How Sebi's stricter guidelines will impact credit rating agencies

On Tuesday, the Securities and Exchange Board of India (Sebi) issued stricter guidelines for credit rating agencies (CRAs), as the financial sector continued to grapple with the fallout of the Infrastructure Leasing and Financial Services (IL&FS) crisis.

Three issues are of critical importance. First, the impact the financial position of the holding or parent company has on the rating assigned to the subsidiary or group company. Second, disclosure of a firm’s liquidity position, and third, monitoring of repayment.

On the first, typically, when CRAs rate a particular instrument of a company, they often take into account the financial support that is likely to be extended by the parent company or the holding company. As this provides a financial cushion to its subsidiaries or other group entities, this expected support has at times led CRAs to assign a higher rating to a company than what would have been the case if the rating was assigned on a standalone basis.

Thus, in cases when the financial position of the parent or holding company deteriorates, such a framework would have a material bearing on the ratings and the repayment ability of the subsidiary.

Further, under this framework, while CRAs take into account the support the parent/holding company is likely to extend, they have not at times taken into account the impact of a likely deterioration in the financial position of the subsidiary on the parent/holding company. In cases where the financial position of the subsidiary deteriorates and the parent company stands as guarantor, this would have a bearing on the ratings assigned and the repayment capacity of the main company.

The new guidelines are likely to address these issues, experts told Business Standard. CRAs will have to clearly articulate the rationale for expectation of support from the parent company in the analytical section of their release. They have also been asked to review the framework they employ to view the relationships between the holding company and the subsidiaries.

On the issue of liquidity, the various parameters listed by Sebi are incorporated by CRAs in their assessment of companies. However, since much of this information is confidential in nature, issuers have at times stressed upon rating agencies not to disclose the information in the public domain, experts said. The new guidelines now make these disclosures mandatory.

However, the guidelines do not address the ratings approach that CRAs follow. Rating agencies in India follow the probability of a default approach. Under this approach, ratings estimate only whether the firm will service its debt on time and in full. They do not take into account the underlying collateral or whether it can be used to compensate for investors losses. By comparison, the probability of expected loss approach, which is often used in developed countries, takes into account the collateral against which the security is issued.

While some CRAs are looking at different approaches in sectors such as infrastructure, experts said once the Insolvency and Bankruptcy Code (IBC) process stabilises, it may be possible to incorporate the expected loss model in their ratings.

On the issue of monitoring repayment, CRAs typically get their information from the company itself, or from lending financial institutions, credit information bureaus or from stock exchanges. At times, they may also call on the debenture trustees to share information on repayment.

In its circular, Sebi has also asked CRAs to treat sharp deviations in bond spreads of debt instruments vis-à-vis the relevant benchmark yield as a material event. Theoretically, this is a sound proposition. Higher yields would suggest that markets are pricing in greater risks than what the assigned ratings may suggest. But this indicator assumes that corporate bonds are actively traded. This, however, may not be the case as the trading volumes in the corporate bond market in India are very thin, the experts said.

Other issues involve CRAs publishing transition studies that are central to evaluating the performance of a CRA and to provide an insight on the stability of their ratings over a period of time. However, while internal audits could ensure that errors of omission or commission are reduced, conversations with experts reveal that such studies are already published by CRAs.

For instance, Icra’s Rating Transition and Default Study — FY18 was published in August 2018. It showed that the stability of investment grade ratings was 92 per cent in FY18, which was higher than the 10-year average of 90 per cent. However, the severity of rating actions taken by Icra, as measured by the Large Rating Change Rate (LRCR1), increased to 5.2 per cent in FY18, compared with 4 per cent in FY2017.