While the battle lines for folding the Forward Markets Commission into Sebi have been drawn — and good luck with that — I believe that there is a more important, and easier, battle that needs to be fought as well. This has to do with the evolution of the corporate bond market. No less an authority than the prime minister has acknowledged that this is a crucial piece of India’s development and I have little doubt that you are already working with RBI on how best to turn this need into a reality.
While there are many operating changes that need to be made within the regulatory system — e.g., permit the use of corporate bonds for repos (with an appropriate haircut) — I believe it is also critical that we design the framework to avoid some of the structural flaws that have once again bubbled to the top during the recent global financial crisis. I am speaking, of course, about the structural conflict of interest issue with bond ratings (as with financial audits), which can be simply understood as follows:
Who gets value from a bond rating? Investors, who use it to take investment decisions, securities exchanges, who earn fees from trading volumes on the rated instrument, and regulators, whose job it is to make sure that there is fair play in the markets.
Who pays for the rating? The company being rated — the same potentially crooked, manipulating management team that regulators want to protect the investing public from.
It doesn’t make any sense. You wouldn’t buy a house or a car (or any other asset) on the say-so of the owner; nor on the certified rating of someone paid by the owner. Which is not to cast aspersions on the owner or the certifier — it simply makes sense to do your own analysis, or pay someone to do the analysis for you.
It’s so straightforward it’s extraordinary that it needs to be said.
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In the case of credit ratings, this fundamental problem is compounded by the fact that institutional regulators (RBI, Irda, etc.) use these same structurally unsound ratings to define capital requirements, which makes a mockery of supposedly crucial issues of capital adequacy and risk management.
Clearly, there is a need for a new framework, where the beneficiaries of any financial service pay, as directly as possible, for that service. And since we are, in a sense, starting our corporate bond market from scratch, we are very well positioned to take the lead.
Now, I know it would be impossible to set up a structure where tens of thousands of investors (the beneficiaries of ratings) would directly divvy up the cost of a credit rating. But what if securities exchanges (another beneficiary) were to pay for ratings and recover the cost through an additional trading fee? This way, investors would end up paying for the ratings, rating agencies would have no incentive to be, shall we say, influenced by the rated company, and securities exchanges would have an additional business opportunity. Indeed, exchanges may have an incentive to pay a higher fee to a rating company if it (a) needed to attract business, and (b) believed it could readily recover the cost from trading volume. It may even provide an entity like the BSE a new lease of life.
Implementing this idea (or something akin to it) would undoubtedly appeal to rating companies, since their fees would be more directly market-determined, rather than serving as loss-leaders (as they sometime are for the rating agencies’ consulting business). This way the ratings business can become a genuinely knowledge-based business, with greater accountability.
If a particular rating agency’s analyses failed too frequently, the securities exchanges would negotiate fees down or simply go elsewhere. Clearly, Sebi would need to substantially lower the barriers to entry into the credit rating business.
While there will always be ratings that fail, my sense is that eliminating the conflict of interest and making the process more accountable will lead to higher quality ratings, which would serve the needs of the institutional regulators as well, making their capital adequacy guidelines more meaningful.
And, just as RBI’s staunch independence (from blindly following “advanced” country processes) has supported our economy through this last crisis and earned India kudos in global regulatory circles, taking such a radical, but simple and sound, step in the area of rating corporate bonds may well push global regulators to change their approach as well. This could lead to a fresh approach to sovereign ratings, which would likely end up improving India’s rating and reducing our borrowing costs.
Chalo, bhaijan, it’s your turn.