Rating the raters

Reforms package must include strong deterrence

Over the past couple of years, the Securities and Exchange Board of India (Sebi) has been announcing tougher rules around disclosure by credit rating agencies (CRAs) in a bid to boost transparency and accountability. The fresh norms, announced last week, were part of that process and triggered by the crisis in Infrastructure Leasing & Financial Services (IL&FS), which saw its ratings downgraded from investment grade (AAA) to junk (D) status in just 45 days, impacting mutual funds and other investors who had bought bonds of IL&FS and its subsidiaries. The consensus was that the CRAs failed miserably to raise the red flag in time until an IL&FS subsidiary defaulted on some of its debt earlier this year.

Sebi has now asked CRAs to analyse the deterioration in the liquidity conditions of the issuer and take into account any asset-liability mismatch while reviewing ratings. CRAs will also have to disclose any linkage to external support for meeting near-term maturing obligations and have a special section on “liquidity,” which will highlight parameters like liquid investments/cash balances, access to unutilised credit lines, the liquidity coverage ratio, adequacy of cash flows for servicing maturing debt obligation, etc. CRAs will have to publish information about the historical average rating transition rates across various rating categories so that investors can understand the historical performance of ratings. To further strengthen disclosures, Sebi said if a subsidiary company got support from the parent group or government, CRAs would have to name the parent company or government that would provide support towards timely debt servicing. Rating agencies will also have to provide the rationale for this expectation.

While the disclosures will help in improving transparency, they are unlikely to prevent the recurrence of the IL&FS kind of fiasco without a sufficient deterrent. At the heart of the problem is the “issuer-pays” model, which has conflict of interest baked into it, as CRAs produce ratings used by investors, but obtain most of their revenue from issuers, both as ratings fees and as payment for other services. Though CRAs say they have adequate firewalls between their rating and non-rating businesses, the questions will never go away. A way out of this could be to increase the legal liability of CRAs for compensating investors for any loss caused to them by negligent or fraudulent rating. But adequate safeguards have to be built in because CRAs could challenge such a rule in court on the grounds that ratings are mere opinions. It will also be prudent to deal with the issue as part of a package of reforms. This includes treating CRAs similar to that of auditors — putting a cap on the number of clients or making it mandatory for companies to change rating agencies every three years. The reforms package should include asking CRAs to separate their rating and non-rating businesses in order to avoid conflict of interest. Sebi could also look into suggestions that regulators create a centralised clearing platform for rating agencies, which would assign a rating firm for an issue using its discretion. More disclosures can help up to a point, but will hardly solve the problem of opaquely structured securitised mortgages being rubber-stamped as AAA by rating agencies, as they may be more interested in generating fees than doing careful risk assessment.