This article is written by Anumeha Agrawal pursuing BA.LLB (Hons.) from Symbiosis Law School, Pune. This is an exhaustive article on the growth, regulation, role and the industry structure of the Indian Credit Rating Agencies, additionally, it also discusses the current issues with CRAs along with corrective reforms.
Table of Contents
Introduction
A credit rating agency is a company which advises creditors concerning the creditworthiness of individuals and corporate entities by their credit score. Such a score is dependent on various factors like assets, liabilities, debt repayment capacity, collateral and credit repayment, or default history.
History of the emergence of the Indian Credit Rating Agencies
The Indian CRAs emerged first in the late 1980s, the first Indian CRA being credit Rating Information Services of India Limited (“CRISIL”) established in 1987. At present, there are seven CRAs registered with SEBI namely, CRISIL, Fitch Ratings India Private Ltd., Investment Information and Credit Rating Agency (“ICRA”), Credit Analysis & Research Ltd (“ CARE”), Brickwork Rating India Pvt Ltd., Infomerics Valuation and Rating Pvt Ltd and SME Rating Agency of India Ltd, (“SMERA”).
Major growth factors of rating in India
The primary factor for the growth of CRAs in India is the increased,the average national income growth of 5.8% from 1981-90 and the industrial growth of 10.5% of 1989-90. After 1991 due to the strong infusion of capital in several sectors in India like the banking sector, industrial sector, infrastructure sector, insurance sector, and several others there was a general increase in per capita spending capacity. Such an increase in body corporates and individual investors led to an increase in the value and volume of total investments.
The political instability in the country aggravated the financial crisis leading to the point where the only measure to take control of the acute fiscal deposit was to adhere to the bold restructuring of the Indian Economy advised by the IMF and World Bank in exchange for the credit extended. The liberalization increased foreign investment in the domestic market, especially in the underdeveloped sectors like that of the corporate bond market. The markets were extremely volatile, the turnover of stock exchanges increased from Rs. 6364 crores in 1984 to 194000 crores in 1986.
Another worth mentioning the cause of the growth of CRAs is witnessing the huge capital market scams like Harshad Mehta Scam and Ketan Parekh Scam, which led the market participants and the regulator to realize the need for transparency and investor education to mitigate the risks associated with the market. Regulators imposed requirements to acquire a credit rating to avail credit facilities beyond a specified threshold by banks or the general public, like Basel II Norms by RBI.
Regulation of Credit Rating Agencies in India
The Indian Credit Rating agencies are governed by the Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 (“the Regulations”).
1.Eligibility Criteria of Promoters of the CRA
The registration is mandatory with SEBI for functioning as a CRA, and requires the following for the registration u/r 4 of the Regulations:
The CRA must be promoted by a person belonging to one of the following:
(i) A public financial institution
(ii) A scheduled commercial bank
(iii) A foreign bank operating in India with RBI approval
(iv) A recognized foreign CRA with a minimum of 5 years of experience in rating securities
(v) Anybody corporate having a minimum net worth of Rs. 100 crore for the last 5 years according to its audited financial statement
2.Eligibility Criteria of the CRA
The eligibility criteria for a CRA to be recognized by SEBI is given u/ 5 of the Regulations as follows:
(i) The applicant must be a company registered under Companies Act 2013 or prior company law
(ii) The applicant’s MOA lists one object as providing credit rating activities.
(iii) The applicant has a minimum net worth of Rs. 5 crores, if the applicant is functioning as CRA before the commencement of the regulations it was given 3 years to increase its net worth to the said minimum.
(iv) It is equipped with the necessary infrastructure to provide the said services
(v) The applicant and its promoters or directors must :
- Be a person having professional competence, expertise, financial soundness, and a reputation for fairness and integrity.
