How to stop rating shopping?

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Beginning 1 October, listed companies will have to disclose defaults on loan repayments within one working day. They will have to keep the stock exchanges informed in case they have defaulted in payment of interest on loans taken from any financial intermediary as well as external commercial borrowings, and instalments for any other debt instrument with micro details such as the date of default, name of the bank/financial institution, the amount of default and also their debt exposure to the particular financial intermediary. They are also required to keep the credit rating agencies concerned in the loop.

Therefore, more work for the rating agencies. I’m not sure what a rater will do if the corporate entity involved doesn’t want to disclose the information. The Securities and Exchange Board of India (Sebi) had announced this in August.

While the idea behind this particular directive is to bring loan defaulters out of the closet, India’s capital market regulator has been taking a close look at the rating agencies for quite some time now. A series of directives culminating in a consultation paper to review the regulatory framework of the credit rating agencies is testimony to this.

Sebi has proposed capping one credit rating agency’s equity holding in another—direct or indirect—at 10%. The acquirer must also refrain from having any representation on the board of the other rater in which it is buying a stake. This is in response to the latest development on the rating turf in India.

In the last week of June, Crisil Ltd, a Standard and Poor’s associate company, bought 2.62 million shares of Care Ratings Ltd or an 8.9% stake for Rs435.26 crore in a block deal from Canara Bank. I highlighted the issue in my 7 August column ‘What next Crisil?’

The proposed norm is applicable to all entities except for broad-based domestic financial institutions. The acquisition of shares or voting rights in a credit rating agency, which could result in a change of control, will require Sebi’s prior approval.

The consultation paper has pointed out, and rightly so, that “significant crossholdings may give rise to conflict of interest wherein the independence of such a CRA (credit rating agency) to function may get affected in terms of rating process followed, instruments having dual ratings from these CRAs.”

The other significant suggestion is increasing the minimum net worth for a credit rating agency from Rs5 crore to Rs50 crore, citing their systemic importance. The existing rating agencies will get three years to fulfil this requirement. The three large rating agencies in India—Crisil, Care Ratings and Icra Ltd— roughly account for 85% of the rating business.

The rest is shared by India Ratings and Research Pvt. Ltd, Brickwork Ratings India Pvt. Ltd, Smera Ratings Ltd and the newest entrant, Infomerics Valuation and Rating Pvt. Ltd. Both Smera and Infomerics would need to ramp up their capital base.

More than a year back, Sebi started taking a close look at the world of Indian raters. In November 2016, it had asked the rating agencies to disclose how they rate a company, the rating history and responsibilities of their analysts. Besides, it had also directed the respective rating committees of the agencies to explain if there was a sudden downgrade of rating of a company and asked the raters to continue with the rating process through the instrument’s life, even if the issuer is not cooperating.

By asking the raters to reveal the ratings that were not accepted by a corporate entity, Sebi wanted to crack down on rating shopping or 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. The raters were asked to disclose the name of the borrowing company, the size of the loan or bond issue and the rating assigned to it.

Between 1 January (when the new norm came into force) and June, around 650 listed and unlisted companies did not accept the credit ratings assigned to them by the four rating agencies—Crisil, Care, Icra and India Ratings. There have been many instances of a sharp downgrade of debt instruments in the recent past even as the agencies involved are different.

For instance, Amtek Auto Ltd’s Rs9,000 crore debt was downgraded from ‘AA’ to ’D’ in four months. Reliance Communications Ltd’s debt this year was downgraded to the default grade in an even shorter time.

There could be many reasons why a rater fails—ranging from unforeseeable events that impact the business of the rated company to non-disclosure or selective disclosure of information, incompetence or the lack of predictive ability of rating models, and rating agencies assigning better rating compared to competition to acquire clients.

At times, rating agencies delay in acting for fear of backlash; they also avoid a public display of multi-notch downgrades and hence suspend or withdraw the rating. The industry and the regulators should address these issues through a systematic process and not ad hoc measures. Since the consultation paper will be open for public comments till 29 September, I am tempted to put forward a few suggestions.

The biggest ill that plagues the industry is assigning a liberal rating to acquire clients.

Globally, India is the only country with seven rating agencies and Sebi must look at the competitive aspects of the industry. Already, the growth in bank loan rating—which is at least one-third of the Rs1,200 crore rating industry—is slowing down and the bond market is still shallow, even though the larger raters are chasing unrealistic margins and growth targets. How much competition can it afford? Unrealistic targets and some of the prevalent market practices could lead to misselling, rating promises and rating-linked pricing.

One way of preventing this could be monitoring the compensation and targets of the CEOs and top management of raters. Sebi can also introduce a code of conduct for ‘rating advisers’. The flip side of making the unacceptable ratings by the corporate entities public is business opportunities for so-called rating advisers or agents. Such agents promise better ratings at a commission and get it done by certain raters with whom they enjoy a cosy relationship.

A credit bureau can be entrusted with the responsibility of default recognition. Sebi can also explore the possibility of a mandatory rotation of rating agencies by the debt issuers, say every three or five years. If corporations are required to change their auditors every three years under the Companies Act, why can’t Sebi suggest a similar course for the debt issuers? Of course, all seven raters may not be entitled to get this business; Sebi can always lay down the norms (in terms of track record, number of ratings issued, and so on) for a rating agency to be eligible to get business following the mandatory rotation system.

Finally, the regulator must also assess the predictive ability of the current rating models followed by the agencies. Most rating agencies in India take it for granted that rating should remain a high-margin business and there is no need to invest in high-tech modelling, which is now possible due to the availability of exotic new technology. Both governance and the rating model of some of the agencies are suspect. Let’s call a spade a spade.