Credit rating agencies evaluate the creditworthiness of different businesses and financial instruments. They measure their ability to repay financial commitments by looking at their assets, liabilities, and cash flows, as well as past lending and borrowing transactions. This process entails a qualitative and quantitative evaluation of the business. It demonstrates the dangers of investing in debt instruments. As a result, investors have a clear picture from which to make decisions. It also aids businesses in raising funds to fund their ventures.
Moreover, credit ratings come in a variety of forms. Short-term credit rating and long-term credit rating are two of them. The credit ratings are usually for the short to long term. In the current environment, however, investors are more likely to choose short-term ratings over long-term ratings.
In India, the highest rating is AAA. Financial instruments with an AAA rating are considered to be the safest. Furthermore, the businesses that issue these financial instruments have a lower risk of defaulting on their payments. As a result, these instruments have a low-interest rate or rate of return. Also, rating agencies are regulated and authorized solely by SEBI. In addition, the rating system in India is governed by the SEBI Regulations, 1999, of the SEBI Act, 1992.
What are the new norms?
For the benefit of investors, rating agencies must explicitly state the “probability of default” of the instruments they rate. The probability of default for a given time frame is referred to as the probability of default. It predicts whether or not a creditor will be able to fulfill his or her debt obligations.
SEBI will develop and disseminate standardized and uniform default probability benchmarks. For one-year, two-year, and three-year cumulative default rates – both in the short and long run – this will be fixed for each rating category.
The economic cycle and a 10-year marginal default rate will be used to calculate the probability. The agencies will also be required to publish details on their debt instrument rating performance in relation to a benchmark established in consultation with SEBI. This will enable investors to assess credit rating agencies’ performance more accurately.
SEBI also mandated the disclosure of factors that affect the rating. Each SEBI press release will include a section on rating sensitivities, which will clarify the wide range of operational and financial performance thresholds that may cause a rating change, both upward and downward.
This is important for end-users to recognize the factors that may affect the entity’s creditworthiness. Furthermore, SEBI requires rating agencies to make meaningful disclosures about their clients’ liquidity positions using simple words, such as superior or good, adequate, stretched, or poor. This should also provide appropriate examples to help end-users better understand them and prevent misunderstanding.
What is the rationale?
Since the global financial crisis of 2008, rating agencies’ reputation has been eroding. This is largely due to the conflict of interest created by the issuer-pays model. The rating agency is compensated by the issuer of the instrument it rates.
As a result, rating agencies have been found to be more loyal to the businesses whose instruments they rate than to the investors who provide valuable resources. In effect, rating agencies fail to downgrade troubled firms until they are on the verge of bankruptcy.
The defaults at Infrastructure Leasing and Financial Services (IL & FS) in 2018, which resulted in a liquidity crisis among India’s non-bank lenders, have refocused attention on CRAs.
As a SEBI-registered intermediary, CRAs are expected to serve as an early warning mechanism for an instrument before it defaults.
However, the legitimacy of CRAs as an institution and their utility under the regulatory system was questioned after they failed to identify early signs of the crisis.
Because of the ramifications for the broader economy, SEBI tightened the disclosure guidelines. This is believed to improve the consistency of information provided by rating agencies to investors.
In general, SEBI seems to be attempting to align rating methodologies with global best practices. However, it is unclear how the new system can effectively address the conflict of interest problem that has plagued the rating industry for years.