- Be a fit and proper person for grant of a certificate (as defined under SEBI (Intermediaries) Regulations, 2008)
- Not have legal proceedings against him connected with the securities market and having an adverse impact on investors
- Not be convicted of an economic offence or any offence involving moral turpitude
- Not be refused the grant of a certificate under these regulations or subject to proceedings for a contravention of SEBI Act or regulations made The Regulations require CRAs to not rate securities in which there exists a conflict of interest, including securities where a promoter of CRA (holder of 10% shares in the CRAs) is the issuer, or the issuer is the borrower or subsidiary or associate of the promoter.
A CRA can also not rate securities issued by its associate or subsidiary company, the associate company refers to a company where CRA owns 10% or more shares whereas a subsidiary company is a company in which CRA owns 50% or more shares.
Rating of securities is allowed where the issuer company and the CRA have common Independent Directors (“IDs”), provided the ID does not take part in the rating process and disclosure of the same effect is made by the CRA therein.
3.Periodical Review of Ratings
All CRAs are to periodically review the ratings assigned to it to the securities to the stock
exchanges by the manner of press releases or on the websites u/r 24 of the Regulations.
4.Disclosures
The CRAs are mandated to disclose the definitions and symbol of the concerned rating and the information relating to the analysis of various factors and the rating methodology u/r 18 of the Regulations
The CRAs are prevented to disclose any confidential information to any person except as permitted by law u/r 23 of the Regulations.
5.Accountability
The CRAs are required to appoint an internal auditor and keep a copy of the auditor’s report for each such accounting period u/r 21 and 22 of the Regulations. As per regulation 19, SEBI also has the power to call for information or conduct investigation in the affairs of the CRAs whenever required.
6.Conflict of Interest
The III Schedule of the Regulations requires CRAs to not rate securities in which there exists a conflict of interest among the issuer of the securities and the CRA. This includes securities where a promoter of CRA (holder of 10% shares in the CRAs) is the issuer, or the issuer is the borrower or subsidiary or associate of the promoter.
A CRA can also not rate securities issued by its associate or subsidiary company, the associate company refers to a company where CRA owns 10% or more shares whereas a subsidiary company is a company in which CRA owns 50% or more shares.
7.Liability
As per regulation 34, CRAs will be held liable for any act or omission contravening the Act, the
Regulations or any other regulations made therein under Chapter V of SEBI Intermediaries Regulations.
Credit Rating Information Services of India Limited (CRISIL)
CRISIL was the first CRA incorporated in India and it initiated its operations in the year 1988 when the concept of credit rating itself was new. The agency at the time of its incorporation was staked by public institutions like ICCI Ltd, UTI, SBI, LICI, HDFC, GIC, and SBI, it went public in 1993. Due to steep increase in the market transactions, CRISIL felt the need to enter into a strategic analysis with Standard and Poor’s Rating Services (S&P) a Global credit rating giant in 1997 where the later also acquired 9.68% in the former, and in the year 2005 S&P acquired a majority stake in CRISIL.
CRISIL diversified its operations from solely credit rating to advisory and research as well. Now the advisory services are handled by the subsidiary of CRISIL, Risk and Infrastructure Solutions Limited. It operates on two broad arenas, risk solutions, and infrastructure advisory and amounts for around one-fourth of CRISIL’s total revenue.
As per the public data available, CRISIL’s research operations include capital market research, sectoral research, company’s research, and also economic research. It adheres to 90% of the Indian Banking industry’s research requirements and has more than 1000 domestic and international clients.
Rating Division of CRISIL
The following are the eight types of credit ratings rated by CRISIL
Investment Information and Credit Rating Agency of India Limited (ICRA)
The ICRA was established in 1991 and is the second-largest credit rating agency in India, it was promoted by Industrial Finance Corporation of India Ltd, Moody’s Investment Corporation India Pvt. Ltd., LIC, GIC and several banks like Allahabad Bank, SBI, HDFC, Canara Bank, Union Bank of India, etc.
ICRA entered into an MoU with Financial Performance Inc. ( a Moody Group’s company) to provide risk management, credit research, and education, and other consultancy services to commercial banks, financial institutions. Moody’s company became the majority stakeholder in ICRA in 2001 and in 2005 the agency was listed on BSE and NSE. ICRA has also collaborated with several other foreign rating agencies like Bulgarian Credit Rating Agency, Turkey’s First Turkish Credit Rating Agency, and e-Credit Rating Agency of Bangladesh.
