Credit ratings have become so well-known that if I asked, "Do you know what credit ratings are?" even students would say, "Of course, I do." But I think there are many crucial things that people don't know about credit ratings. If we're talking about the credit ratings of major companies, then you may feel like you know about them just by reading Japan's leading financial daily, the Nikkei Shimbun. But there are only several hundred major companies in Japan, and only about 10,000 publicly listed companies in the country. Do you know about the credit ratings and how credit records are made for the 3 million other enterprises in Japan?
This column is a Q&A sheet about corporate credit record databases written for the general public, not professional company researchers. I have chosen topics that are never covered in books, magazines and newspapers.
For those of you working in the finance industry, please skip over this document as I'm sure it will bore you.
Q.1
I'd like to research corporate credit data from sources other than credit
agencies. Who should I contact?
A.1
In the case of the private sector, there are effectively only two private-sector
firms that provide credit records, excluding the credit record databases at
financial institutions.
If you think in terms of credit records for the entire nation or all industries, Teikoku Databank, Ltd. and Tokyo Shoko Research, Ltd. are the only two firms recognized as private corporate credit research companies in Japan. Most business owners have little to gain from being researched by credit record companies. Therefore, many of them seem to believe that it's okay to ignore - actually they firmly believe that they should reject - private corporate credit research companies other than these two top-ranked firms in the industry. Private credit research companies ranked third and lower in the industry are recognized by society as "credit agencies." Therefore, I don't think any decent manager would disclose financial information to such companies.
But it's difficult to generalize because there are private credit research companies that specialize in specific prefectures or industries. In addition, financial institutions develop their own corporate credit record databases on their own or jointly with other companies. However, I don't think these institutions would disclose financial data to an individual who calls for information.
I said earlier that corporate credit data is concentrated in the industry's top two credit record companies, but many people misunderstand and think that credit-rating agencies that rate major enterprises would also have information on small to medium sized enterprises. In other words, people want to know if Japanese rating agencies like Rating and Investment Information, Inc. and Japan Credit Rating Agency, Ltd., or U.S.-based rating agencies like Moody's Japan K.K. and Standard & Poor's can be sources of credit information. Well, you should expect the answer to be, "no." For example, Standard & Poor's gives credit ratings to small and medium sized Japanese enterprises that make between 1 billion to 10 billion yen in annual sales. However, according to Standard & Poor's web site, only 50 companies have obtained credit ratings from the company between December 2005 - when the company began giving credit ratings to small and medium sized Japanese enterprises - and November 2006. In other words, unless companies have a particular reason for obtaining credit ratings - for example, they're preparing to go public, issuing bonds and debentures, or their bank asked them to obtain a credit rating - they won't actively seek to disclose their financial results unless they are very good-natured, or are trying to look better than they actually are. The truth is, even Moody's, S&P, R&I or other credit rating agencies completely ignore credit information for most unlisted companies or small to medium sized enterprises.
As a simple example of how closed this industry is, the Ministry of Justice's Legal Affairs Bureau - despite being a public office - has two baskets dedicated to Teikoku Databank and Tokyo Shoko Research.
Q.2 How do private-sector corporate credit research companies do their research to collect information for their corporate credit record databases?
A.2 I will mention three methods, but one of them will be discontinued starting 2006.
There are many books on this topic, and I believe the small to medium sized enterprise assistance centers at local government offices can answer a lot of questions. Private corporate credit research companies basically have three research methods: (1) Go to the Legal Affairs Bureau and view the target company's certified copy of commercial registration (2) Go to the local tax office where the target company files taxes, and look through the disclosed information on corporate tax payments, and (3) Conduct their own direct research.
