Crackdown on Indian Credit Rating Firms

Credit rating industries are part of a closely held industry. For years, this has worked in favor of these agencies since they have to face less competition. However, these agencies are also the first ones to get blamed after every financial crisis. It is a known fact that no one can really predict a market crash. However, the expectations from credit rating agencies are high. They have access to information that the average person does not. Hence, they should be able to identify if a company is headed in the wrong direction. Since Indian credit rating agencies have failed to decipher the true financial positions of the companies that they rate and warn investors, they are now the subject of a crackdown by the regulator viz. SEBI (Securities and Exchanges Bureau of India)

In this article, we will have a closer look at the events that led to the crackdown. Also, we will try and find out what the effects of this crackdown have been.

Events That Lead To the Crackdown

Infrastructure Leasing and Financial Services (IL&FS) was a major player in the financial services industry in India. This company would borrow money by issuing bonds. Then, the money so raised would be invested in long-term infrastructure assets. Most Indians trusted this company and would regularly invest their savings in the bonds issued by them.

One of the major reasons behind this trust was that the company enjoyed AAA ratings by almost all credit agencies. Cracks started appearing in the company’s financials in October 2018. This is when the credit rating agencies made a slew of changes and quickly downgraded the debt issued by IL&FS to junk grade. The problem is that the credit rating agency should have seen this financial crisis coming.

Hence, the rating for IL&FS should have been lower a long time ago. The changes made by the rating agencies were made in retrospect. Hence, instead of proactively warning the investors, these companies were retroactively warning them. Such sharp changes in the opinion of credit rating agencies end up creating panic. This panic leads to tremendous loss of investor wealth.

Since a lot of Indian investors lost a lot of money in this crisis, SEBI was forced to act. The result is that SEBI has tightened the screws over Indian credit rating agencies.

Some of the changes made by SEBI have been listed in this article.

Changed Made By SEBI

  • Firstly, SEBI has decided to create more competition amongst the credit rating agencies. This is being done by preventing cross-shareholding. SEBI has announced that no credit rating agency can hold more than 10% share in another credit rating agency. Also, new rules have been created to prevent the officials of one credit rating agency from being on the board of another. This is being done to ensure that credit rating agencies act on their individual accord and not in tandem. If each agency acts individually, there is a greater likelihood that at least one of these agencies will be able to spot financial problems and report it to the investors.
  • Earlier credit rating agencies would just provide their opinion about the liquidity position of a company. However, now these companies are required to disclose more details. Credit rating agencies need to disclose the amount of cash that the company has on hands. Also, access to unutilized credit lines needs to be mentioned in the report.

    If the credit rating agency is assuming that a third party will provide the money to a given firm, they have to specify that assumption. SEBI has created precise rules to ensure that the liquidity position of any company is correctly reported and that investors are no longer in for a shock.

  • Rating agencies have now also been given the responsibility of ensuring that investors are made aware of deteriorating cash or debt situation at any firm. They are now supposed to notice that the financials of a company are undergoing sudden change and are also supposed to report the same to the investors.

Who Will Rate The Rating Agencies?

The new measures planned by SEBI are likely to be effective. However, they will not be able to solve the problem from the root cause. This is because the problem really is about who will rate the rating agencies! SEBI needs to come up with an internal department which keeps track of the ratings being issued by these agencies.

Agencies themselves should be rated based on the accuracy of the ratings given out by them. This will help investors to understand the quality of research that has been put in order to arrive at these ratings.

The bottom line is that rating agencies will now have to run a tight ship. SEBI has been embarrassed by their performance many times before. If the agencies continue to behave in an irresponsible manner, then SEBI might be forced to come out with more stringent rules.

More rules increase the compliance costs that rating agencies have to bear. Hence, it is in their interest to start giving more accurate ratings since this will help them to avoid all costs.

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