Full disclosure: on the credit rating
Mains Paper 4: Economy
Prelims level: Credit Rating agencies
Mains level: Investment models
- 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
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
- 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.
- 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.
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
Q.1) Structural reforms are needed to bring accountability to the credit
rating industry? How should SEBI respond to its situation?