The rules for credit rating agencies need to be overhauled

Along with the news about the slowdown in various parts of the economy, reports about alleged corporate governance problems in companies are also increasing. As businesses grapple with this phase of slowing consumption, they are likely to find it increasingly difficult to service the debt on their balance sheets. In these conditions, credit rating agencies (CRAs) have a critical role to play in alerting the external stakeholders about the true state of affairs at a business and give early warnings about possible deterioration in debt servicing capability. The recent exits of the chiefs of few CRAs show that there is much that is amiss in the functioning of these companies. The regulations governing them need to undergo a revamp.

The sharp slowdown in consumption and capital expenditure in the first half of 2019 is likely to exert further pressure on corporate India that has relied excessively on debt to fund growth. A recent report by McKinsey and Company indicates that the share of long-term debt of companies with interest cover of less than 1.5 per cent was 43 per cent in 2017; the highest among emerging economies. With the economy decelerating in the recent quarters, the numbers could have deteriorated further, increasing the instances of creative accounting. CRAs have been found wanting in detecting cases of misrepresentation in recent instances such as the IL&FS issue. Market regulator SEBI has been bringing about changes to the regulations governing CRAs including mandating the disclosure of one-year forward probability of default and asking these agencies to grade the liquidity position of the issuer. SEBI has also asked for an independent audit of the processes employed and the data used in default analysis. Also, it was recently mandated that CRAs could obtain information about the issuer directly from FIs. While these measure are welcome, they are not sufficient. The crux of the issue lies in the manner in which rating agencies earn their income. With the issuer having to pay the raters, questions are being raised, and rightly so, about the independence of the rating process. The way out would be to make the investor pay for the rating by deducting the fee from the issue proceeds. Making the selection of the rating agency transparent through an auction, overseen by a statutory body and limiting the number of rating assignments awarded to an agency in a year, are measures that can quell the inclination to bend backwards for a large issuer. Mandating that all ratings, even those that are not taken to the final stage, are published, will stop the practice of rate-shopping.

Besides this, making the ratings committee report to the board of directors rather than the CEO who spearheads the overall growth of the CRA is another way to make the rating process more objective. It should also be mandated that rating agencies should not solicit business and there should be rotation of the rater every three years.

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