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ARE CREDIT RATING AGENCIES JUSTIFYING THEIR EXISTENCE?

Introduction
Credit Rating Agency (CRA) are the ones who give a rating to the creditworthiness of an instrument (like Debt securities; Short term debt instruments; Mutual fund schemes; Structured debt products; Loans and Fixed Deposits) issued by a borrower/debtor (which will be a company and not an individual person), based on their ability to pay back their principal loan and interest on time[1]. The ratings are merely an opinion per se which is futuristic, relative and are relied upon the study of past events and assumptions of prospective events which helps investors to get an overall idea of the strength and stability of a company. In India, CRA’s are regulated by SEBI which gives them a license to operate and to continue its operations as stated under the Security and Exchange Board of India (Credit Rating Agencies) Regulations, 1999.
Role of CRA’s:
The code of conduct for CRA’s as stated under the Regulation No. 13 and further elaborated by Schedule III of the Regulation[2] is inspired by the International Organization of Securities Commission (IOSCO) Code of Conduct Fundamentals for the working of CRA’s. Some of the key objectives of the IOSCO Code of Conduct are: To maintain the integrity of the rating process; Independency and avoidance of conflicts of interest; Providing investors with timely information about the procedures, methodologies and assumptions behind a rating; Protection of non-public information from premature disclosure.
Ratings are generally done in an alphabetical combination of lower and uppercase letters, with either “+” or “-” signs or numbers added to further fine-tune the ratings[3]. CRA’s play a significant role as they can create havoc in an economy by rating a company which would either allow them to raise loans easily or will make it difficult for them to borrow during the whole lifetime of the company. They provide information about the credibility of the company on which a lot of unaware potential investors rely upon. Just by taking a glance at those ratings it helps the investor to understand the financial strength of the company which are given after conducting due diligence of various documents of the company.
Problem with CRA’s:
In India CRA’s have an oligopolistic market they need to work towards the asymmetric[4] relationship between the issuer/company and investor in order to maintain the quality of ratings. Currently, India has 6 renowned CRA’s namely CRISIL, ICRA, SMERA, FITCH INDIA, ONICRA, & CARE and nonetheless they all have to face the same problems which are:
  1. Rating shopping – With a limited number of CRA’s prevailing in the market, companies tend to prefer the one who would quote the less price and promise a good rating in return which leads to getting a faulty rating at the very outset only. This uprightly raises a question whether the CRA’s are also the ones affected by today’s competition among the competent people?
  2. Quality and disclosure of ratings – CRA’s try to gather as much information as they could from a company but reluctance on the part of the company to share essential information leads to manipulation of the ratings and making it confined only to the documents available or presented to CRA’s[5].
  3. Conflicts of interest – The Company pays the CRA’s itself for the rating of its own instruments leading to conflict of interest wherein the main purpose of the CRA’s is to serve the investors with the credibility of the company which.
IL&FS Case
In September 2018, IL&FS defaulted which created panic in the financial market. IL&FS (Infrastructure Leasing & Financial Services Limited) which operates through more than 250 subsidiaries is an Indian Infrastructure development and Finance company. When news broke out that IL&FS defaulted on payment obligations of its bank loans, term and short-term deposits and even failed to meet the commercial paper redemption obligation pursuant to which CRA’s, as for example ICRA which rated it as ‘A1+’ in August First Week changed it to ‘D’ on 17th September 2018 and CARE which rated it as: ‘AAA’ in August first week also shifted its rating to ‘D’ on 17th September 2018[6]. The company had a major short-term Asset-Liability Mismatch and liquidity was affected at various systemic levels. The moment the news broke out NBFC’s halted its funding to the real estate development sector which resulted in a domino effect of liquidity crunch. RBI was forced to supply liquidity in the economy with Open market Operations[7] and relaxation of norms on the securitization of NBFC loans. It was not the first time where the CRA’s downgraded their previously rated companies all of a sudden. As for example in the case of DHFL, Amtek Auto, IDBI Bank, and Reliance Communications they all were suddenly downgraded as compared to their earlier ratings. It clearly shows that the CRA’s haven’t been working diligently and up to the mark under the nose of market watchdog, SEBI.
Conclusion:
Pursuant to a lot of chaos and questions been raised upon SEBI and its functioning a penalty of 25 Lakhs Rupees[8] has been imposed by SEBI on CARE & ICRA after the non-vigilant activities in IL&FS case but, is that penalty justified in comparison to the default amount which had happened due to faulty ratings? One of the common problems of CRA’s though has been looked into to some extent by SEBI post this in order to maintain the quality & disclosure of ratings as for instance by incorporating the concept of “explicit consent” whereby the company would provide all the details related to their existing and/or future borrowing of any nature, its repayment and delay or default about the company form all its sources[9]. Irrespective of this the problem of rating shopping & conflict of interest still exists and needs to be resolved properly as the interest of a lot of investors is at stake. For instance, it could be done by removing the profit motive interest of CRA’s and allowing them to undertake independent reviews to rate a company instead of waiting for the companies to approach them, which would substantially solve the problem of rating shopping and there won’t be any conflict of interest too. Imposing a penalty will always give room to the CRA’s to work dishonestly and escape by paying a fine. It is to be noted that when ratings are rightly done it would lead to an ease in borrowings which would lead to a further chain of benefits for each and every sector.

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References

[1]Issues Around Credit Rating Agencies, (10th February 2018) https://www.gktoday.in/gk/issues-around-credit-rating-agencies

[2] Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999

[3]Credit Rating Agency (Last visited on  12th February 2020, 7:47 PM) https://en.wikipedia.org/wiki/Credit_rating_agency

[4]Carmel Rawhani, Are credit rating agencies the problem or part of the solution? , (25th April 2017), http://www.polity.org.za/article/are-credit-rating-agencies-the-problem-or-part-of-the-solution-2017-04-25

[5]Gunja Kapoor, Credit rating: The agency problem, (05th August 2016, 01:36 AM), https://www.livemint.com/Opinion/Q1HislHb11z6Yto1Kz8KGP/Credit-rating-The-agency-problem.html

[6] Aashika Suresh, More bad news for IL&FS! Ratings cut to lowest level as debt woes worsen, (18th September, 2018 14:55),  https://www.business-standard.com/article/companies/more-bad-news-for-il-fs-ratings-cut-to-lowest-level-as-debt-woes-worsen-118091800651_1.html

[7] RBI to inject Rs 10,000 crore through open market operations on Thursday, (4th Decemebr, 2018, 08.14 PM) https://economictimes.indiatimes.com/markets/bonds/rbi-to-inject-rs-10000-crore-through-open-market-operations-on-thursday/articleshow/66940431.cms

[8] Ashley Coutinho, IL&FS case: Sebi imposes Rs 25 lakh fine on rating agencies ICRA, CARE ; (27th December 2019, 08:44 PM) https://www.business-standard.com/article/markets/il-fs-case-sebi-imposes-rs-25-lakh-fine-on-rating-agencies-icra-care-119122700057_1.html

[9] SEBI Notification No. SEBI/LAD-NRO/GN/2019/34 Dated: September 23, 2019

ABOUT THE AUTHOR

 

Harshit Dhandhia is a 4th-year law student (2016-2021) at the University of Petroleum and Energy Studies(UPES), Dehradun. He has a keen interest in corporate laws, PE, VC M&A.

 

In Content Picture Credit: Dialabank

1 Comment

  1. Sushant jha says:

    I can see the effort you put in research.

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