SEBI’s decision to cancel the credit rating registration of Brickwork Ratings comes after a legal battle that began around 2014 with a series of oversights by the regulator (some conducted in consultation with the RBI). As Mint first broke the news, an order issued October 6 bars the agency from taking on new mandates and directs it to terminate existing mandates within six months.
The regulator had earlier fined Brickwork Ratings for delay in recognition of default of non-convertible debentures issued by Bhushan Steel, even after the disclosure of the default. It was also penalized by SEBI for its failure to downgrade the debentures issued by Gayatri Projects. In addition, the order lists other loopholes, such as not listing material information on press releases. This highlights conflicts of interest, such as the same individuals being part of the Credit Rating Division and the Business Development Division.
While Brickwork may be grim in the number of omissions it has committed, there is a wider issue that goes beyond an immediate matter relating to a rating agency. Because credit rating is an inherent problem in the business model, and it is a global issue. The subprime crisis of 2007–08, which turned US mortgage defaults into a global financial problem, was the result of these unresolved conflicts of interest.
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Credit rating agencies play an important role as the “gatekeepers of the financial markets” (as stated in the SEBI order). Banks, pension and provident funds, mutual funds and other institutional lenders have mandates that prevent them from investing in debt unless it is rated. , or above, a certain level. Even with unsecured loans, the rate of interest varies inversely with the rating of the borrower. Secured debt (debentures and bonds) must be rated before they are issued, and that rating requires regular review.
Agencies also provide other consulting services. A common example is “ratings evaluation services”, which includes the analysis of entity pre-ratings, as well as assessment of the potential impact of the balance sheet affecting transactions such as mergers, spin-offs and share repurchases. Agencies are also frequently consulted on issues related to risk management, debt restructuring, delivering strategy, regulatory compliance etc.
The rating itself is given based on the information provided to the team. But when these decisions are based on well-known variables (such as balance sheet ratios, free cash flow and revenue projections, business models and growth projections), ratings are subjective in the final analysis. Often, members of the credit rating team differ on interpretations, and the rating assigned is the one that most teams agree on. In addition, the business performance of the borrower should be monitored subsequently for material changes.
A major problem is the payment structure: it is the borrower (the issuer of the loan) who pays for the rating and this creates an incentive for the agency to provide attractive ratings. Somewhat counter-intuitively, competing agencies may actually make these conflicts of interest worse; An issuer can shop around for the agency offering the highest rating.
The second conflict arises when a rating agency is providing other services to an entity which is also a rating. There too, the incentive exists to bump up the ratings. One way to mitigate this is to create internal “Chinese walls” between the agency’s various divisions. If the same individuals are part of the credit rating team and also part of the other business development teams (as in Brickworks), then it clearly becomes even more of a problem.
So agencies have to tread a very narrow line to follow best practices in governance and ethics. This means that rigorous systems and processes must be implemented. In practice, this does not happen often. For example in the debacle of IL&FS, the group had the highest possible rating till the day it defaulted. Similar delays hurt investors in Jet Airways, Zee Group and Dewan Housing.
While there has been academic debate about moving to a model where lenders pay the agency, this has not been the case in practice after the subprime crisis. Similar studies by Ramin P. Baghai and Bo Baker (Conflict of Interest and Provision of Consultancy Services by Rating Agencies: Indian Evidence) It also claims that corporates who consult agencies for “other services” consistently get better ratings. Certainly, it can be argued that consultants have helped improve processes.
SEBI has tried to keep more checks and balances. “Rapid Rating Actions” meaning a change of three notches in consecutive rating periods should now be highlighted, and non-affiliating issuers (who are not sharing relevant information in a timely fashion) should be flagged. These are useful steps. But it can be argued that there remains a conflict of interest in the current rating agency business model.
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