First, a company's "certified copy of commercial registration" can have information on when the company was founded, the company's location, board of directors and other information. But reliable companies typically disclose that kind of information actively on their web sites under "corporate overview" or publish such information on pamphlets. So checking a company's certified copy of commercial registration is not so much for obtaining new information, but rather for double checking facts. When corporate credit researchers look at certified copies of commercial registration, their biggest concern is the Board of Directors' list. If the name of the president on the certified copy of commercial registration is different from the actual person running the company, the company could be preparing for a bankruptcy. (If the wife's name is registered as the president, this would be a prime example.) If a company's entire board of directors has been replaced, it might be a suspicious entity where a dormant company was purchased and established as a new one. If a person with a bad reputation is on the board of directors, the company may get involved in a criminal case. If the company has transfers of claims, it is sure to collapse. You learn these things early on if you work at a financial institution. But you can't get financial data through methods like this.
Next, disclosed information on corporate tax payments refers to the disclosure system for high-income companies. Companies must file their income taxes with their local tax offices within two months after their fiscal period (usually 12 months) ends. In the case of Numerical Technologies, our fiscal year ends in March so we have to file taxes by the end of May. Until April 1, 2006 - when a partial legal revision to the income tax law was implemented - there was a system where companies that posted more than 40 million yen in revenue a year (or 20 million yen in revenue over a six-month period) had to disclose their income because they were considered high-income companies. (The law has since been abolished.) This is about the only financial data that is accessible to the public at a public institution. But this reveals only the income that the company filed under tax laws. The figures don't match with the pretax profit on the company's books. And you cannot get basic financial information such as sales or detailed breakdowns. And obviously, you can't obtain information on unprofitable companies that are not recognized as high-income companies. In addition, companies could try and avoid this disclosure system by underreporting their income and later making revisions to their tax payments. This means you can only obtain financial information on less than 10 % of the roughly 3 million companies in Japan. (Less than 70,000 firms as of 2006.) To be more outspoken, a high-income company merely means a company with large cash flow. In other words, young growing companies tend to be high-income companies but don't necessarily have much savings. So the equation of high-income companies "having a lot of savings=having money=having a high credit rating" doesn't always work. So it's accurate to think that the so-called rich (high credit rating) executives are not always the same as the high-income (high-growth) executives. Diamond Inc. publishes a filed-corporate-income ranking as a separate issue from its weekly business magazine called Shukan Diamond. The ranking is based on basic data obtained under this disclosure system. Because of the abolishment of the disclosure system, Diamond is reportedly going to publish its final edition of "filed-corporate-income ranking" in 2006.
Finally, let's look at direct research. The only way to obtain a company's financial results may be to contact the companies directly. In other words, corporate credit research companies do many things like dispatch workers to visit the target company or send them survey sheets (I have displayed a photo of a sample below) and have the companies fill them out. Please read the answer to Q3 about this direct research as well.
 A full set of survey sheets sent to Numerical Technologies. (Click to enlarge) |
 A corporate credit research survey form (Click to enlarge) |
Q.3 Now I know that the only way to obtain financial data from companies is to
conduct direct research. But would a company executive release financial data
to a private corporate credit research firm?
A.3 That depends, but it seems pretty tough.
I've already told you in my answer to question 1 that many executives of ordinary businesses basically turn away corporate credit research firms other than Teikoku Databank and Tokyo Shoko Research. An inquiry from these two companies has a special meaning to executives. Executives need to find out why someone needs their financial information. These are some possibilities - (1) A business partner is seeking information about the company (2) An unknown third-party is conducting research into the firm, or (3) The corporate credit research company is just conducting their periodic research. Therefore, the first thing companies ask when a corporate credit research company contacts them is "Who is seeking information?"
Of course, corporate credit research companies outwardly say that they will maintain confidentiality about their research. But that is just a superficial comment. It seems that information seeking companies and data providing companies both understand that the identities of the information seekers will be revealed to the data providers. Private corporate credit research companies know this, and in some cases, researchers will hint at who is seeking information. In that sense - just as when you ask a credit agency to dig up information on your fiancé, - the information seekers' names will basically be revealed to the data providers. But because these kinds of researches are, after all, voluntary, companies can always refuse to be studied or submit false data. When approached, companies usually calculate the information seekers' reactions and decide whether to either submit real financial data, release just snippets of good data, provide window-dressed data, or simply turn down the inquiry. As I explained in my answer to question 2, there is no way of finding out if a company provided falsified data.
