A critique of credit rating regulations in India

by Rishi A.

Credit Rating Agencies are creating a lot of news of late. The Russian Central Bank, recently, decided that it wouldn’t use credit ratings issued by any of the western rating agencies like, S&P’s, Fitch or Moody’s. In February, this year, S&P’s paid close to USD 1.4 billion in a settlement with the United States Justice Department. The settlement meant that the credit rating agency was responsible for not taking into consideration the risk associated with residential mortgage-backed securities before the 2008 crisis.

The rating agency, during the enquiry, also admitted to the fact that they took money for providing favourable ratings and that these were not based on fundamental assessments, further they lied about the risk of default in various corporate cases and also marked down debt when this was further destabilizing the financial system. The investigation report quoted some of the analysts of S&P saying that ‘I hope that I am rich and retired by the time this house of cards falters’ and ‘we rate any deal, it could be structured by cows and we would rate it’. Some also blame the agencies for the further downfall of the Greek economy, after its securities got downgraded to ‘junk bonds’. Thus responding to the problem of rating, many countries, like, Canada, various countries in the European Union, etc., removed the reference to credit rating from their laws and regulations.

While SEBI has its own guidelines with respect to what qualifies as a credit rating agency, the underlying problem lies in the fact that there is no way to ensure that the rating is not done for personal interest. SEBI further makes it mandatory for issuers to get their securities rated before they are offered to the public.[i] There was a High Level Committee, that was setup in 2009, to recommend changes to the then CRA regime. This article hopes to not just analyse the reforms recommended but also the status quo, as well as any further changes that can be brought about.

Credit Rating

The rating process generally starts with entering into a ‘rating agreement’ entered into by the CRA and the Issuer, trying to get its securities rated.[ii] The agency uses a number of factors to reach their conclusion, i.e., the appropriate rating, but it is important to note that the process adopted is discretionary, as there exists no set ‘standards for rating’. ‘Rating’ has been defined as ‘an opinion regarding securities, …’.[iii] Thus, it does not bind the CRAs to the rating that they provide. This leads to a lack of accountability in this regard. The SEBI (CRA) Regulations also mandate that CRA’s abide by the ‘Code of Conduct’ that has been provided in the 3rd Schedule. But the problem persists as these remain to be soft regulations and lack the teeth that are required to get the rating system in order.

There are guidelines or standards placed for credit rating laid down by the International Organisation of Securities Commissions and also the Financial Stability Board. Most importantly, it also talks about the rating process in specific. The CRA, it says, could ‘adopt, implement and enforce written procedures’ to ensure that they provide a robust analysis of the security. It further requires every analysis to be conducted as per the procedures that these CRAs lay down.

SEBI must collect the different procedures that the agencies’ might want to follow and thus hold them to it. Any analyst hired by the CRAs to conduct the rating must also follow these procedures. But this obviously means that there will be no uniformity in the procedures being adopted. SEBI could try streamlining the rating process after due consideration given to the types of process followed by the different CRAs, and thus coming out with a uniform process.

It is true that large investors, like FPIs or Mutual Funds, can easily conduct their own risk assessment and therefore, their own credit rating; it is also true that investors who relied on the global rating systems were worst hit during the global financial crisis. But can the RIIs or small time investors be allowed to conduct their own rating of the securities they are interested in. What could the alternative be then? Can we allow investors to make their own due diligences of the company and thus themselves decide the ratings for the securities? If you think this is what must be done, you should also remember than more than half of the investors in the stock market are largely market illiterate.

Suggestions

In the United States, the SEC, no longer requires debt instruments to be mandatorily rated for them to be eligible to be issued. Eminent persons have moved for the removal of mandatory rating of securities. The main reason for so much resentment is that of late rating agencies have been giving favourable rating to entities they might have business interests in. But if the process of rating itself has been corrupted, this makes it difficult for investments to be made. Such an example can be seen in the case of Deccan Chronicle, where credit rating agencies had positively rated the company but it subsequently defaulted on most of its payments.

With respect to the payment of a CRA, there exists two models prevalent in this scenario: ‘Issuer-pays’ and ‘Subscriber-pays’. While, the former is quite obvious, the latter requires the subscribers/ investors interested in investing the rated-security to pay the CRAs fees. The latter would heavily restrict ‘credit shopping’. But in this also an agency can alter its rating to make it more attractive so that it can attract more numbers of investors, who would in-turn pay their fees. Neither of these models effectively answers to the problem being discussed above.

In lieu of the payment issue, a fixed percentage over the actual cost incurred by the CRA could be the fixed amount that could be stipulated that a CRA will be able to charge for every rating project. A fixed price can avoid the situation of rating-shopping as an issuer will not be allowed to pay more for a better grade. Another manner could be that a company or issuer, instead, could be asked to rotate their credit rating agencies. Since, a CRA needs to monitor and review the securities it has rated,[iv] they could continue to do so, but for every new issue of security a new CRA could be asked to provide a rating. This would create a need for both the agencies to do well and this would automatically encourage fair competition in the market.

Last year the Bertelsmann Foundation in Germany advanced the notion of an international non-profit credit rating agency known as International Non-Profit Credit Rating Agency (INCRA), to be funded as a sustainable endowment. It envisages that its stakeholders would be the primary source of funding and it will be responsible for rating its stakeholders’ securities. Since, INCRA is responsible for rating sovereign securities, what if it allows a subsidiary, to be established in every stakeholder-country, who would rate the country’s’ financial markets and be made liable for the rating it offers? This will ensure that rating processes get standardised, rating-shopping can be removed and will also solve the issue of accountability. However, if such an entity is ever created, it is absolutely necessary to restrict the state’s role to just funding and they must not be allowed to interfere in the conduct of the business of rating as such. This would effectively also mean that in the credit rating sector all other private players must be removed and thus the path must be cleared for the branch/ subsidiary of the supra-national credit rating agency.

Thus there are a number of things a regulator can do to solve the problem of inefficient rating. We will, hopefully, be capable of all-together removing the concept of a CRA, once our investors become a little more market literate. But as of now, an all-out ban of CRA will only become an obstacle for small investors, like RIIs. Thus, this step must be deferred for a later time. But for now, streamlining the process is a must. Heavier regulation, constant regulating, making them accountable could be a decent start. Otherwise, the above suggestions should also help.


Rishi A. is a fourth year student at HNLU


end notes 

[i] SEBI (Issue of Capital and Disclosures Requirement) Regulations, 2009

[ii] Regulation 24, SEBI (Credit Rating Agency) Regulations, 1999.

[iii] Regulation 2(q), SEBI (Credit Rating Agency) Regulations, 1999.

[iv] Regulation 15 & 16, SEBI (CRA) Regulations, 1999.

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