Should The Rating Agencies Be Blamed For This Credit Crisis?

Jun 18, 2019

Independent credit rating agencies are in the line of fire, and rightly so.

According to The Hindu dated June 12, 2019, credit rating agencies have downgraded 163 credit facilities in 2019, which is a 51 per cent increase in the total tally for the last four years.

Have these downgrades come just too late?

The present corporate debt crisis has called rating agencies' credibility into serious scrutiny.

Looking at IL&FS, Reliance ADAG and DHFL episodes, it seems like, rating agencies have failed to give investors a heads-up on ratings downgrade. Isn't it amusing that "AAA" rated papers (so-called top-quality papers) get downgraded to "D" (Default) in just a few months?

Was that merely ignorance or something more?

On the other hand, mutual fund houses are calling themselves just pass through and shrugging off their accountability towards investors.

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Who can/should investors rely on?

The capital market regulator has taken the IL&FS fiasco seriously and immediately swung into action. It's nudging credit rating agencies to modernise their corporate structure and improve governance practices.

According to media reports, listed below are the likely changes one may expect in the corporate structure of credit rating agencies going forward:

• They must have the majority of directors as independent directors on their board.
• Rating agencies should appoint independent directors only for a 3-year term and one director shouldn't serve more than two terms.
• There will be a capital market regulator nominated director on the board of each rating agency.
• Shareholder-directors can't be appointed in any position of compensation and audit committee.
• It would be mandatory for the rating agencies to disclose their rate card and whistle-blower policies.
• Credit rating agencies may also have to store ratings related data on servers located in India.

Moreover, the regulator has come up with the enhanced disclosure norms for credit rating agencies.

New disclosure norms:

• Rating agencies will now have to disclose Cumulative Default Rates (CDR) based on long-run averages (of 10 financial years) and short-run averages (of the recent 24, 36, and 48 months)
• Credit rating agencies will have to provide a Probabilistic Default (PD) benchmark for each rating category for various periods such as 1-year, 2-year and 3-year cumulative default rates for long-run as well as short-run averages.
• In case of any credit enhancement, credit rating agencies will now have to explicitly assign the suffix CE' (Credit Enhancement) to the rating of instruments.
• Agencies must disclose sensitivity of the rating in the press release, indicating probable changes in the rating subject to the performance of the company.
• Now onwards, rating agencies will also have to consider liquidity parameters and the spreads in the bond yields of the rated instrument and that of its relevant benchmark as material factors that could trigger a change in the rating.

While the regulator is busy revamping the regulatory framework, some credit rating agencies have initiated an internal investigation based on complaints they received by the whistle-blower. Such instances highlight that there were possibly some compromises in the credit evaluation processes at the rating agencies.

Will anything change for the investors?

Capital market regulator's recent attempts to tighten up screws around credit rating agencies may bring in more discipline and transparency in the credit rating processes. Nonetheless, it's crucial to see if the suggested regulatory reforms and changes in the corporate structure will produce desired results. After all, the rating agencies will depend on their customers for their revenues. Thus, the conflict of interest won't disappear entirely.

Since capital market regulator is pondering on nominating directors on the boards of credit rating agencies, can we treat ratings assigned as those endorsed by the regulator? While, 'no' would be the obvious answer to this, but investors might misinterpret this change in the corporate structure.

Finally, no matter how recklessly credit rating agencies missed the deteriorating conditions in the bond market, mutual funds can't hold the rating agencies entirely responsible for the on-going debt market fiasco. There can't be any substitute for the independent credit evaluation by the fund houses. Credit ratings shall be treated just like a guiding force. No mutual fund shall base its investment decision to the credit ratings.

Remember these points if you are a debt fund investor:

• Investing in debt funds isn't risk-free.
• You shouldn't invest in schemes only because they have outperformed their benchmarks in the recent past.
• Consider your financial goals, risk appetite, and time horizon before investing in any debt-oriented scheme.
• Following your personalised asset allocation is the key.
• Ideally, you should invest only in schemes that have a maturity profile matching your time horizon, to avoid negative surprises.
• Last but not least, invest only in debt schemes offered by mutual fund houses which follow robust investment processes and have adequate risk management systems in place.

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Author: PersonalFN Content & Research Team

This article first appeared on Certified Financial Guardian.

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