Employees at corporate credit research companies can, as I mentioned earlier, go through certified copies of commercial registration or check the disclosed list of high-income companies to back up the data as a basic gesture. They will then check the company's appearance; observe employees' attitudes and appearances; and look for unsuitably expensive paintings, golf bags, foreign cars and other signs that the company may be headed for bankruptcy. But these methods are not ways to obtain financial data. So again, I feel there is nothing they can do to prevent getting falsified data. With companies that are on the high-income list, a basic research is probably enough for the time being to fulfill the requirements as a credit research, even if the corporate credit research company only takes superficial procedures. On the other hand, companies that really have problems would try very hard to hide their problems and make everything look okay. So a decent information seeker probably relies on corporate credit research companies with the results already forecast to a certain degree. I believe this is the basic flow of the case where (1) the information seeker is a business partner.
On the other hand, case (2), where an unknown third-party is conducting research into the firm should be considered a very obnoxious inquiry from the information providers' point of view. You should expect these inquiries to be turned down. If the third party is a large company, you might think it was a white-collar crime involving the general affairs department. But that sounds more like you've been reading too many economic novels. You can't negate the possibility of a clumsy rival firm looking into a company, but most likely the information seeker is either a venture capital firm wondering who to invest in, a financial institution eager to extend loans to small to medium sized enterprises or conduct business with wealthy companies, a company or fund looking for a firm to purchase, or a brokerage that wants to encourage a company to go public. In other words, they are the kind of people who cold call companies and seek appointments with the company president. The right thing for company executives to do when approached by these people is to turn them down. A researcher from a major private corporate credit research company would go home quietly and calmly at that point. And God only knows what kind of information the information seeker will get in cases like this.
In case number (3) "periodic research," corporate credit research companies don't get decent reactions from new contacts. So they go after companies that either responded cordially to them in the past, purchased many research tickets in the past, or perhaps regularly read the Teikoku News. I think it's rare for any corporate executive to want to take time out of their busy schedule for a "periodic research" to welcome a researcher or financial specialist who has a unique aura as if they were out to label people. Employees of private corporate credit research companies know this well. For this reason, the recent trend is to simply mail survey sheets I mention in my answer to question 2 and end it at that.
Companies who receive these survey sheets fill in only the numbers that make them look good, and mail them back if they have time. If they find the surveys obnoxious, they simply throw them away. In other words, they react the same way they do when they receive a survey sheet from the Ministry of Finance's survey on corporate data, which is increasingly becoming merely a façade. Let me give you a more personalized example to make this more relatable to individuals. The companies feel like households chosen for the study of household by the Statistics Bureau of the Ministry of Internal Affairs and Communications. They doubt the data they provide will "really" help the archaic government-like GDP estimates. And even if you wanted to respond seriously, you don't know how to fill them out. Corporate executives feel like housewives who have been asked by their husbands to fill out these massive documents that look like poorly organized household account books. Most ordinary executives - like the housewives - feel like throwing the surveys out. Of course, if this was the census conducted by the Statistics Bureau of the Ministry of Internal Affairs and Communications, they might consider answering the surveys seriously. But the research by private corporate credit research companies could easily be used against the companies that provide data. Therefore, smart executives don't take them seriously.
These comments are my personal comments, but I believe that most owners of small to medium sized enterprises engaging in ordinary businesses - which is common in Japan - feel the same way. As a corporate executive who was also a loan specialist at a bank, I have made an attempt to show you both sides of the story. But there are still things I don't know, so please feel free to do some thinking on your own to make up for any lack of information.
Q.4 I use a corporate credit record database. Can I trust the information I find
on these databases?
A.4 I think it would be safe to assume that most of the information - aside from
information on publicly listed companies - is extremely unreliable.
