Rating agencies’ ineffectual functioning must be reformed

| Updated on January 05, 2020 Published on January 05, 2020

Strict regulation, deterrent punishments and a fundamental change in business model are needed

Faulty assessments by credit rating agencies have played a big role in Indian investors getting singed by a series of bond market blow-ups in the last couple of years. It is therefore about time that the Securities Exchange Board of India (SEBI) initiated direct penal action against rating agencies for their role in these episodes, instead of merely tightening regulations and disclosure norms. In orders passed last week, SEBI has upbraided ICRA, CARE and India Ratings for their ‘lethargic indifference’ and lack of due diligence in assessing IL&FS, and imposed fines of ₹25 lakh each. But this seems to let the agencies off the hook rather lightly, considering that over ₹90,000 crore of borrowed funds are hanging fire in the IL&FS case alone. For more effective deterrence, SEBI ought to levy penalties that are at a multiple of the rating fees and consider suspending the licenses of agencies found to be repeatedly remiss in their duties.

Though rating agencies like to claim that their business of offering credit opinions is subject to human error, their repeated failure globally to fulfil their fiduciary mandates points to a deeper malaise. By now it is widely acknowledged that the root cause of rating agencies’ ineffectual functioning lies in their conflicted business model where it is the issuer of debt, and not the user of it, who commissions their ratings and pays their fee. In the IL&FS case, a forensic investigation by Grant Thornton has hinted at an unhealthy nexus between the IL&FS management and rating agencies, with the allegations of quid pro quo for ‘favourable’ ratings. Shifting from the issuer-pays model to a user-pays one offers the best solution to this problem. But global regulators have found it a tricky one to put into practice, with pushback from bond investors. This, however, need not deter Indian regulators from initiating a consultative process on whether rating fees can be funded from issue proceeds of bond offers, or funded from levies such as the securities transaction tax.

There are other viable methods to crack down on issuers shopping for ratings too. The industry practice of issuing ‘indicative’ ratings must be dealt with a strict hand. Requiring rating agencies to disclose their standard rate cards as well as rating fees for individual mandates could deter under-cutting and ‘negotiated’ ratings. Aligning top management compensation in rating agencies to credit outcomes, rather than business parameters, can help correct the skewed incentive structure that prompts them to chase after business volumes. It is also about time that institutional investors in India built internal capacity for assessing bonds, as they have for equities, instead of blindly relying on third-party ratings. This would not just shield investors in pension funds, mutual funds and insurance plans from errors of omission and commission by rating agencies, it would also ensure that market prices of bonds are aligned to the true financial position of borrowers even if credit ratings aren’t.

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Published on January 05, 2020
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