Report on Regulation of Credit Rating Agencies in India

[Guest post by Shreya Prakash, who is a Research Fellow in the Corporate Law & Financial Regulation vertical at the Vidhi Centre for Legal Policy]

Credit ratings are an opinion of a recognised entity on the relative creditworthiness of a debt instrument. Entities that form these opinions, i.e., credit rating agencies (‘CRAs’), are essential gatekeepers of the financial system. In fact, obtaining ratings from CRAs is mandatory for various instruments and entities, which has led commentators to liken their role to that of granting ‘regulatory license’ to function in the market.

Despite the inherent risks and extensive power of CRAs, they were not regulated comprehensively in developed countries until the advent of the global financial crisis. However, widespread concerns regarding the failure of CRAs to estimate the market risk of structured financial products before the financial crisis has led to increased global focus on the regulation of CRAs.

In India, on the other hand, the Securities and Exchange Board of India (‘SEBI’) began regulating CRAs in 1999, and since the financial crisis it has significantly strengthened the regulatory framework for CRAs. However, in light of recent studies alleging that certain failures on part of CRAs could have contributed to the NPA crisis in India, and that credit ratings are not entirely reliable due to the prevalence of rating shopping, there is a renewed need to review the regulatory framework for CRAs.

Vidhi Centre for Legal Policy recently released a report analyzing the regulatory framework for CRAs in India. The report highlights the main concerns regarding the regulation of CRAs in India, collates international practice on the regulation of CRAs, and makes recommendations to improve the regulation of CRAs in India.

Specifically the report finds that the following problems continue to exist regarding CRAs :

Persisting Conflicts of Interest

CRAs function on the issuer pays model. This makes them dependent on issuers of instruments for the payment of their fees, although their main role in the market is to serve investors. This possibility of conflict is exacerbated by the fact that CRAs and their employees typically have long relationships with issuers due to less competition in the industry.

The report recommends that SEBI should enable and promote the adoption of other models of remuneration for CRAs. Moreover, SEBI should consider promoting the rotation of employees of CRAs in respect of the same issuer, so that long-term relationships do not impede the independence of individuals.

Prevalence of Rating Shopping

Rating shopping occurs when an issuer solicits ratings from multiple CRAs, but only pays for and discloses the highest rating(s). SEBI has taken extensive measures to combat rating shopping, some of which are extremely onerous. For instance, SEBI requires CRAs to rate securities during their entire lifetime. It also prevents them from withdrawing their ratings except in extremely limited circumstances.

The report recommends that a balanced approach should be adopted regarding the regulation of CRAs. Accordingly, SEBI should revisit grounds for withdrawal of ratings to permit withdrawal in a larger number of situations and establish a framework to regulate preliminary rating estimates, instead of completely prohibiting them. Moreover, SEBI should consider establishing a platform to disclose all ratings given, which will ensure that all ratings are displayed in one place. This will reduce the possibility to suppress unfavourable ratings.

Lack of accountability towards investors

CRAs lend reputational capital to issuers, and have significant impact on investment decisions. In fact, some institutional investors have to mandatorily rely on ratings. Despite this, they have little accountability towards investors.

The report recommends that SEBI should encourage investors to provide them information on the basis of which they can investigate into any irregularities in the functioning of CRAs and take action where appropriate. SEBI should also consider incorporating a provision to make CRAs liable for compensating investors for any loss caused to them by negligent or fraudulent rating, with adequate safeguards.

Lack of regulation of rating activities, other than rating of securities, and the possibility of mechanistic reliance on ratings

SEBI originally intended to regulate only those rating activities of CRAs that are directly related to the securities market. However, in recent years, CRAs rate a wide variety of instruments and entities directly related to the financial sector. SEBI has attempted to extend its oversight to these rating activities through a circular. However, the Regulations under which the circular has been issued apply only to rating of securities, and SEBI’s general powers to issue circulars to promote the development of the securities market may not be appropriately employed to extend the scope of its oversight to rating of instruments other than securities. Moreover, the differences in instruments are not accounted for while making regulations for CRAs. A separate concern that arises is even when rating activities are adequately regulated, if reliance is mandated on them without allowing for alternative evaluation of credit risk, mechanistic reliance on these ratings is promoted.

The report recommends that SEBI should regulate all rating activities of CRAs relating to the financial system by amending the CRA Regulations to create a sound legal basis for their regulation, instead of relying merely on the circular. Moreover, the CRA regulations and directions issued by SEBI should address the special concerns that arise for different instruments and entities. Finally, regulators should only extend reliance on ratings where they are adequately regulated, and in no event, should they promote mechanistic reliance on credit ratings.

The full report can be accessed at: https://vidhilegalpolicy.in/reports-1/2017/7/31/regulation-of-credit-rating-agencies-in-india.

– Shreya Prakash

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2 comments

  • As per the RBI regulatory framework banks have to rely on their own internal credit risk assessment majorly. Under the Basel II framework, for capital adequacy purposes, ratings of external CRAs come into play in the NPA scenarios. But these external CRAs are accredited by the RBI on the basis of their ability to adhere to the Basel II framework, therefore while linking NPA crisis to CRA regulations shouldn’t the role of the RBI in accrediting and evaluating the ratings be analysed instead of the SEBI CRA regulations?

    • Hi!

      Thanks for your comment.

      Absolutely, RBI’s role in accrediting CRAs has to be analysed, and the report does make certain recommendations in this regard. However, many of the issues due to which CRAs could have allegedly contributed to the NPA crisis, are structural. Thus, it becomes important to examine and analyse the CRA regulations.

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