To give you an idea of what I mean, I did some research into the corporate credit records of our company, Numerical Technologies Inc. Below is information from a database run by a corporate credit research company to whom we had not provided any information. (Please refer to the chart below)
What do you think? Do any of you feel that "All they did is stretch the graph a bit and place numbers randomly?" That's how it looks to me. Sales for the fiscal year ended March 2003 is incorrect - almost twice the actual figure - and the ordinary profit is three times the actual number. It is a mess. What's outrageous is that even though the database was updated on May 26, 2006, the database does not even have the statistics for the ordinary profit posted for fiscal year ended March 2003. Even if the tax office is really slow in processing information, the numbers should be disclosed two years after the end of the fiscal year.
I feel awkward saying this myself, but - as you would know if you regularly visit our web site - Numerical Technologies has been posting our earnings results on our web site for eight consecutive years, which is very unusual for a small to medium sized enterprise. In addition, by definition, we are one of the 68,824 high-income companies nationwide (according to the 2006 version of a filed-corporate-income ranking published as a separate issue of Shukan Diamond.) Of course, we are a small company that owns no buildings and whose earnings are mostly taken away in the form of taxes. But we have been categorized as a high-income company for eight straight years since our founding, so I would assume that it would be fairly easy to obtain statistics on our ordinary profit simply by going to the tax office.
Now, if this is the level of accuracy corporate credit research companies have for the less than 70,000 high-income companies nationwide, what kind of quality can you expect from them when it comes to an ordinary company's credit research? Major credit research companies have information on more than 1 million companies on their databases. Imagine that.
Q.5 How can I check the reliability of data stored in the corporate credit
research companies' databases?
A.5 The best thing to do is to contact the target company directly and obtain
financial data from them. If you can't do that, you should contact the
corporate credit research companies without blindly believing the information
in the database.
As I had explained in my answer to question 2 earlier, the disclosure system at the tax office has been abolished. And as I explained in my answer to question 3, corporate executives rarely give out financial data light-heartedly. And as you saw in my answer to question 4, some corporate credit research companies just fill in data randomly. Therefore, it would be delusional to think that an ignorant lay person could use online services, which have become cheap and convenient lately, to obtain corporate data. There are credit rating services that use data taken from corporate credit record databases, but as a person working in the finance industry, it' hard to believe that there are people who believe in credit ratings. Let me explain the basic knowledge held by inspectors in regards to question 5.
Now can you understand why I say, "as a person working in the finance industry, it' hard to believe that there are people who believe in credit ratings"? This is the same reason why people in charge of billing accounts as well as people working for financial institutions or trading companies directly obtain financial data from their business partners.
By the way, I need to explain that what I have written pertains to the current situation (I am writing this document at the end of 2006.) I don't mind corporate credit research companies over-reporting our earnings the way I have demonstrated in my answer to question 4. But if a company's earnings were under-reported, a company may lose the chance to get loans or form partnerships with other companies because banks and business partners saw the credit ratings based on these false earnings figures. If that happens, there would, of course, be a civil lawsuit. The much-feared Financial Services Agency might step in as well. And if you're not careful, someone might turn this small to medium sized enterprise bullying issue into a political issue. Since that would mean a life or death situation for private corporate credit research companies, I'm sure they're in the middle of deleting inaccurate data right now. That is why I personally believe that - unless my company is itself a victim - I should refrain from filing a complaint with the Financial Services Agency's financial services user assistance center about the cases I have mentioned above.
Q.6 What do you think of the future of the corporate credit report database business?
And what is the outlook for credit scoring?
A.6 I think the database business has passed its peak. As for credit scoring, I
think it will settle down as a type of loan where you take it seriously with
the people who really give you information, but not with people who don't.
As I had explained in my answer to question 2, after 2006 - when the tax office abolished the disclosure system - private corporate credit record databases will lose the only way to secure reliable information - be it information researched by private corporate credit research firms or data collected by financial institutions. Unless enterprises correct mistakes they find in these databases, junk data will remain junk data. Naturally, the databases run by private corporate credit research companies should become emptier after 2006 if these companies take their work seriously. Obviously, credit rating agencies that make credit ratings based on these master databases should not be able to provide any reliable credit ratings. In other words, the future of databases on corporate earnings and credit ratings is grim.
