India's capital market watchdog barks again!
The Securities and Exchange Board of India (SEBI) notified rule including probability of default (PD) benchmarks in a bid to strengthen the revelations made by credit rating agencies to improve the rating standards. The new guidelines are in addition to the rules and regulations prescribed earlier for rating agencies by the market regulator. This is the fifth change for rating agencies in the previous three years to improve transparency and clarity in all the processes. Notwithstanding these strategies, the agencies have been caught on the wrong foot on quiet a lot of junctures.
The global financial disaster in 2008 erased the reliability of rating agencies because of the clash of interest rising from the fact that they are paid by the issuers to rate their securities and for their failure to relegate troubled firms until they are on the verge of insolvency. The SEBI's new instructions come at a time when the nation is whirling under many debt defaults and rating downgrades. India's premier rating agencies, namely CRISIL, ICRA, CARE, Brickwork Ratings, India Ratings and Research etc have been under a cloud in the last few years for failing to red-flag many defaults. The latest story of Infrastructure Leasing and Financial Services Ltd (IL&FS) and Dewan Housing Finance Corporation Limited (DHFL) gave birth to a liquidity crisis among non-bank lenders in India has focused attention again on credit rating agencies.
What is new in the game?
To address the loopholes in the nation's credit rating ecosystem the SEBI issued new guidance notes. The rating agencies have to disclose additional information in their press releases and on their websites. They have to fabricate a uniform benchmark to reveal probability of default (PD) for each of their instruments well in advance. These standards formed to target computation of cumulative default rates (CDR), standard operating procedure (SOP) so that defaults can be traced in time. Rating agencies have to consider factors that could influence the ratings of a specific instrument. In addition, rating agencies have to allot a suffix, CE (Credit Enhancement), to the rating instruments having unambiguous credit enhancement. These agencies also have to design a model to trace non-conformity in bond spreads.
Now the rating agencies have to follow the Marginal Default Rate approach employing a monthly static pool for the previous 10 years while adjusting the computation of CDR. They have to disclose the average one, two, three-year CDRs on an annual basis and this is at par with global rating ideals. The rating agencies have to disclose liquidity status by using simple terms, such as superior or strong, adequate, stretched or poor which should be supported by meaningful explanations to aid end users so that they understand better. Liquid investments or cash balances, access to any unutilized credit lines and adequacy of cash flows also have to be unveiled by the rating agencies.
Will it be a Game changer?
The goodwill of rating agencies is on the rough track in the past few years. An epidemic of sudden ratings downgrades of corporate debt instruments in a span of a few months has placed the agencies under the market regulator's radar. All relegates came too late, very long after the entities in question had defaulted on payments to their lenders.
Investors have lost the trust and have turned doubtful of every credit rating because even an AAA does not appear to be secured. This lack of confidence in credit ratings is in danger of weakening India's financial solidity, leading to a drying up of credit lines for Indian borrowers.Hopefully, the new rules introduced by the market watchdog may tackle apprehensions surrounding rating agencies and restore regularity in the financial markets. If not, we continue reading horror stories of scams and scandals daily!
NEW WINE IN THE NEW BOTTLE
• Credit rating agencies (CRAs), in consultation with SEBI, should prepare and disclose standardized and uniform probability of default (PD) benchmarks for each rating category on their website, for one-year, two-year and three-year cumulative default rates, both for short-run and long-run.
• Issuing guidelines for enhanced disclosures by CRAs, the regulator has called for having a uniform Standard Operating Procedure (SOP) for tracking and timely recognition of default. Each CRA has to disclose the same on their websites.
• It has also mandated a specific section on 'rating sensitivity' from the agencies to indicate possible trigger for an upward or downward rating change in a simple language rather than like a general risk factor.
• CRAs have to make meaningful disclosures about liquidity conditions by using simple terms such as superior or strong, adequate, stretched or poor, with proper explanations to help the end users understand them better.
• CRAs will have to devise a model to track deviations in bond spreads.
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