What is the issue?
- Securities and Exchange Board of India (SEBI) has released a new framework for financial disclosure by credit rating agencies (CRAs).
- Credit Rating Agencies (CRAs) are companies that evaluate the financial condition of issuers of debt instruments.
- CRAs assign a rating that reflects its assessment of the issuer’s ability to make the debt payments.
- Rating is denoted by a simple alphanumeric symbol. E.g. AA+, A-, etc.
- In India, CRAs are regulated by SEBI (Credit Rating Agencies) Regulations, 1999 of the Securities and Exchange Board of India Act, 1992.
- The entities that are rated by credit rating agencies comprise companies, state governments, non-profit organisations, countries, securities, special purpose entities, and local governmental bodies.
- Some of the key CRAs in India include –
- Credit Rating Information Services of India Limited (CRISIL)
- ICRA Limited
- Credit Analysis and Research limited (CARE)
Issues related to Credit rating agencies
- Ideological biases: CRAs might favour certain political ideologies to limit negative policy and market surprises as they strive to keep ratings stable over the medium term.
- A panel analysis of Standard & Poor’s, Moody’s, and Fitch’s rating actions for 23 OECD countries from 1995 to 2014 shows that left executives and the electoral victory of non-incumbent left executives are associated with significantly higher probabilities of negative rating changes.
- Conflict of interests: CRAs are funded by the very companies they rate.
- Lack of ability to predict: CRAs follow the market, so the markets alert the agencies of trouble. This happens post-market and after something has happened. This is the reason for CRAs inability to predict frequent near default, default, and financial disasters.
- Negligence & incompetence: Methodology of CRAs has come under question. For example, even after using different methodologies, the result for sovereign debts comes the same. It is also alleged that, CRAs can make sound judgement on rating, but they didn’t make an effort to do it.
- For e.g. Moody accepted that it did not have a good model on which it could have estimated a correlation between mortgages backed securities, so they made them up.
- Politically motivated: It has also been alleged that CRAs, through their rating mechanism forces the govt to follow the path prescribed by them.
- For e.g. during the turmoil in Tunisia, S&P issued a report warning of “downward ratings pressures” on neighbouring governments if they tried to calm social unrest with “populist” tax cuts or spending increases.
- Further, after Crimea annexation rating agencies downgraded the rating of Russia.
- Policy meddling: In 2003, to stop predatory lending, state of Georgia brought a law. Other states of USA were to follow the suit, until S&P retaliated.
- And it is well known that predatory lending is responsible for financial crisis of 2008-09.
New norms in this regard
- Rating agencies have to clearly state the “probability of default” of the instruments they rate for the benefit of investors.
- Probability of default describes the likelihood of a default over a particular period.
- It provides the likelihood that a borrower will be unable to meet its debt obligations.
- SEBI will prepare and share standardised and uniform probability of default benchmarks.
- This will be fixed for each rating category for one-year, two-year and three-year cumulative default rates – both for the short run and long run.
- Probability will be based on a 10-year marginal default rate and the economic cycle.
- The agencies will also have to publish information on their performance in the rating of debt instruments, in comparison with a benchmark created in consultation with SEBI.
- This will help investors to better judge the performance of credit rating agencies.
- SEBI also introduced disclosure of factors to which the rating is sensitive.
- Rating agencies will have a specific section on rating sensitivities in each SEBI’s press release.
- This would explain the broad level of operating and financial performance levels that could trigger a rating change – upward and downward.
- This is critical for the end-users to understand the factors that would have the potential to impact the credit worthiness of the entity.
- Besides, SEBI expects rating agencies to make meaningful disclosures on client’s liquidity position using simple terms.
- This may include terms such as superior or strong, adequate, stretched or poor.
- This should also come with appropriate explanations, to help the end users understand them better and avoid any ambiguity.
Issues the credit agencies
- The credibility of rating agencies has been eroding since the global financial crisis in 2008.
- This is primarily because of the conflict of interest arising from issuer-pays model.
- Under this, the ratings agency is paid by the issuer of the instrument that it rates.
- So agencies are found to be more loyal to companies whose instruments they rate rather than to investors who provide precious capital.
- In effect, agencies fail to downgrade troubled firms until they are on the verge of bankruptcy.
- The defaults at Infrastructure Leasing and Financial Services (IL & FS) in 2018 that led to a liquidity crisis among non-bank lenders in India has brought the focus back to CRAs.
- CRAs as SEBI-registered intermediary are supposed to be an alert system of an instrument before the actual default.
- But after failing to detect early signs of the crisis, credibility of CRAs as an institution and their utility under the regulatory system were questioned.
- Given the impact of this over the larger economy, SEBI aimed at tightening the disclosure guideline.
- This is believed to enhance the quality of information made available to investors by the rating agencies.
- Overall, SEBI’s attempt seems to be to align ratings methodologies with global best practices.
- But it is not clear how the new framework will effectively resolve the conflict of interest issue that for long deteriorates the rating industry.
National Credit Rating in India
- No uniformity among rating companies in India: An average investor in India is not able to understand the different credit ratings prevailing in India as there is no uniformity among the credit rating agencies.
- No standardization in rating and no standardized fee structure for rating agencies in India is one of the other issues.
Need for Credit Rating Agencies
- From the 80s onwards, as the financial system became more deregulated, companies started borrowing more and more from the globalised debt markets, and so the opinion of the credit ratings agencies became more and more relevant.
- Reduce information asymmetry: Since CRAs get access to the management of the company, and confidential information about its working, they can give an informed opinion about the ability of an instrument to meet its obligations.
- RAs provide tangible benefits to financial market regulators by reducing the costs of regulation.
- Some financial regulators mandate that certain instruments must be rated mandatorily before they are issued.
- It compels developing countries to pursue more prudent and sensible monetary and fiscal policies.
Need for CRAs Regulation
- Rating shopping: It has often been seen that both issuer and investor are involved in rating shopping.
- Oligopolistic Tendencies: Around 95% of market is controlled by only 3 CRAs VIZ. S&P , MOODY’S and Further they use expansionist marketing.
- Hegemonic Control: As the big three CRAs are located in North America, America exerts a great control on the functioning of CRAs.
- CRAs have great control on the world economy as their ratings can result in the flight of capital from any given country.
- CRAs are not accountable to any country and moreover their functioning is not transparent.
- Rotation of credit rating agencies: Under the current framework, there is no provision for the rotation of credit rating agencies.
- Regulators in India may consider other options as well, such as ‘investor pays model’ or ‘regulator pays model’ after weighing the relevant pros and cons.
- For resolving conflict of interest disclosures being made by credit rating agencies should also include important determinants such as: Extent of promoter support, Linkages with subsidiaries and Liquidity position for meeting near-term payment obligations.
- With the help of technology, open source models, such as Credit Risk Initiative of National University of Singapore Risk Management Institute, with fully transparent inputs and outputs should be created and promoted.
- Legal liability of credit rating agencies should be increased.
- Use of credit ratings in regulations that set capital requirements and restrict asset holdings for financial institutions should be removed or replaced
# Practice Question
- “Strict enforcement may work better than higher disclosures in disciplining rating agencies”. Critically examine the short comings in the functioning of the credit rating agencies in India. (200 words)