What I would like to note here is that I am saying that the future of corporate earnings databases is grim, not the future of private corporate credit research companies themselves. On the contrary - I think the abolishment of the tax office's disclosure system will boost demand for credit agency-like tasks.
On the other hand, I believe there is a tough future awaiting corporate credit rating calculation firms that reprocess these databases and offer them as products. There should already be an impact in terms of the reliability of credit ratings. Even the not-so-bright user should start noticing such an impact. If such corporate credit rating calculation firms try and force themselves to stay afloat, people will really start to ignore credit ratings. When I think about how the few companies that provide such services are going to deal with this environment, I imagine that the safe bet is that they will use stock information services like Moody's-KMV.
As for credit scoring, I think enough has been said about this issue. In the past, there had been ideas about credit scoring using the databases of private credit research companies. But this won't work unless the companies that will be taking out loans provide their financial data. Will this be a problem? I don't think so. Financial institutions are heading toward building their own databases so it won't make a difference. Credit scoring should be conducted using financial information obtained by the financial institutions themselves. This probably means credit scoring has taken root.
Q.7 Are bankruptcy risk scores considered relevant to the credit ratings
disclosed by credit-rating agencies? Are credit ratings neutral and fair?
A.7 In principle, yes. But the inside information concerning this matter is very
complicated.
For those of us who have worked in the financial sector - not just us at Numerical Technologies - it's considered common sense to consider the sales aspect when credit rating companies make ratings. Moody's reputation has especially fallen in the past 10 years. First, it went on a mad rush to downgrade everything just because Japan was in a recession. When the Japanese economy improved, Moody's realized that it had downgraded companies to a point where everything was too low. And then they went on a mad rush to upgrade everything. Market participants were laughing, wondering if Moody's really analyzes anything. It got to a point where even the media began poking fun at Moody's, making comments like, "Moody's credit rating irony." (Shukan Diamond, Nov. 25, 2006 edition. Page 22) The rush of upgrades is making Moody's lose market credibility.
But it would be too simple to say that Moody's is to blame. If you just use common sense, don't you think it's impossible for Moody's weak team of analysts to cover major companies in Japan? Major companies are so complex that even a company president doesn't have a good grasp of the entire company. When I worked at a bank, we sometimes had to prepare documents to help bankers explain things to analysts. When we heard that someone from Moody's was coming, we used to make very simplified versions of these documents because we knew that their analytical skills were limited. If that's how limited their understanding of simple bank operations are, what kind of analysis can they do for science and technology firms engaging in difficult issues that the lay person has never heard of, or an unlisted company whose business is tied up by various industry customs? I think the truth is, they are only conducting analysis that we learn in business school or through textbooks (such as XX ratios), adding their own intuition (fiddling with numbers) and following the policies outlined by their bosses or headquarters ("Let's downgrade all Japanese firms.") What happens most of the time is this: Instead of credit ratings guiding stock prices, someone in this world analyzes the outlook of a particular firm, moves stock prices, and the analysts who thought, "Why is this company's stock falling?" goes ahead and downgrades the company. That's why, as many people say, "Credit ratings are a far less reliable credit indicator than stock prices." This can be said for all credit researchers and inspectors. Moody's is not a team full of Supermen and Superwomen. They just proved that point.
The reason I am sympathetic toward these analysts is because credit ratings used to be taken more lightly in the past, but are now over-rated. This is the side effect of Basel II, the new BIS regulation. The new regulation on capitalization requires financial institutions to set aside capital reserves appropriate to their borrowers' bankruptcy risk scores. Without bankruptcy risk scores, this framework itself wouldn't work, would it? That's why there is a need now for bankruptcy risk scores=credit ratings. And in line with the new regulation, the global market for credit derivatives expanded. And in order to trade credit risks on the market, you need - obviously - credit ratings. This is how, starting from a certain point in the late 1990s, credit ratings transformed from being a mere figure to show "the safety of institutions issuing bonds" to one that demonstrates "the credibility of companies in general" regardless of whether the company issues bonds or not. In that sense, Moody's may be a victim. But what makes it difficult to consider Moody's a victim is the so-called "unsolicited credit ratings." (In other words, when a credit-rating agency rates a company based on information the agency got even though the agency was not asked to do so.) Standard & Poor's, Moody's and others began giving unsolicited ratings around 1990. Therefore, you can't deny the moral hazards of these credit rating agencies. Anyone following the news would know - judging from the recent case involving a U.S. auditing firm, which made it to Parliament - that credit rating agencies can prioritize the business aspect of things.