Rating Services of ICRA
ICRA provides rating services in a number of fields some of which are:
(i) Bank Loan Credit Rating
(ii) Corporate Debt Rating
(iii) Corporate Governance Rating
(iv) Financial Sector Rating
(v) Issuer Rating
(vi) Infrastructure Sector Rating
(vii) Insurance Sector Rating
(viii) Mutual Fund Rating
(ix) Public Finance Rating
(x) Project Finance Rating
(xi) Structured Finance Rating
(xii) SME Rating
Role in capital markets
The role of CRAs in the Capital market is threefold,
- it enables the investors to make a more informed decision,
- its ratings having its goodwill makes the issue more trusted by the investors and
- It plays the role of the watchdog of the market by reducing information asymmetry in the investors.
By analyzing the financials, management policies and even confidential information disclosed by the companies the CRAs are able to make a more informed decision about the credit risk of specific debt or equity issued by a company, than that of individual creditors.
The market price of such securities or debt instruments is highly influenced by the ratings given by renowned CRAs. When an issued instrument is rated as low risk by a recognized CRA the creditors or investors associate the expertise and goodwill of the CRA to the said security thus developing the investor’s trust in the issuer.
Lastly, the regulators also mandate credit ratings before an issue which ensures the same information is available for all the securities of that kind and brings symmetry and comparable ground to the market.
Industry structure of Credit Rating Agencies
The current structure of the Credit Rating Industry in India is that of an oligopoly with only seven CRAs giants functioning in the market even after three decades from the incorporation of the first CRA.
This form of the market leads to several difficulties like:
- a lack of competition
- compromise on the quality of service provided
- long term business relations between the issuers and CRAs
- risk of biased or influenced ratings
All of this is against the combined interests of the market and investors.
Some steps that can be taken to restructure the industry can be to remove such high entry barriers which are existing like the stringent eligibility criteria for the CRAs and their promoters. Rather there should be measures taken by the government to encourage the establishment of new CRAs.
Major Uses of Ratings by Sectoral Regulators
Uses of Credit Ratings by SEBI
SEBI has the following major uses of ratings by CRAs:
Guidelines for Mutual Funds
SEBI (Mutual FundRegulation), 1996 prohibits mutual funds from investing more than 15% in a security which is issued by a single issuer who is rated below investment grade by a CRA, and not more than 10% in unrated security.
Listing of Debt Securities
SEBI vide its circular dated September 30, 2003, made it compulsory for every public and right issue of debt instruments having a tenure of an year more than that to be compulsorily rated by an approved CRA.
Investor Protection Guidelines
SEBI ( Disclosure and Investors Protection) Guidelines, 2000 deals with primary issues of shares, debentures, and various other financial instruments, and regulation 2.5.1A prohibits any public issue or rights issue of convertible debt instruments unless a credit rating is obtained from at least one CRA registered with SEBI.
IPO Guidelines
In case of an IPO the SEBI ICDR Regulations, 2018, regulation 10 additionally requires the issuer of a convertible debt instrument to mandatorily obtain a rating from one CRA and to disclose all the grades obtained by the CRAs which were approached by the issuer in a red herring prospectus.
Collective Investment Scheme
According to SEBI (Collective Investment Scheme) Regulation 1999 u/r 24 states an entity cannot issue agro bonds or plantation bonds without obtaining rating from one CRA registered with SEBI.According to SEBI (Collective Investment Scheme ) Regulation 1999, u/r 24 states an entity cannot issue agro bonds or plantation bonds without obtaining a rating from one CRA registered with SEBI.
Uses of Credit Ratings by RBI
RBI utilises the credit ratings issued by the CRAs in the following manner:
Non- Banking Financial Companies Regulations
The NBFCs Acceptance of Public Deposits (Reserve Bank) Directions, 1998 requires NBFCs with a net owned fund of 25 lakhs and above to have a minimum investment grade granted by a recognised CRA annually to be allowed to accept deposits from the public.
