Rating agencies must be strictly regulated; SEBI should do the job

In India, unlike the west, rating agencies were set up by the development finance bodies, which were themselves government controlled institutions.

What do the five major Indian rating agencies study before giving a rating? They examine the financial statements of the entity being rated. For a corporate enterprise they look at the return on capital, debts in relation to revenues and equity, total interest burden, gross margins, etc. They do not usually look at the cost of servicing debts and repayment in relation to cash flow, nor look at projections of the debt burden. Nor do they consider the future prospects in relation to the economy, market, competition, etc. The quality and stability of management and the transparency in corporate governance as well as its ethics are also not considered.

The ratings are often based only on available numbers released by the entities. The quality of the entity’s governance, effectiveness in meeting objectives, absence of fraud, etc, are not usually considered because of the lack of data, either published or sought by the rating agency. The case is similar for governments. Thus, India frequently is angered by rating downgrades, as these raise the cost of the country’s borrowings. In the last half century, as Indian financial markets have become deeper, a variety of financial instruments—preference and ordinary equity shares, convertible and non-convertible debentures, corporate borrowings, individual borrowing from banks in India and overseas and from other corporates—have found their way to the market. In addition, there have been government and municipal borrowings, country borrowing in international markets. In all these cases the investors need some assurance by a qualified third party, of the ability of borrowers to pay interest and repay loans. While investors do their diligent work, rating by an independent expert agency is reassuring. It also influences the investment decision.

Thus, ratings today cover most entities including industries, banks, non-banking financial companies (NBFCs), infrastructure entities, microfinance institutions, insurance companies, mutual funds, structured debt, fixed deposits, state governments and urban local bodies.

In India, unlike the west, rating agencies were set up by the development finance bodies, which were themselves government controlled institutions. CRISIL was set up in 1987 and is by far the leader. It was originally started by ICICI, UTI and others, but is now a partner with Standard & Poor’s. ICRA was created by IFCI and CARE by IDBI. Brickworks is a very recent entrant.

Ratings by these agencies are based on an analytical framework that aims at comprehensiveness, standardisation, comparability, and effective communication of the ratings. They are expected to be completely independent.

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Neither RBI nor Sebi has over the years looked closely at the methodology used by rating agencies. No rating agency has been held accountable even when a highly-rated company has reneged on its due payments. Nor has anyone checked whether rating agencies have any other financial earnings from their rating clients. These are possible conflicts of interest which could influence the rating (given for a fee paid by the rated entity), to clients.

It is clear that rating agencies must be strictly regulated. Since rated entities are mostly companies, SEBI should regulate rating agencies. Agencies must be held accountable for flagrant deviations of a company’s performance after it has received a high rating. Fees for the rating service should be paid by Sebi and not directly by the rated entity. The relationship should be between the rated company and Sebi, not the rating agency that does the job.

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