Rethinking the CRA regulatory framework

Mains Paper 4: Economy
Prelims level: CRA
Mains level: Indian Economy and issues relating to planning, mobilization of resources, growth,
development and employment. Inclusive growth and issues arising from it

Context

• • On 13 November, the Securities and Exchange Board of India (Sebi), in its continued effort to improve the functioning of credit rating agencies (CRAs).
• • It came up with a fresh set of guidelines for enhanced disclosures on rating rationales. Sebi has been actively trying to enhance regulations pertaining to CRAs, particularly post-2012.
• • However, debt investors remain a worried lot since there have been four defaults among borrowers rated at AA and above.
• • If anything, the frequency and intensity of such events are increasing, with the most recent being an AAA-rated borrower defaulting.

Shortcomings

• • There has been no dearth of effort from Sebi.
• • It does call for a rethink on the regulatory approach to CRAs, as well as the efficacy and sufficiency of the regulations.
• • The general criticism of ‘issuer pays’ model as the crux of CRA performance may be missing the complexity of the matter.
• • Globally, this model goes back to the 1970s.
• • The alleged slippage of India CRAs is a more recent phenomenon despite them having been around since 1990.
• • The evaluated-pays-the-evaluator model is not unique to CRAs. Auditors and universities follow the same model.
• • If more questions are raised on CRAs than on universities, then one may need to look beyond popular but over-simplistic explanations.

Regulatory approach

• • Sebi’s regulatory approach to CRAs has been more inclined to a rule-based approach as opposed to a principle-based approach.
• • Under a principle-based approach, the regulator states the desired outcome, leaving it to the regulated firms to figure out the steps they need to take to achieve the regulator-mandated end-state.
• • In a rule-based approach, the regulator specifies the action to be taken by the firms to be considered compliant.
• • Rule-based regulations, despite their appearance of regulatory micro-management, tend to be preferred by firms relative to principle-based regulations.
• • Firms prefer less ambiguity associated with the rule-based approach.
• • Additionally, they are relieved of the burden of proof of being compliant, as may be required in a principle-based approach.
• • However, if there is a failure in a rule-based regulatory framework, it is the system that tends to bear the cost.
• • Firms, to the extent that they remain compliant, do not share the downside and, arguably, have limited skin in the game.

Need regulations

• • It may be borne in mind that rule-based regulations assume a high degree of technical sophistication on the part of the regulator.
• • The regulator needs to have a well-articulated end objective.
• • This is different from having rules in response to a specific crisis, since there is always a risk that the end objective becomes unclear if not non-existent.
• • It leaves the system exposed to more risks.
• • If Sebi adopts a higher dose of principle-based regulations, it may set specific end-objectives.
• • For CRAs, it may be best to act and function in a way that the market’s faith in the quality of ratings is maintained.
• • This faith, in turn, will facilitate development of the Indian bond market.
• • While Sebi may not suddenly turn to the principle-based approach, it may still achieve the end objective by fine-tuning its latest, well-intentioned guidelines.
• • The rating rationale disclosures should be such that most market participants can easily evaluate the quality as the risks associated with the rating decision itself.
• • Merely adding more verbiage to the rating press release with lot of tick-boxes that can be filled subjectively will not leave anyone wiser.

Suggestive measures need to be taken by the SEBI

• • Quantitative disclosure: Rules should be such that they do not commoditize the CRAs’ offerings since divergence of views/approaches across CRAs is critical for any well-functioning system. The CRA may be required to publish the median values of the critical ratio of their choice, for a specific industry, across various rating levels and for the last five years. This will allow an investor to compare whether the current rating is more or less stringent, and whether, over the period, the CRA’s standards have been consistent. The objectivity and transparency of this numerical disclosure will go a long way towards building confidence in a rating .
• • Enhanced transition matrix: The transition matrix should track default rates over multiple years. Investors need to know the default rate of AAA/AA/A ratings over three to five years from issuance, and not just one year. Withdrawn ratings should also be a category, and defaults occurring within one year of rating being withdrawn should be included in the default study.
• • In fact, Sebi may consider independently calculating the default transition matrix by accessing data from a commercial credit bureau or Reserve Bank of India’s central repository of information on large credits database and not depend on the CRAs at all.
• • Cursory disclosure of all ratings: CRAs may be required to also summarily refer in the press release to the outstanding ratings of other CRAs for the same borrower and the previously withdrawn rating of the same borrower from other CRAs and the reason for the rating withdrawal. The palpable reputation risk that errant CRAs will face may go a long way towards preventing rating shopping.
• • Legal protection for CRAs: Most critics tend to forget that instances of Indian CRAs being sued by the company it rates, in a bid to prevent the rating downgrade, are not unknown. The regulator should consider framing laws that allow CRAs to express their rating opinion without fear of being sued.

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General Studies Pre. Cum Mains Study Materials

Prelims Questions:

Q.1) Consider the following about the Coalition for Epidemic Preparedness Innovations (CEPI) that was recently seen in news.
1. It was launched by the World Health Organization (WHO).
2. It is a public-private alliance to finance and coordinate the development of new vaccines to tackle epidemics.
3. It will fund programmes in LDCs that build a geographical information system (GIS) for mapping epidemic prone regions.

Select the correct answer using the codes below.
a) 1 only
b) 2 and 3 only
c) 2 only
d) 1, 2 and 3

Answer: C

Mains Questions:
Q1. For state-sponsored insurance, governments should avoid insurance companies. Explain it