On the other hand, how are the credit ratings of unlisted companies? As I mentioned earlier, the corporate credit record databases are extremely unreliable when it comes to information on unlisted companies. If you asked me, I would say ratings are not as bad as the information on these databases. (I believe, at least) That is because behind the ratings are the efforts of corporate credit record researchers. But as you would immediately notice when you look at the grades (substitutes for credit ratings), there are an abnormally large amount of companies that are rated "average." There are so many average-rated firms that the chart shows an abnormally shaped distribution, in stark contrast to a bell-shaped curve that a normal distribution would demonstrate. This happens because credit ratings are more similar to elementary school art teachers assessing their students' artwork, rather than a scientific measurement (where time or weight is measured.) In other words, it's easy to find outstanding students. That's why no one would miss a future Pablo Picasso or a Salvador Dali. These students get awards at art competitions so there is no question about their talents. On the other hand, it's hard to figure out the students who seem hopeless. If there was a Kiyoshi Yamashita, Takashi Murakami, James Ensor or Frida Kahlo in the class, teachers may have been concerned about them, thinking "You're so stupid," "You're such a fanatic," "You're weird," or "Are you alright?" But who would've guessed these students would turn out to be sensations? I need not say much about the remaining students. Teachers typically give bad grades to students based on their attendance, their attitudes in class and other things unrelated to art. And they probably give average grades to the remaining students. Credit evaluations are the same. "Companies that have no apparent problems - from anyone's point of view - and companies that are clearly bad are easy to detect. But the rest are difficult to assess, so they get average grades." This is closer to the truth, I think. In some ways, these may be more honest ratings than those given by Moody's.
On the other hand, what we have to careful of - as industry people - is that if some research firms falsify data, the general public might consider it an ego problem on the part of the entire industry. The Shukan Diamond article that I quoted, cites a market participant who says "I rely less on (credit ratings.)" The article concludes, saying, "if more and more people feel this way, there is a strong possibility that credit ratings themselves will lose the credibility of the market." The author fears that if we continue to ignore the opinion of outsiders, the current trend will lead to ruining the image of the entire credit rating industry.
The year 2006 will be the moment of truth for corporate credit research firms and credit-rating companies. For the time being, the future will be grim for analysts. Corporate credit record databases run by private companies will continue to deteriorate in quality. That is the inevitable future. If in 2007, there is a research company that insists on "obtaining financial data for the fiscal year ending March 2007 through our corporate credit record database," I take pride in telling you that this is a flat out lie. This is how a real credit risk management professional should act.
Epilogue
There may have been some inaccuracies, but do my comments largely match what you understand of this world? The reason why our company has continued to disclose our financial data to corporate credit research companies regardless of whether the results are good or bad is because we are a company whose mainstay business is credit risk management, and we would like to remain on good terms with Tokyo Shoko Research and Teikoku Databank. However, following the April 1, 2006 implementation of a partial legal revision to the income tax, we have decided to discontinue filling out the survey sheets from these firms after 2006 for various reasons. We would like to avoid causing or getting wrapped up in some crime due to the misinterpretation of data - whether the data or true or false. Such data seem to wander off on its own. It is also dangerous to light-heartedly disclose our information at a time when internal control is being strengthened within companies. Not to mention, this cause many obnoxious phone calls. This is the decision we have made, but we still hope to be on good terms with Tokyo Shoko Research and Teikoku Databank.
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