternative methods of establishing creditworthiness. Find out more in ‘Credit rating, audits, and the African environment III: potential solutions’.
Originally published at FiftyFor.
