Ever since the collapse of IL&FS, credit rating agencies in India have been under the scanner for having failed to flag the financial stress at the firm and its subsidiaries. Reports paint an even more worrying picture. The rot runs deeper. Investigations into the IL&FS fiasco have revealed that its group companies were able to retain high credit ratings, even as they were facing a liquidity crunch, allegedly in return for favours to rating agencies. This practice was apparently going on for years. These reports come after the heads of two rating agencies were sent on leave by their respective company boards in response to questions raised over the assigned ratings. In response to concerns, last month, SEBI had mandated “enhanced disclosures” from credit rating agencies in order to boost transparency and accountability. Clearly, more needs to be done.
At the heart of the matter is the “issuer pay” business model. Under this model, the firm that is being rated pays for the ratings, which are then used by investors to evaluate the level of risk that a firm/instrument poses. This creates a conflict of interest. As rating agencies, which are profit-making enterprises, depend on fees paid by issuers, they are more susceptible to being influenced by them. But as ratings serve as a guide for investors, providing signals about the ability of the issuer to repay the debt, this raises legitimate questions over who is safeguarding the interests of investors. A case in point: Recently, a rating agency downgraded a firm’s rating by nine notches, from AA+ to D, in a single stroke, leaving investors in disarray. There has been some discussion on how to deal with this issue in India. In fact, in February, the parliamentary standing committee on finance had suggested the government explore shifting to an investor or regulator paid model. While switching to a new architecture is likely to be resisted by rating agencies, as it would hurt their profitability, there is a genuine case for re-examining the incentive structure of rating agencies. Mere tinkering will not yield the desired outcomes.
Globally, credit rating agencies came under the scanner in the aftermath of the financial crisis of 2008, with accusations of flawed methodology and rating shopping being made. Subsequently, they were penalised to the tune of hundreds of millions of dollars to settle cases over their ratings of risky mortgage securities. But, imposing hefty fines is only a part of the solution. The regulator needs to undertake a comprehensive review of the ratings architecture in India. The first step could be to enforce mandatory rotation of rating agencies. This could address the issue of familiarity exerting influence. The option of compulsory rating of a firm/instrument by more than one rating agency could also be explored.