'Need for studying role of rating agencies'

The Reserve Bank of India is concerned with the rating methodologies of complex products.

The Reserve Bank of India (RBI) has said that there is a need for examining the role of rating agencies in structured products. These products include securitisation of loan pools.

The central bank is concerned with the rating methodologies of complex products, particularly when securities with very different structures, assumptions and liquidity characteristics receive the same ratings.

"There is a need also for examinining risk analysis of credit derivatives and structured products, and the role of rating agencies," RBI said, listing out lessons learnt from the recent global financial market developments in its Report on Trend and Progress of Banking in India, 2006-07.

Banking analysts said RBI would be particularly worried at the triple-A rating given to perpetual bonds, which qualify as tier-I (core) capital of banks along with equity capital and reserves. Perpetual bonds are rated as triple-A, same as 10-year bonds bonds issued by banks for reckoning as tier-II capital, despite clauses that prevent banks from paying the coupon.

The events include fall in the capital adequacy ratio below the stipulated 9 per cent.

RBI has said the issue of valuation of complex products, in the context of a market where liquidity is insufficient to provide reliable market prices, also needs to be examined.

Investors may have to consider the associated liquidity aspects and include an appropriate liquidity risk 'premia' as part of the price when purchasing such products. Financial institutions holding such securities as collateral will also have to assign a 'haircut' to factors in liquidity characteristics.

It said there also is a need to generate more objective information on the market value of collaterals, especially in situations where they are not fully marked to market since such information may not be available on an ongoing basis.

The crisis has also raised the issue whether there are limits to marking the market to certain kinds of assets whose values are not available on a high frequency basis.

Credit and market risks have increased and financial markets have become more volatile in the recent period as a fall out of the sub-prime episode. Excessive leveraging has enhanced the vulnerability of the global financial system. Large changes in liquidity conditions are obscuring assessment of risks with attendant uncertainty.

In order to strengthen the financial system, several lessons for the private sector and the regulators and supervisors could be drawn. Although the full impact of the episode is not yet known, several areas will require increased attention.

RBI said though the smooth running of banks, financial institutions and financial markets depends crucially on trust and credibility, the transparency of the distribution of risks across the financial system has tended to decrease. Thus, it has presented official agencies with the question of how it might be possible to increase this transparency again.

Much of the recent discussion on hedge funds has revolved around this point. Accurate and timely information about underlying risks is a critical component in the market's ability to differentiate and properly price risk.

Greater transparency is also needed on links between systemically important financial institutions and some of their off-balance sheet vehicles. However, given the volume and complexity of the information and the cost of providing it, it will be important to carefully consider the appropriate amount and type of disclosure needed to ward off such episodes in future.

While securitisation and financial innovations have, through enhanced risk distribution, made markets more efficient, their role in the current situation may have to be better understood. The relationship between checks and balances throughout the supply chain of structured products may require some rethinking.

Thus, while evaluating future stability, it will be even more important than in the past to combine a proper examination and assessment of new instruments with an analysis of the behaviour of new market participants. This would appear to be the best way to deal with the fact that the financial system is not only expanding but also becoming increasingly complex.

The relevant perimeter of risk consolidation for banks has proved to be larger than the usual accounting or legal perimeters.

For instance, reputational risk may force banks to internalise losses of legally independent entities and new instruments or structures may mask off-balance sheet or contingent liabilities.

The result is that risks that appear to have been distributed may yet return in various forms to the banks that distributed them. The relevant perimeter is not only an issue for supervisors but also for the financial institutions themselves - their risk managements systems, audit processes and internal oversight and governance structures.

Various market segments have become highly integrated as the problem which originated in the credit markets spread quickly to money and debt markets. This underlined the need for strengthening the oversight of financial markets in advanced countries.

Also, while financial markets are becoming increasingly global, regulation of financial markets continues to be national. This deficiency needs to be addressed, RBI pointed out.