SEBI has come out with new guidelines to improve the quality of disclosures made by credit rating agencies recently.
What does the guidelines say?
The regulator issued a circular tightening disclosure norms for rating agencies when they rate companies and their debt.
Experts say rating agencies in India often failed to consider cash flows and ground conditions before assigning a rating.
Hence rating agencies must now disclose the liquidity position of a company.
They have to inform investors about a company through parameters such as their cash balance, liquidity coverage ratio, access to emergency credit lines, asset-liability mismatch, etc.
If the rating is assigned on the assumption of cash inflow to the company they rate, the agencies would need to disclose the source of the funding.
Thus they would now be required to furnish information on whether the rating is factoring in support from a parent company, its group companies or from the government.
They are also required to name of such entities, along with rationale for such expectation.
Rating agencies must also disclose their rating history and how the ratings have transitioned across categories.
This is to inform clients about how often their rating of an entity has changed over a period of time.
Also, when subsidiaries or group companies are consolidated to arrive at a rating, list of all such companies, along with the extent (e.g. full, proportionate or moderate) and rationale of consolidation, will have to be provided.
All rating agencies would require furnish data on its rating actions in investment grade rating category, to stock exchanges and depositories for disclosure on website on half-yearly basis, within 15 days from the end of the half-year.
Why are the norms revised?
SEBI has been working hard to improve transparency and credibility among rating agencies for some time now.
It has already issued a circular in November 2016 calling for enhanced standards for rating agencies.
But the latest disclosure norms seem to be a response to the IL&FS defaults and the ensuing crisis.
Rating agencies came under the spotlight following the crisis at Infrastructure Leasing & Financial Services Ltd (IL&FS) and its group entities.
Many mutual fund houses, invested in it, were caught unaware as major credit rating agencies started to cut ratings from high investment grade to default or junk.
The agencies faced criticism that they had failed to see the financial troubles in the group and adjust its rating of IL&FS only when its debt jumped by 44% at the end of March 2015.
This prompted the regulator to review the rating standards and whether there is a need for increased accountability, and insist on more disclosures.
Thus the recent measure mandating the formal disclosure of these facts is welcome.
The ready availability of information can help investors make better decisions.
What are the concerns?
However, the latest regulations can only help to a certain extent as a lot of the problems with the credit rating industry have to do with structural issues rather than the lack of formal rules.
The primary one is the flawed “issuer-pays” model, where a bond’s issuer pays the rating agencies for the initial rating of a security, as well as ongoing ratings.
The public (and investors) can then access these ratings free of charge.
This often leads to a situation of conflict of interest wherein the entity which issues the bond/debt instrument also pays the ratings agency for its services, with tremendous potential for rating biases.
Second, the credit rating market in India has high barriers to entry, which prevent competition that is vital to protecting the interests of investors.
This is not very different from the case in many developed economies where rating agencies enjoy the benefits of an oligopoly.
Better disclosures can increase the amount of information available to investors, but without a sufficient number of alternative credit rating providers, quality standards in ratings will not improve.
It is thus no surprise that even after repeated ratings failures in their long history, credit rating agencies continue to remain and flourish in business.
Structural reform should aim to solve another severe problem plaguing the industry, which has to do with rating shopping and the loyalty of credit rating agencies in general.
Rating agencies will have to come up with lucrative business models that put the interests of investors above those of borrowers.
Such a change requires a policy framework that allows easier entry and innovation in the credit rating industry.
