Credit rating agencies still vulnerable to new biz risks, say experts

Agencies insist they have improved supervision and governance

Credit ratings agencies (CRAs) are in the spotlight, even though several measures have been initiated to fix the issues plaguing them. Some challenges that arose during the global financial crisis in 2008 are still unresolved, while developments that led to the threat of the revocation of licence of a major market intermediary indicate that lapses remain in the rating process.

Rating firms maintain that they have made an effort to address the issues, including going for external hirings and using leveraged technology to ensure that the entire process is seamless and automated.

However, industry experts say that CRAs still lack an evaluation model to recognise new business risks. The rating agencies have to use better market intelligence than depending on historical data, they emphasise. Rating firms have also been facing certain regulatory challenges, particularly real-time information on bank defaults.  

“CRAs may not have the necessary evaluation models to recognise new business risks which probably impact the outcome of their rating action. Hence, the ratings do not necessarily reflect the financial health of the company or the instrument rated. Liquidity risk during the global financial crisis was the classic example and even now it is a challenge for them,” said Ashvin Parekh, managing director, Ashvin Parekh Advisory Services, a global management consulting firm.

Besides, there is a lack of coordination between the Reserve Bank of India (RBI) and the Securities and Exchange Board of India ( Sebi) over the disclosure of bank loan default by listed companies. CRAs have approached Sebi and the RBI many times over the issue of new norms for the disclosure of bank loan defaults.

Sources said that CRAs are of the view that the differential disclosure norms for bond and bank-loan defaults could lead to information asymmetry and make the rating process open to manipulation.

At present, any default of interest or principal repayment in the case of bonds is reported immediately. However, in the case of bank loans, companies are given a 30-day grace period before the disclosure norms kick in.

CRAs are accredited by the RBI, since their key function is to provide ratings to debt instruments such as bank loans, non-convertible debentures (NCDs), commercial papers and certificates of deposits. The ratings that CRAs give to these instruments are critical as they impact pricing and investment decisions.

According to Parekh, there is a need for proactive communication wherever the regulator has a different view from that of other stakeholders. “I believe a consultative approach could prevent AT-1 (additional tier-1) bonds from causing surprises where investors have to suffer,” he said.

The AT-1 bonds issue pertains to the Yes Bank restructuring scheme announced in March, 2020. The YES Bank crisis led to huge risk for a new class of investors, apart from retail investors and mutual funds. AT-1  bonds, also called perpetual bonds, issued by YES Bank caused losses to their holders since the restructuring scheme allowed the lender to extinguish its outstanding Rs 8,415 crore AT1 bonds.

However, rating firms insist that they have embarked on a deep, transformational journey.

“Our board of directors is entirely new and has systematically focused on improving ratings processes and ratings governance. Also, external hirings have been made to support the existing team of professionals to ensure that changes can be brought about where required. The firm has a new MD and CEO, a chief rating officer (CRO), chief financial officer, head – legal, compliance and secretarial, and a chief culture officer at the helm,” a CARE ratings spokesperson said in response to a media query.

It further said that the ratings supervision and governance have been strengthened with the CRO reporting to the risk sub-committee of the board.

CARE Ratings also has an external risk supervision committee, comprising senior and independent professionals who review its ratings periodically and offer suggestions for further improvement, the agency said.

It added that the firm has leveraged technology in a big way to ensure that the entire process is seamless and automated. Steps are being taken to add a layer of artificial analysis and machine learning to make the rating analytics more predictive in nature in regard to default calculations, it said.

Rating action is nothing but the guidance for taking informed investment decisions. Even institutional investors like banks, pension funds and insurance firms go by the rating action. Hence, lapses in the process cannot be taken lightly.

In this context, an action like the cancellation of licences is a welcome step as it will ensure better functioning of the agencies, Parekh pointed out.

“In the recent past, Sebi has asked for the removal of top officials at rating agencies. However, the revocation of licence is an extreme step that may be considered by the regulators if there are repeated lapses,” said Shriram Subramanian, founder and managing director of domestic proxy advisor, InGovern Research Services.  

Earlier, CRAs were happy to rely on the financial numbers provided by the management. “The required deeper due diligence was lacking. That doesn’t mean CRAs haven’t changed. The increased scrutiny on them has meant that CRAs would rather let go of an errant client or rating than continuing to provide the ratings,” Subramanian said.

The IL&FS crisis in 2018 saw several top officials at rating agencies step down. In August 2019, Moody’s India arm, ICRA, sacked its managing director and CEO Naresh Takkar, following allegations of wrongdoing. In December 2019, CARE managing director and CEO, Rajesh Mokashi, too, had to step down after there were whistleblower complaints, alleging management interference in the ratings of certain companies, including IL&FS. In February 2020, CARE chairman S B Mainak also tendered his resignation.