A robust credit rating system is key for India - Hindustan Times
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A robust credit rating system is key for India

ByMonika Halan
Oct 10, 2022 07:45 PM IST

A recent Sebi decision to scrap Brickwork Ratings’ licence has sent a strong message. Now, courts must consider carefully the issue of investor protection as many funds rely on rating agencies to deploy the household savings of citizens

The capital market regulator’s extreme step of cancelling the licence of credit rating agency Brickwork Ratings got the financial sector to miss a heartbeat on October 6. Whole time member Ashwani Bhatia’s 51-page order asked Brickwork Ratings to wind down its business in six months and barred it from taking on new clients.

The market regulator, Sebi, cancelled the licence of Brickwork Ratings because of poor stability in ratings, failure to exercise due diligence and no effort to address the issue of conflict of interest (Shutterstock) PREMIUM
The market regulator, Sebi, cancelled the licence of Brickwork Ratings because of poor stability in ratings, failure to exercise due diligence and no effort to address the issue of conflict of interest (Shutterstock)

It is not often that a big financial firm gets its licence cancelled in India; therefore, the messaging from the Securities and Exchange Board of India (Sebi) has sent shockwaves through the industry. While the firm will appeal the decision and probably get a stay from the court, we must look at the issue through the lens of investor protection rather than the impact on the business of the firm, its employees, the papers it rated, and its clients.

Put simply, a bond is a promise by the borrower to the lender to pay a certain rate of interest, at a certain periodicity and the return of principal in exchange for a loan. To create a market where there are unknown lenders and borrowers, the evaluation of the risk of default of both interest and principal becomes important. How will the buyers of bonds understand the risks of thousands of businesses that are borrowing by issuing bonds? This problem was solved by credit rating agencies whose job is to evaluate the business and the risk, and then give their “opinion” on the quality of the paper. This risk is denoted by a series of alphanumeric symbols — for example, a triple-A or A1 rating denotes very low risk to the lender, and a D-minus or A4 rating points to very high risk.

During the 2008 North Atlantic Financial Crisis, rating agencies were blamed for rating bundles of junk bonds as the highest in safety, causing a large part of the market failure that ensued. The rating agencies escaped blame and regulatory action as they hid behind the word “opinion”. They argued that since the rating is an opinion, they cannot be held accountable if it goes wrong. Investors then asked: Why do these rating agencies exist if they do not stand by their own ratings? That question has not been answered in the United States.

A similar story has played out in India over the past few years as big blowouts in the debt market found the role of rating agencies suspect. For example, the Infrastructure Leasing & Financial Services (IL&FS) paper was downgraded from triple-A by several notches in a matter of weeks. The story was repeated in papers concerning Amtek Auto, Bhushan Steel, Jaiprakash Industries, and many more. While the media was full of stories of debt defaults, rating agencies maintained their high ratings, citing internal procedures and timelines as excuses for not taking note of the changed risks of a firm. Sebi then began a process of tightening the rules for rating agencies, making them disclose information material to investors.

For example, in November 2018, Sebi made it mandatory for rating agencies to publish transition studies or data showing how stable the ratings are. Remember that rating a bond paper is an ongoing exercise over the life of the bond. A bond may start as being triple-A, but due to poor business decisions or environment, lose its rating as the risk on repayment rises.

Sebi’s order shows Brickwork Ratings had poor stability in ratings, especially when compared to some other rating firms. On another metric that tracks the default rate of bonds (people investing in bonds do not want defaults as they lose both interest and principal), Sebi’s order maps defaults rising above the benchmark rates prescribed by the regulator.

Apart from having poor metrics on both parameters, Sebi found that Brickwork Ratings failed to follow a proper rating process or exercise due diligence. It did not maintain proper records to support its ratings. It delayed the dissemination of information concerning the monitoring of ratings and also failed to follow an appropriate rating process. It did not comply with timelines prescribed in its internal operational manual in over 75% of the cases taken up during the third inspection by Sebi.

The firm also failed to address the issue of conflict of interest arising due to a rating committee member having a business development role. An earlier order from Sebi’s first inspection in 2018 found a delay in the recognition of default of non-convertible debentures (NCDs) of Bhushan Steel Ltd even after the disclosure of default by the debenture trustee and a second failure to downgrade the rating of Gayatri Projects Ltd even after receipt of information from the debenture trustee.

Reading through the 51-page order, it is clear that the battle between the regulator and the rating agency is ongoing and has gone through the appeal process in the Securities Appellate Tribunal and a Karnataka high court order preventing Sebi from moving ahead with its recommendation. The high court order was eventually stayed by the Supreme Court.

This order of Sebi, too, will go through the appeal process. In such cases, the fate of employees, clients and markets are often used as arguments to protect errant firms. But it should also be noted that investors in general and retail investors, in particular, have no one other than the regulator to look after their interests.

It is in the interest of robust credit ratings in India and the future of the debt market that the courts look carefully at issues of investor protection embedded in robust credit rating and their agencies, especially when institutions such as provident funds and mutual funds rely on these ratings to deploy the household savings of millions of citizens.

Monika Halan is adjunct professor at NISM and author of the best-selling Let’s Talk MoneyThe views expressed are personal

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