The market for risk opinions on loans and debt instruments in India is roughly ₹1,000 crore, or $150 million. That is a bit of a surprise, considering that in the US, the rating industry is worth roughly $11 billion, for an economy that is worth around $17 trillion, in nominal terms. India, at $2 trillion, represents a little less than a fifth of that and, thus, its rating industry should be at least eight times the current market size.
Looked at from another perspective, it is not such a surprise as the Indian public and corporates alike are rather credit-averse, preferring to use own resources to finance their consumption/ investments. But what must occasion surprise is the domination of the market by just four players, as is the case in the US. Indeed, one could go so far as to say that this trend is broadly reflective of the state of play in the global arena where three or four players account for 95 per cent of the total volume of business.
This raises a larger question: Why is the market for assessment of credit risk so oligopolistic in structure? As a knowledge industry with minimal capital requirement, it should have seen the entry of a lot more players and become a vigorously contested area. One need look no further than the Indian software industry, which features a large number of players big and small, operating in their own little niches. Nasscom, the software industry association, boasts of over 7,000 member firms, competing for a $70-billion market growing at 15 per cent annually.
Formidable challenges
The auditing profession, the function of which is not dissimilar to that of the credit rating industry, is another sector where competition is quite intense. Although exact data on the value of auditing and other professional services rendered by them is not readily available, it is easy to gauge the level of competition from one simple statistic: There are roughly 1,15,000 auditing professionals rendering an opinion on the financial state of affairs of roughly eight lakh incorporated companies, big and small.
Strategic management literature has looked at what makes some industries present formidable challenges for new entrants, becoming the preserve of only a chosen few. Some years ago, the Harvard Business Review published an article that identified a number of factors that could potentially act as stiff entry barriers for new entrants in an industry. It identified 12 factors, such as proprietary knowledge, scale of operations, and so on.
However, a closer analysis reveals that none of these really apply in the context of thwarting the entry of new players into the credit rating industry. For instance, there seems to be no single critical piece of proprietary knowledge that dictates dominance among rating agencies — the way it does in, say, the automotive industry.
No unique advantage
Toyota is credited with exclusive proprietary knowledge in the electrical drive system of its brand of hybrid cars, such as Prius, that experts concede is an advantage that even other established car manufacturers find difficult to replicate, leave alone someone who is completely new to the business. So, as long as there is a demand for hybrid vehicles, Toyota will always be a difficult competitor to dislodge until someone comes up with a technology that is on par with or superior to what Toyota possesses.
But it is clear that no such technological edge operates to the advantage of the three or four risk assessment players. While they may claim to employ some unique model of appraisal of credit risk, the financial and operational parameters that go into judging the degree of risk are now fairly well settled. So, one can safely rule out any proprietary knowledge that gives incumbent players any advantage in their business.
Similarly, though rating agencies do enjoy a scale of operation, it is rarely an advantage in the way scale confers advantage in mass manufacturing. An IKEA can keep the prices of the furniture it sells competitive through manufacturing cost-efficiencies stemming from its well-diversified and large facilities spread across the world. But credit rating doesn’t lend itself to mass manufacturing as no two debt instruments can be treated as identical.
One can, similarly, examine other parameters that confer advantages to the existing players and end up acting as entry barriers to the new entrants. But none of these apply with any degree of force in the business of appraising credit risk.
User doesn’t pay
What, then, explains the oligopolistic nature of the credit rating industry, practically all over the world? Principally, two factors. One, the regulatory framework itself imposes an entry barrier. In India, for instance, individuals cannot set themselves up as professionals rendering a service of appraising credit risk. The entity will have to be a company with a minimum paid-up capital of ₹5 crore.
In contrast, a person can set himself up as an auditor to render a professional opinion on whether the financial statements (profit and loss account and balance sheet) of a company reflect a ‘true and fair view’ of the state of affairs. The only requirement under law is that the person should be a member of the Institute of Chartered Accountants of India, having passed the qualifying exam for admission as one of its members.
By far the most serious impediment to entry of new players is the peculiar nature of the business where the consumer of credit risk information and the person paying for the services are two different entities. The consumer of such information is a prospective investor. But he/she has no direct contractual relationship with the rating agency.
The issuer of a debt instrument — who is interested in raising money from the investor — pays for the rating service. The incentive structure is skewed in such a way that neither of them is interested in trying out a new player as part of a larger objective of getting more value for money. Unless regulators, who have been grappling with this conundrum all these years, find a way out of this predicament, the industry is set to continue to operate with a structure (stiff entry barrier for new entrants) as at present.
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