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SEBI’s efforts are good but reforming India’s bond markets is a big ask

Tightening regulations for credit rating agencies will not be adequate to solve the problems of the bond market.

analysis Updated: May 13, 2019 07:56 IST
Ila Patnaik
Ila Patnaik
After the sudden and sharp downgrade of IL&FS bonds in September 2018, SEBI, the securities regulator, introduced new, tighter norms for credit rating agencies.(REUTERS)

A series of difficulties continue to plague India’s bond markets. These have been brought to light after the IL&FS crisis. The regulator is trying to keep a strict watch and reduce losses for millions of households. In this context, the role of rating agencies is evident. Rating agencies failed to detect discrepancies in companies like IL&FS, Dewan Housing, Zee and Reliance Communications as they progressed over time. This led to sudden downgrades, which, in turn, required funds to sell off their holdings of the bonds that were downgraded.

The safety of life savings in mutual funds, pensions, provident funds and insurance policies is related to regulations for measuring the riskiness of the bonds that funds put money in. The role of regulation is to protect small retail consumers and their savings to the extent possible. The small retail investor puts money in provident funds, mutual funds, insurance companies, etc. and does not know or understand where fund managers are investing his savings.

Investment guidelines are created to reduce the risk that fund managers may take in their quest for higher returns. Many funds cannot hold low rated or risky bonds under their investment guidelines. Liquidity for most corporate bonds is low as there are not many buyers and sellers. As a consequence, sudden downgrades cause difficulties. Prices of bonds fall and consumers incur large losses as funds find it hard to sell bonds at short notice. Securities and Exchange Board of India’s (SEBI’s) focus has, therefore, turned to rating agencies.

Under the present system, investment guidelines often say how much should be invested by various funds in AAA rated, or AA rated companies. These ratings are provided by credit rating agencies who rate bonds according to their risk profile. Credit rating agencies, therefore, have a huge say in which companies are able to borrow from the market and at what cost. Companies that borrow, pay rating agencies to rate their bonds.

This model is ridden with problems. The problem is not unique to India. The same issues were seen in the US at the time of the Lehman crisis. Highly-rated bundles of housing loans were suddenly downgraded to junk status, which led to a debate around the role of credit rating agencies in the global financial crisis. The problem is not easy to solve as investors are averse to paying for ratings. Proposals for independent raters have also not taken off. The world has so far stuck with the issuer-pays model.

The incentive of the borrower who gets his bond rated is always to get a better rating. Higher rating lowers the cost of borrowing. Whether a rating agency genuinely rates a bond high as it fails to detect trouble in its balance sheet, or whether it knowingly gives a company a higher rating is debatable. It is reported that four rating agencies are currently being probed in India by the Serious Fraud Investigating Office (SFIO) for their rating of IL&FS’s finance subsidiary.

After the sudden and sharp downgrade of IL&FS bonds in September 2018, SEBI, the securities regulator, introduced new, tighter norms for credit rating agencies. Nearly one company has been downgraded each month since November 2018. Asset managers also shun companies that look risky, related companies and group companies. This has a feedback loop as the value of the bonds of these companies falls.

This story also feeds into the health of the NBFC (non-banking financial companies) sector. NBFCs normally borrow money in the bond market. They constitute about a third of the non-government bond market borrowing.

Starting with the trouble with IL&FS, DFHI and India Bulls, weaker NBFCs found it difficult to borrow. Some NBFCs were seen to hold bonds of their own group companies. Others were holding bonds of illiquid or risky companies. Overall, there has been a sharp decline in borrowing by NBFCs after the IL&FS downgrade. As the figure shows, in July 2018, mutual funds were investing Rs 1.58 trillion in short term bonds of NBFCs. By March 2019, this number had fallen by more than a third to about Rs 1 trillion.

In the last few weeks, promoter loans against shares has become an issue in the bond market. It seems many mutual funds entered into an agreement with the Essel group to not sell off promoter shares as they were required to do after a default on the grounds that selling of shares of the defaulting company would have hit share prices. This violated the terms of Fixed Maturity Plans through which the money was invested. The extent of loans against shares in mutual funds could be the next source of problems in the bond market.

While tightening regulations for credit rating agencies is a step in the right direction, it will not be adequate to solve the problems of India’s bond market. There is a need to build deep and liquid markets. The reform of the bond market requires an integration of the government and corporate bond market infrastructure and regulation and an independent government debt manager. There is a need to bring all markets for bonds, equities, commodities, currencies and derivatives under the securities markets regulator as proposed by various expert committees like Committee on Mumbai as an International Financial Centre and the Financial Sector Legislative Reforms Commission. SEBI’s actions are to be appreciated but broader bond market reform requires legislative reform and amendments of the powers given to regulators.

Ila Patnaik is an economist and a professor at the National Institute of Public Finance and Policy

The views expressed are personal

By special arrangement with The Print

First Published: May 13, 2019 07:52 IST