Whenever there is a doubt about a player’s action, people look towards the umpire. Now that there are doubts about rating agencies, we will look at what capital markets regulator Securities and Exchange Board of India (Sebi) has been saying about them. As per popular perception, Sebi is seen as a regulator for stock markets and mutual funds, but not for rating agencies. To be clear, credit rating is an opinion and an opinion cannot be controlled or regulated; it is about whether they followed due process and diligence for arriving at and tracking the rating.
Let’s start with Sebi’s circular issued on 13 June. Among other things, the circular states the manner in which rating agencies will publish cumulative default rates (CDR) i.e. historically what has been the default rate for various instruments rated by the agency. As of now, agencies publish CDR, but the directions in the circular will lead to uniformity and transparency.
The circular also introduces the concept of probability of default (PD) for rating agencies. It gives the parameters for computation of PD and the tolerance level for the outcome. For AAA rating, PD is zero-tolerance for up to two years and 1% for three years. This means that once an instrument is rated AAA, it should not normally be expected to default within two years and PD should be within 1% for three years. Similarly, for AA rating, it is zero-tolerance for a year and 2% for two years. This means that an AA-rated security should not default within one year of assigning the rating and over two years PD should be within 2%
The circular attaches the suffix CE (credit enhancement) to rating of instruments having explicit credit enhancement. The background is, there is a suffix SO (structured obligation), meant to denote securitization transactions. However, rating agencies assign SO even to ratings which are not securitization transactions. In particular, the ones with some form of explicit credit enhancement from a third party or parent or group company, in the form of corporate guarantee or letter of comfort or pledge of shares, etc. In such cases, the rating looks that much better, but SO does not clearly convey whether it is a pass-through certificate or credit enhancement. From now on, rating agencies will put CE for ones with enhancement, so that the investor knows that the rating would have been lower otherwise.
Apart from the credit rating, the agency will also disclose its opinion about the liquidity indicators of the issuer such as strong or poor, says the circular. Servicing of debt, apart from the intentions of the promoter, is largely a function of liquidity through cash flows or credit lines, among other factors.
In November 2016, Sebi issued a circular, titled “Enhanced standards for credit rating agencies (CRAs)”. It was about the processes and criteria followed by CRAs and stipulated, inter alia, default recognition norms, review of sharp changes in ratings, and disclosure of ratings not accepted by an issuer. In June 2017, Sebi issued another one with significant provisions. A prominent point raised in the 2017 circular was that sometimes agencies are behind the curve; the market knows about a delay by an issuer in servicing debt, but not the rater. Sebi mandated agencies to monitor servicing of debt obligations, based on International Securities Identification Number (ISIN), and track deterioration in financials for early leads. While this should have been par for the course for raters, sometimes it takes the regulator to remind them of the basics. The 2017 circular says the rating agencies should monitor exchange websites for disclosures by issuers. In the same circular, Sebi mandated that all material events or corporate action by the issuer should be reviewed by the agency, and the outcome, which could be a reiteration of the existing rating, should be published within seven days of the event.
However, in spite of the provisions, rating agencies remain more reactive than proactive. The instances of sharp and fast downgrades we saw over the past 10 months show that agencies are covering up for lack of action that should have been taken earlier. What we need now is restoring the trust and confidence of investors in credit rating symbols. To that effect, rating agencies will do well to come out in public about the daily tracking they do and explain their failures. Confidentiality may be an issue, but for companies that have defaulted, there is nothing much to hide.