RBI vide its circular dated March 31, 2006, also mandated all residuary NBFCs to invest a minimum of 20% of aggregated amounts of liabilities in FDs or certificate of deposits in commercial banks and financial institutions not rated less than AA+.
Small and Medium Enterprises
To boost the economic growth of SMEs, RBI issued circulars in the year 2005 to improve credit availability in the sector by adopting a transparent rating system, thus the CRA, Small and Medium Enterprises Rating Agency ( SMERA ) emerged which solely focuses on rating the SMEs. SIDBI also developed a Credit Appraisal Rating Tool and Risk Assessment Model. The AGency takes into account several financial and non-financial factors to rate an SME, it uses a 5 point scale ranging from SE1 to SE5, with each grade further qualified by subgrades A, B, and C.
Primary Dealers in Government Securities
RBI through its circular mandates all primary dealers in government securities to invest only in credit-rated non-government securities. The upper limit for investment in unrated securities is 10% of their total non-governmental securities portfolio.
Commercial Banks and Financial Institutions Regulations
RBI mandated by its circular that the securities issued by an SPV in a securitization transaction should be compulsorily rated by a registered CRA, and must not be older than 6 months.
RBI vide its circular required all commercial banks to make fresh investments in rated SLR securities by registered CRAs.
RBI’s Basel II Norms
The Basel II norms issued by RBI state that the external credit ratings granted by CRAs under the Standardised approach is the basis of credit risk evaluation and for different kinds of debtors, the ratings have been matched to their respective risk weights, i.e. the better the rating the lesser the risk weight with a AAA only having 20% and an unrated having 150%.
Uses of Rating by IRDA
The Insurance Regulatory Development Authority under its IRDA (Investment) Regulations, 2000 mandates all insurance companies to invest its assets of the pension business, general annuity, and group businesses solely in securities rated ‘very strong’ by registered CRAs.
Development of CRAs in recent years
The Vijay Ranjan Committee which recommended the enactment of SEBI CRA Regulations had the view that, since credit ratings are essentially opinions there is an extent to which they can be regulated, as it is possible that in a situation with same facts and figures different professionals will have different interpretations thus varying ratings. Nevertheless, the Regulations comprehensively govern the conduct of CRAs and strive for greater transparency and efficiency in the process of rating.
2010 Amendment
There have been some key developments in the recent years which have aided the credibility of the CRAs, the 2010 CRA Amendment to the Regulations provided for the following:
- All CRAs were required to maintain records of factors on which rating was made
- CRAs were to publish details of the history of defaults to enable investors to judge their performance accuracy.
- CRAs shall not provide consultancy/ advisory services with regards to the design of the structure of financial instruments.
- CRAs are mandated to make disclosures to the stock exchanges related to several matters like details of the ratings, agreements with the issuers, issuer wise percentage-wise income of CRAs, and other details of CRAs like shareholding pattern.
2011 Amendment
The next amendment was brought by the 2011 CRA Amendment Regulations, which introduced the concept of initial registration for 5 years and subsequent permanent registration to CRAs.
2018 Amendment
The 2018 CRA Amendment Regulations, required every foreign credit agencies incorporated under FATF members jurisdiction to have a minimum of 5-year experience.
In absence of cooperation of the Client with the CRA to provide the information required to periodically review the ratings given to the client, the CRA is directed to carry out its review as best possible with the available information and disclose to the investors the fact that the rating is so based.
Another important addition was the insertion of Regulation 24A which prohibits a CRA to hold 10% or more shareholding/ voting or representation in a BOD of another CRA.
It also prohibited shareholders of a CRA (with 10% or greater shareholding) to hold 10% or greater shareholding in other CRAs, this restriction is inapplicable to Pension funds, Insurance Schemes, and Mutual Fund Schemes. This is a commendable step in maintaining the independence and separation of ownership of the CRAs.
