Full disclosure: on the credit rating industry

Mains Paper 4: Economy
Prelims level: Credit Rating agencies
Mains level: Investment models

Context

•  After he IL&FS crisis, the Securities and Exchange Board of India is now trying to increase the level of scrutiny on credit rating agencies that failed to warn investors about it.
•  SEBI has come out with new guidelines to improve the quality of disclosures made by credit rating agencies.

Key highlights of this new norms

•  According to the new norms, credit rating agencies will have to inform investors about the liquidity situation of the companies they rate through parameters such as their cash balance, liquidity coverage ratio, access to emergency credit lines, asset-liability mismatch, etc.
•  The rating agencies will have to disclose their own historical rating track record by informing clients about how often their rating of an entity has changed over a period of time.
•  SEBI has been working hard to improve transparency and credibility among rating agencies for some time now, including through a circular issued in November 2016 calling for enhanced standards for rating agencies.
•  The latest disclosure norms seem to be a response to the IL&FS defaults and the ensuing crisis.
•  The ready availability of information can help investors make better decisions.

How these regulation are important for the investors?

•  But the latest regulations can only help to a certain extent as a lot of the problems with the credit rating industry have to do with structural issues rather than the lack of formal rules.
•  The primary one is the flawed “issuer-pays” model where the entity that issues the instrument also pays the ratings agency for its services.
•  This often leads to a situation of conflict of interest, with tremendous potential for rating biases.
•  Second, the credit rating market in India has high barriers to entry, which prevent competition that is vital to protecting the interests of investors.
•  This is not very different from the case in many developed economies where rating agencies enjoy the benefits of an oligopoly.
•  Better disclosures can increase the amount of information available to investors, but without a sufficient number of alternative credit rating providers, quality standards in ratings will not improve.

Way forward

•  It is thus no surprise that even after repeated ratings failures in their long history, credit rating agencies continue to remain and flourish in business.
•  Structural reform should aim to solve another severe problem plaguing the industry, which has to do with rating shopping and the loyalty of credit rating agencies in general.
•  Rating agencies will have to come up with lucrative business models that put the interests of investors above those of borrowers.
•  Such a change requires a policy framework that allows easier entry and innovation in the credit rating industry.

Online Coaching for UPSC PRE Exam

General Studies Pre. Cum Mains Study Materials

Prelims Questions:

Q.1) With reference to debentures, consider the following statements:
1. Debentures are long-term financial instruments which acknowledge a debt obligation towards the issuer.
2. Non-convertible debentures are usually given at a higher rate of return compared to convertible debentures.

Which of the statements given above is/are correct?

(a) 1 only
(b) 2 only
(c) Both 1 and 2
(d) Neither 1 nor 2

Answer: C

Mains Questions:
Q.1) Structural reforms are needed to bring accountability to the credit rating industry? How should SEBI respond to its situation?