KAAND: The Rating Agency Kaand TACTIC: AAA yesterday, default tomorrow — how credit ratings are managed not earned
THE TACTIC IN ONE PARAGRAPH Credit ratings are not predictions of solvency but negotiated outcomes. The mechanism is simple: a borrower pays a rating agency to assess its debt, then shops around for the highest possible rating by threatening to take its business elsewhere. The agency, incentivized to retain the client, assigns a grade that balances statistical risk with commercial pressure. The borrower then uses this inflated rating to raise cheaper debt, often from banks or mutual funds bound by regulatory mandates to invest only in "investment-grade" paper. When the borrower defaults, the rating agency claims it was merely an opinion, shielded by disclaimers. The system is designed to fail investors, not the rated entity. A smart 22-year-old would think of IL&FS, DHFL, and Yes Bank—all rated AAA until they weren’t.
HOW IT WORKS IN INDIA SPECIFICALLY India’s regulatory architecture makes this tactic particularly potent. First, the Reserve Bank of India (RBI) mandates that banks and mutual funds invest only in securities rated "investment grade" (BBB- or higher). This creates artificial demand for high ratings, as borrowers without them are locked out of institutional capital. Second, the Securities and Exchange Board of India (SEBI) regulates rating agencies but does not cap their fees, allowing borrowers to pay agencies directly—a clear conflict of interest. Third, the Insolvency and Bankruptcy Code (IBC) prioritizes speed over recovery, meaning lenders often accept haircuts of 60-90% on defaulted debt, reducing the cost of misrating. Finally, India’s judicial system moves slowly, allowing promoters to delay recovery proceedings for years, further insulating rating agencies from accountability. The gap between RBI’s oversight of lenders and SEBI’s oversight of rating agencies ensures no single regulator bears responsibility for systemic misrating.
THE HISTORICAL RECORD The IL&FS collapse in 2018 was a masterclass in this tactic. The group’s commercial paper, rated AAA by ICRA, CARE, and India Ratings, defaulted on ₹91,000 crore of debt. The rating agencies had downgraded the paper only after the defaults began, despite clear signs of liquidity stress for months. A parliamentary committee later noted that the agencies had "failed to exercise due diligence" and that their "conflict of interest was glaring." The perpetrators—IL&FS’s promoters—faced no personal liability; the victims—mutual funds and retail investors—recovered less than 30% of their money.
In 2019, Dewan Housing Finance Limited (DHFL) defaulted on ₹90,000 crore of debt, despite being rated AA+ by CRISIL and CARE just months earlier. The agencies had ignored DHFL’s reliance on short-term commercial paper to fund long-term loans, a classic asset-liability mismatch. When the defaults began, the ratings were slashed to D overnight. The National Company Law Tribunal (NCLT) later found that DHFL’s promoters had siphoned funds through related-party transactions, but the rating agencies faced no penalties. Investors, including pension funds, lost billions.
In 2020, Yes Bank’s AT1 bonds, rated AA by India Ratings, were written down to zero as part of a bailout. The rating agency had failed to flag the bank’s deteriorating asset quality, despite RBI’s repeated warnings. The bonds, sold to retail investors as "safe," were wiped out overnight. The rating agency later claimed it had relied on RBI’s regulatory filings, absolving itself of responsibility.
THE INSTITUTIONS THAT ENABLED IT Rating agencies are the most visible enablers, but they do not act alone. Banks, bound by RBI’s "investment grade" mandate, lend against inflated ratings without conducting independent due diligence. Mutual funds, regulated by SEBI, are required to hold only highly rated paper, creating captive demand. Auditors, appointed by the borrower, sign off on financial statements that understate leverage or overstate cash flows. Boards, often packed with promoter-appointed directors, approve related-party transactions without scrutiny. Regulators—RBI, SEBI, and the Ministry of Corporate Affairs—conduct post-mortems but impose no meaningful penalties. The Insolvency and Bankruptcy Board of India (IBBI) ensures lenders recover pennies on the rupee, reducing the cost of default. The system is designed to protect the rated, not the rater.
THE CURRENT STATE Nothing has changed. SEBI’s 2020 regulations require rating agencies to disclose "rating shopping" (when a borrower approaches multiple agencies for the best grade) but do not ban the practice. The RBI’s 2021 guidelines on "expected loss" provisioning for banks are a step forward but do not address the root conflict: agencies are paid by those they rate. The IBC remains a recovery mechanism, not a deterrent. The tactic continues because the incentives remain unchanged. Borrowers still pay agencies, agencies still compete for business, and investors still bear the risk.
WHAT TO WATCH FOR First, look for frequent rating changes—especially upgrades followed by sudden downgrades. This suggests the agency is reacting to events, not predicting them. Second, check if the borrower is paying the rating agency directly. SEBI filings disclose this; if the fee is a significant portion of the agency’s revenue, the conflict is structural. Third, examine the borrower’s related-party transactions. If the company is lending to or borrowing from entities controlled by its promoters, the financials are likely being managed to secure a high rating. These are not red flags; they are the playbook.
This newsletter describes documented business tactics and systemic patterns based on public records, regulatory orders, and published financial journalism. It does not make allegations against any individual or entity. Readers are encouraged to consult primary sources and form their own conclusions.