2019 Amendment
More recently the 2019 CRA Amendment Regulations made it mandatory for the client of a CRA to cooperate with it for various processes like a periodic review, disclosures related to information, offer documents, and other relevant information.
The amendment also requires the Client to provide CRA with explicit consent to obtain information related to current and future borrowings, repayment, delay, and default in borrowings form both statutory and non-statutory lenders.
Problems arising out of CRAs
Conflict of Interest
The major issue raised numerous times in the functioning of CRAs is that of the conflict of interest between the CRA and the issuer entities of the securities, as the CRA industry is issuer paid industry it creates a conflict of interest.
The CRAs are offered whether directly or indirectly incentives to issue favorable credit ratings, the incentives can be either monetary or non-monetary like securing their long-standing business relations which in the end jeopardises the investors’ interests.
Effect of Non- CR Activities
A research study shows that issuers who were engaged with the CRAs in non-credit rating activities were assigned higher ratings by that particular CRAs as compared to the CRAs which were not engaged with them in any other activities. Also, the Issuers providing greater non-rating revenues were given higher ratings.
This shows clear partiality resulting from the commercial engagement between the CRAs and the issuers which need to be addressed.
Rating Shopping
Rating Shopping refers to the practice of an issuer entity soliciting multiple CRAs but only pays for and discloses to the public the one which rates it highest. This practice was seen during the year 2008 financial crisis and is even considered one of the causes of it.
The phenomena are common where there is a complex set of assets and liabilities leading to the purview of the difference of opinion and ultimately the CRA taking the most liberal view i.e. granting the highest rating will be paid and disclosed to the public thus incentivising the CRA to take this approach.
Lack of Accountability to Investors
Currently, in India, there is a lack of accountability of CRAs towards the investors who are the direct bearers of the consequences of a default of the credit ratings issued by the CRAs. Although CRAs can be held liable under the SEBI CRA Regulations, the Intermediary Regulations, SEBI FUTP Regulations, and even Companies Act.
The issue is that the nature of liability therein is either functionary like suspension or cancellation of the certificate, ban from the capital market, or penal like an imposition of fine by SEBI. Under Companies Act section 35 provides liability for misstatement and section 447 for fraud, but the issue of its applicability to CRA unclear, as the credit ratings are not merely statements of facts, they are opinions of experts where the discretion of interpretation exists.
However, none of these options are viable for compensating the loss of aggrieved investors who relied on an incorrect rating. Furthermore, due to a severe lack of awareness, the investors of the market should not be expected to know and pursue such indirect liabilities of CRAs but alternatively should be provided with a more direct course of action.
Statutory Reliance
As cited above the Regulators like SEBI, RBI and IRDA rely on CRAs rating to make several important decisions irrespective of subjective factors of all the issuers. This reliance increases the impact of these ratings which exacerbates when these ratings are biased or incorrect, and even in a scenario where such ratings are correct and well regulated, it depicts the dependence of a statutory body on a private entity’s opinion.
Market Structure- Lack of Competition
As stated earlier the CRA industry resembles an Oligopoly market, which has few well-established agents, coordinated operations between these agents, and high entry barriers which ultimately results in reducing the market competition. Any entry of a new agent is opposed on multiple levels, firstly by the existing CRAs in a combined manner, secondly by the stringent statutory requirements and lastly by the capital extensive nature of the industry itself.
How can CRAs be improved
Developing new Payment Models
An obvious solution to the issuer pay model of CRAs is the establishment of investor pay models, however, it poses another risk of conflict of interest with the bigger investors. In India, 90% of issuances are a private placement of debt accounts which have a remarkable potential to influence such investor paid CRAs if established.
The US SEC has developed another practical solution that the issuers will be required to obtain two ratings, first from a CRA of their choice (maybe Issuer paid) and other of the investor’s choice (Investor paid) thus to maintain neutrality in the ratings.
Another possible solution can be a government or regulator paid model which will eliminate any pecuniary bias between the CRA, Issuer, and Investors (excepting PSEs). These can also disseminate CRAs to all, but it has complications like lack of choice of available to issuers, maintenance, and enhancement of quality beyond a minimum threshold and the determination of payment mechanism.
