Credit ratings agencies often share a love-hate relationship with the Indian market regulators. News often pops up regarding the tussle between market regulators and agencies.
The friction has been reflected again with Brickwork Ratings India finding itself in the eye of the storm with regulators.
India’s capital markets regulator, the Securities and Exchange Board of India (SEBI), cancelled Brickwork Ratings India’s licence and asked the agency to shut down its operations within six months for allegedly violating various rules.
Pointing out violations by Brickwork, SEBI said it failed to follow a proper ratings process and exercise due diligence while providing ratings. Brickwork has also been barred from taking new clients.
SEBI’s latest action against Brickwork only highlights regulators' wariness as ratings agencies have played a crucial role in financial market debacles, not just in India but also in the other corners of the world. It is a story that dates back to the Global Financial Crisis (GFC) in 2008.
What Happened In 2008?
The 2015 film The Big Short depicted how ratings agencies played a crucial role in the 2008 recession. In a scene, an employee of Standard & Poor’s, one of the US’ biggest credit ratings agencies, explained the reason behind providing AAA ratings to the mortgage-backed companies to a hedge fund manager. The former said, “They will go to Moody’s.”
A common allegation to the ratings agencies is that they often provide higher ratings to the mortgage-backed companies, which often mislead investors.
The investors perceive that the mortgage-backed companies are the safest options to invest.Several mortgage-backed securities with junk loans had AAA ratings, meaning they were the safest investment grade.
Hence, the action of providing higher ratings is considered as a cause behind global recession.
“The skewed assessments, in turn, helped the financial system take on far more risk than it could safely handle,” economist Paul Krugman had written in a column for The New York Times.
Ratings agencies have two ways of assessing risk so as to rate the creditworthiness of any financial product or a sovereign nation—issuer pays and subscriber pays. Under the issuer pays model, which resulted in the 2008 subprime mortgage crisis, the issuer of a bond can pay these agencies for the ratings of a security. As a result, ratings agencies inflate the debtor’s credibility to avoid losing established clients. This conflict of interest has been widely criticised following the GFC.
Story Of The Indian Market
Ratings agencies are also providing higher ratings to multiple dubious companies in India. According to a Business Standard column, in India, seven credit ratings agencies together rated at least 920 debt-ridden companies so far.That certainly is a cause for concern for the investors.
The most prominent miss in recent history has been the failure of these agencies in predicting debt defaults of Infrastructure Leasing and Financial Services (IL&FS) and Jet Airways.
Several credit ratings agencies came under regulatory scanner for their failure to disclose timely risk of Jet’s loans worth Rs 11,000 crore taken from state-owned as well as private sector banks. Ratings agency ICRA had, at that time, said it regularly received no default declaration from the company at the end of every month.
IL&FS’ story is also similar. Ratings agencies did not raise a timely alarm on its debt defaults till one of its subsidiaries missed debt payment in 2018. The ratings failed to capture the stress that was mounting in the group. It flagged the stress much later and the IL&FS group had defaulted on its debt repayment from provident funds, banks, and mutual funds. Net asset values of several debt mutual fund schemes experienced erosion because of these defaults. The IL&FS crisis spilled on to other non-banking finance companies, especially housing financiers.
Apart from these two, credit ratings agencies have also failed to raise alarm on the defaults in companies like the Zee Group and DHFL. Financial instruments of both these companies saw sharp ratings downgrades, which were earlier rated as high credit quality. Similar lapses have happened in Reliance Communications and Amtek Auto.
How Does the Regulatory Body Work?
SEBI mainly regulates credit ratings agencies and their functioning in India. To tighten regulation, SEBI, in August, issued fresh guidelines for the credit ratings agencies to bring more transparency in their functioning and standardise the disclosure process for securities.
As per the new rules, ratings agencies now would have to compare two consecutive ratings actions if the change is more than or equal to three notches downward. The same has to be included in their disclosure on sharp rating actions.
Ratings agencies have to also separately disclose sharp ratings actions on non-cooperative issuers along with the current disclosures of sharp rating actions. Its 2016 circular has detailed guidelines for ratings agencies on what amounts to non-cooperation by an issuer.
A Standing Committee on Finance in 2019 submitted a report on Strengthening of the Credit Ratings Framework in the country. It observed that credit ratings agencies are now rating complex debt structures that include covering products and services like fixed deposits, securities, commercial papers, and bank loans.
The report also noted that bankers, investors, and capital markets are heavily relying on these ratings as an instrument or entity and such ratings are a crucial input for financial decision-making. It observed that rating agencies failed multiple times to flag IL&FS’ increasing debt levels and continued providing AAA ratings. It also noted that there was no provision for the rotation of such agencies and it recommended exploring mandatory rotation, which would help avoid the negative consequences of long-term associations between the issuer and the credit ratings agency.
Against this backdrop, it will have to be seen how effective SEBI’s steps, either closing down of ratings agencies or formulation of guidelines, will be in dealing with the issue of transparency in companies’ ratings.