CREDIT RATING AGENCIES – ANALYSIS OF THE REGULATORY FRAMEWORK IN INDIA
This blog is authored by Nargees Basheer, a fifth-year law student pursuing BA.LLB (Hons.) from The National University of Advanced Legal Studies (NUALS), Kochi.
A Credit Rating Agency (CRA) is a body corporate which is engaged in, or proposes to be engaged in, the business of rating of securities offered by way of public or rights issue. They are body corporates that give informed opinions on the performance of securities issued by firms and governments after considering the risk factors to determine the likelihood that the issuers will repay the debt or can recover the losses in the event of default.
History of Credit Rating Agencies
Credit Rating Agencies first came into existence during the early 1900s when John Moody’s started rating rail bonds. Although initially it was associated with debt instruments of commercial entities alone, CRAs now rate sovereign debt as well. The three major CRAs in the world are Moody’s, Standard & Poor’s and Fitch. In India, the first CRA was established in 1987 with the incorporation of the Credit Rating Information Services of India Ltd. (CRISIL).
The Securities and Exchange Board of India (‘SEBI’) regulates CRAs in India through the SEBI (Credit Rating Agencies) Regulations, 1999 and circulars issued under it. The 2007 financial crisis necessitated developed countries to revisit the regulation of CRAs. There was widespread criticism that CRAs had not estimated the market risk associated with the structured credit products correctly and thus, were unable to adjust the credit ratings accordingly.
Need for Regulating Credit Rating Agencies
CRAs have become an integral part of the Indian financial system. The primary function performed by CRAs is reducing the information asymmetry in the credit markets by providing to the investors the information necessary to understand whether a particular instrument will perform well and the risks associated with it. CRAs have access to insider information of companies which may not be available to the investors in its entirety. From the perspective of issuers, the CRAs provide ratings that enable investors to place trust on their instruments. CRAs also perform an important role from the regulatory perspective in that, they function as gatekeepers for financial markets and reduce the cost of regulation.
Apart from the fact that they are very important to financial markets, CRAs have to be regulated as they may not always function in the best interests of the markets. To begin with, there exists an inherent conflict of interest within the functioning of CRAs as they are hired by issuers themselves to provide ratings to their instruments. They are paid by the issuers to give these ratings and that may become a factor that influences the CRAs while giving out ratings. One of the major criticisms against CRAs is that they lag behind market indication and do not update their ratings in a timely manner, which defeats the purpose of the ratings. Moreover, certain regulators place heavy reliance on the requirement of hiring CRAs for licenses and permissions, which may lead to the agencies distorting the market by providing minimum required ratings to the issuers to ensure that their long term relationship with the issuer is maintained.
A 2014 study that analysed 248 firms listed on BSE looked into the credit ratings of these companies and observed that the widening gap between a company’s financial ratio and its credit rating raises questions over the accuracy of credit ratings in the country. Critics are of the opinion that this may be due to the lack of competition among CRAs and the issue of rating shopping that issuers indulge in. Another study analysed the credit ratings of certain corporates and the bad loans crisis. It opined that CRAs were ‘liberal’ with their ratings which may have been the reason for banks lending large sums to these corporates that ultimately, ended up resulting in bad loans. It concluded that problems in ratings could have contributed to the rising non-performing assets (NPA) crisis in India.
Major Issues Associated with CRAs and the Indian Regulatory Framework
At the outset, though effects of conflict of interests have been mostly resolved through the regulatory framework, the inherent issue that arises from the ‘issuer pays’ model has not been resolved. There is less competition among CRAs and they are placed at a pedestal by regulators and are considered to be ‘watchdogs’, which makes the conflict of interests graver in case of CRAs. Cusrrently, the Regulations provide for the ‘issuer pays’ model along with mandating an agreement between the issuer and CRA whereby the rate of payment etc. are to be specified. Alternate models include investor pays model, the government pays model, and the exchange pays model. Another alternative is where investor associations or regulators who aim to protect investors pay for ratings for companies meeting certain criteria. Yet another alternative would be where the issuer approached a clearing house of sorts which will then procure a rating for the issuer, thereby eliminating direct contact between the issuer and the CRA. However, the alternatives come with issues of their own. A rotation mechanism could be a partial solution to the problem. But, there are very few CRAs in the country and the process could end up being very mechanical. It would also increase the costs of rating as it is easier to review ratings rather than to issue new ratings.
The next issue is that of Rating Shopping whereby an issuer solicits ratings from multiple CRAs but only pays for and discloses the highest rating(s). This may lead to CRAs providing higher ratings just so that issuers choose them over other CRAs. In India, this issue has been largely solved by way of the Code of Conduct and mandatory disclosure of ratings not accepted by issuers.
Another problem with respect to regulation of CRAs is that CRAs are not directly accountable to investors. The arguments for CRAs are that firstly, they issue only opinions and not recommendations; secondly, their contract is with the issuers and not the investors; and thirdly, such direct accountability may cause a chilling effect on market activities by CRAs as they would be less willing to make independent judgments on the creditworthiness of instruments. There is also the general argument that CRAs have their reputation at stake and therefore would anyway behave in a rational manner. However, it is uncertain how true this would be in the case of new products where initial errors in rating may be overlooked and may not affect the CRA’s credibility.
India has a comprehensive and extensive regulatory framework with respect to CRAs. Most issues associated with CRAs have been attempted to be solved or their effects tried to be lessened. However, as observed above, the inherent issue of conflict of interest has the ability to tarnish the reliability of Credit Ratings. It is an issue that other jurisdictions also face and extensive research may be required to find a viable solution that is market friendly. Meanwhile, Regulators may place lesser importance on the requirements of acquiring Credit Ratings so that the effects of a wrongly represented Credit Rating may be milder. As for CRAs, it is upon them to keep the interests of the investors and financial markets at the highest level to ensure that their actions do not result in widespread financial crises.