Rotation Mechanism
Rotation mechanism has been adopted by several jurisdictions like European Union to prevent excessive familiarity due to lack of competition, EU Regulation prescribes a maximum of 4 years of a contractual relationship between the Issuer and the CRAs before rotation of rating analysts.
A similar measure can be taken by the Indian Regulators to ensure the independence of CRAs and the Issuers, as is enacted in the auditing Industry u/s 139 of Companies Act. The problem with doing the same was the lack of competition in the CR Industry however the individual level rotation technique can be on an individual analyst level resolving the same, as long as there is no organizational bias itself the mechanism should be effective in maintaining independence.
Regulating Non CR Activities
There should be an absolute prohibition in CRAs and its promoters in extending any non-credit rating services to not only issuers and investors but also promoters of issuers, although SEBI has enacted a regulation the implementation needs to be more stringent.
Complete Disclosure of all Ratings
An effective manner to curb rating shopping is to mandate the issuer entities to publish all the ratings granted to it by all the CRAs whether preliminary or otherwise. These ratings shall be made available to the public as well as the regulator. The same is implemented in European Union u/r 10 of EU Regulations and in the United States by SEC Rules.
In India, the Code of Conduct prevents the rating shopping and requires mandatory disclosures of ratings even when not accepted by the Client but, all of these are only applicable once the Issuer and the CRA come into a contract and to prevent any transaction before that SEBI asked CRAs to refrain from providing preliminary ratings, instead it could have directed them to do so under another contract solely for a preliminary examination as it would make the process more transparent.
Direct Accountability to Investors
Originally the reputational constraints were considered enough incentives for CRAs to work fairly and efficiently however the same was soon realised to be unrealistic. US
EU introduced civil liability of CRAs by its Art 35a of EU Regulations, 2013 on the following occasions:
- Intentional commission or gross negligence,
- Infringe the duties laid down in the Directive,
- Infringement has an impact on the credit rating issued,
- Investor reasonably relies on due care for the decision to invest into or divest of the financial
- instrument,
- Damage to investors.
The article also vests the burden of proof on the investor to prove that CRA ‘s act falls under one of these categories.
There can also be a limitation of liability pleaded by the CRA on the following factors under Regulation 12:
- The contractual negotiation between the investor and the credit rating agency, if any;
- The price agreed between the investor and the CRA;
- Lack of proximity between the investor and the CRA;
- Unexpected and unusual uses of the rating;
- Lack of foreseeability of the losses incurred;
- Lack of the possibility to insure against the loss;
- Lack of resources to meet such a loss.
SEBI should insert a similar section in the CRA Regulations for better investor protection.
Removing Entry Barriers
The nature of the credit rating industry itself requires a CRA to make high investments, have a loyal customer base and earn profits according to economies of scale, however, all this is difficult to achieve by a new entrant, therefore the government should take some steps to aid the establishment of new CRAs.
Developing more Comprehensive Regulations
SEBI should develop a more comprehensive and updated form of Regulations to govern all the activities of the CRAs rating and non-rating services alike. These regulations ought to be exhaustive and inclusive of all the directions issued by Circulars issued by SEBI in the past, such a measure shall not only provide legislative clarity but also ease of adherence to the CRAs.
Conclusion
CRAs play a pivotal role in investor protection and hence their regulation is an important function of SEBI. Although there exists an extensive regulatory regime of CRAs the above-mentioned issues need to be addressed for better functioning.
For other queries related to securities law, you can contact me.
References
- https://vidhilegalpolicy.in/wp-content/uploads/2019/05/170731_CRAReport.pdf.
- https://shodhganga.inflibnet.ac.in/bitstream/10603/68273/9/09_chapter%204.pdf
- https://rbidocs.rbi.org.in/rdocs/notification/PDFs/85BL4697A788DAB5485B826CFA24D35EA1BE.PDF
- https://www.imf.org/external/np/apd/seminars/2003/newdelhi/pana.pdf
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