Role of Credit Rating Agencies in Indian Economy, their lacunas and measures taken to improve them

Context

 SEBI has come out with new guidelines to improve the quality of disclosures made by credit rating agencies.

About:

Why are they Important?

A Credit Rating Agency plays an important catalytic role fostering the growth, stability and efficiency of global and domestic capital markets. A comprehensive analysis of a credit instrument and a subsequent impartial assessment of the credit risk of the instrument, offer numerous benefits to all parties in concern. Reasons for rating credit risk could be rationalised from the following perspectives:

1. Economy
   1. Reducing NPAs: India holds the dubious distinction of having the worst non-performing loan ratio among the world’s major economies. The gross NPA of all listed banks jumped to Rs 10.39 trillion in the March 2018 quarter, from Rs 8.86 trillion in the December 2017 quarter. Ratings reduce uncertainty in giving credit. Less uncertainty means greater saver confidence, which encourages bond market growth and greater market efficiency and liquidity, and hence, reduced NPAs.
   2. Bond Market: Credit Ratings facilitate the development of long-term fixed-rate local currency bond markets that contribute to the management of financial crises and country risk
   3. FDI: Credit Ratings increases the degree of ‘transparency’ in the financial markets which attracts foreign investors to participate in the financial markets.
2. Investors / Savers
   1. Default risk protection: It is imperative for savers to find out from an independent third party the default risk of the fixed income investment prior to investing any money. In the absence of ratings, they will have to make their investment decision purely based on reputation and historical financial information of the borrower that may have little bearing to future financial condition of the borrower.
   2. Not all guarantees are safe: Although various investments are sold using the word “guaranteed”, the borrower itself cannot give a guarantee, only a financially strong third party can give a guarantee.
   3. Enhance returns for Individual Investors: Savers need to invest carefully to have sufficient money for the future for retirement, ill health, children’s education, marriage etc. without loss of value of their money due to inflation
   4. Compare risk and returns offered: Credit Ratings clearly convey the default risks of various fixed income investment products offered to the public such as corporate debentures, Commercial Paper, Finance Company Fixed Deposits, Life Insurance Products, Certificates of Deposit, Promissory Notes, Preference Shares, etc.
3. Borrowers / Debt Issuers
   1. Reduce costs: Corporates can lower their cost of funds (interest they pay) by borrowing directly from the public instead of borrowing from banks.
   2. Increase the flexibility of funding sources: Credit ratings can be used as a ‘credit passport’ to communicate the credit quality to the investors.
   3. Enhance corporate image: A rating would also enhance the corporate standing when dealing with existing and potential foreign clients and partner
4. Intermediary
   1. Merchant bankers, underwriters and other intermediaries will find ratings valuable in the planning, pricing and placement of their clients’ debt securities.

Lacunas in the Functioning of Credit Rating Agencies in India

1. Conflict of Interest – Under Issuer Pay model, which is adopted in India, the entity that issues the instrument also pays the ratings agency for its services. This often leads to a situation of conflict of interest, with tremendous potential for rating biases.
2. Entry Barrier: the credit rating market in India has high barriers to entry, which prevent competition that is vital to protecting the interests of investors.
3. Rating shopping: It is the practice of an issuer choosing the rating agency that will either assign the highest rating or that has the most lax criteria for achieving a desired rating.
4. Poor Rating Quality: Often ratings are provided on limited information. For e.g. If the issuer decides not to answer some determinant questions, the rating may be principally based on public information. Many rating agencies don’t have enough manpower which often leads to poor quality. There have been a record 163 downgrades (negative change in credit worth) of debt instruments this year, according to data released by Prime Database this week.
5. Independence of the ratings committee: Over the years, the membership of the ratings committee has shifted from external experts to employees of the ratings agency which has raised concerns about their independence.

Measures taken by SEBI for their better functioning

SEBI has been working hard to improve transparency and credibility among rating agencies.

1. According to the new norms, credit rating agencies will have to inform investors about the liquidity situation of the companies they rate through parameters such as their cash balance, liquidity coverage ratio, access to emergency credit lines, asset-liability mismatch, etc.
2. Rating agencies will have to disclose their own historical rating track record by informing clients about how often their rating of an entity has changed over a period of time.
3. The agencies will have to publish information on how their performance in the rating of debt instruments compares with a benchmark created in consultation with SEBI.
4. The Securities and Exchange Board of India has asked credit rating agencies in the country to, among other things, clearly state the “probability of default” of the instruments they rate for the benefit of investors.
5. SEBI laid down a new standard framework for financial disclosure by credit rating agencies that it believes will enhance the quality of information made available by these agencies to investors.
6. The suggestion to revise the method of computing default rates and the precise definition of terms that raters should use in describing a client’s liquidity position — strong, adequate, stretched and poor — are aimed at sharpening disclosure and leaving little room for raters to be ambiguous.

Way Forward

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.