Question

Credit Rating Agencies has come under criticism after the IL&FS crisis as it is believed that they failed to pick up the signals of a liquidity crunch. In light of IL&FS crisis, Highlight the various issues involved with Credit Rating Framework in India.

Answer 1

Approach:

• Highlight what are CRAs and why they are in news.
• Highlight various issues involved with them.
• Conclude by giving a way forward as how we can strengthen CRAs.

As per the Regulations, CRA is defined as “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”. All the credit agencies need to be registered with SEBI in order to operate in India. SEBI (Credit Rating Agencies) Regulations, 1999 provide for a disclosure-based regulatory regime, where the agencies are required to disclose their rating criteria, methodology, default recognition policy, and guidelines on dealing with conflict of interest.

Rating agencies have come under pressure after they failed to raise timely red flags ahead of debt defaults by Infrastructure Leasing and Financial Services Ltd (IL&FS) until after a subsidiary defaulted on some of its debt last year. Following are the issues involved with Credit Rating Framework in India:

• Conflict of interest: CRAs follow the 'issuer pays model', under which the entity issuing the financial instrument pays the agency upfront to rate the underlying securities. However, such payment arrangement may lead to a 'conflict of interest' and could result in compromising the quality of analysis.Another example of conflict of interest is non-rating services such as risk consulting, funds research and advisory services given to issuers for which ratings have been provided.
• Rating shopping: It is 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. Hence, the system does not permit publishing a rating without the issuer’s consent.
• Less competition: Credit-rating market in India is oligopolistic, with high barriers to entry. Lack of competition in the market enables CRAs to have longer, well- established relationships with the issuers which can hamper their independence.
• Poor Rating Quality: Often ratings are provided on limited information. For e.g. If the issuer decides not to answer some determinant questions, the rating may be principally based on public information. Many rating agencies don’t have enough manpower which often leads to poor quality.
• Multiple Regulators: Other than SEBI, there are certain other regulatory agencies, such as the Reserve Bank of India (RBI), Insurance Regulatory and Development Authority, and Pension Fund Regulatory and Development Authority, which also regulate certain aspects of credit rating agencies under their respective sectoral jurisdiction.

The role of CRAs in an economy like India can’t be neglected as they help investors, customers etc. to get an overall idea of the strength and stability of an organization and enable them to make informed decisions. To Strengthen the Credit Rating Framework in India, Government and SEBI should ensure more accountability of the CRAs and should review the regulations and suitably modify them to ensure greater objectivity, transparency and credibility in the whole credit rating framework.