Recent defaults by IL&FS and sharp downgrade of DHFL debt put the spotlight on credit rating agencies, whose credibility across the globe had been slowly eroding since the global financial crisis in 2008. In a major shake-up, market regulator Sebi has issued new set of guidelines that seek enhanced disclosures from Credit Rating Agencies (CRAs).
Firstly, rating agencies have been directed to start disclosing the probability of default for the issuers they rate. This is an important step because Indian rating agencies have had a troubling track record of detecting defaults. In the case of IL&FS, when the infrastructure lender was struggling to service $12.6 billion in debt, the CRAs didn’t see the crisis coming. In the case of DHFL, rating agencies downgraded its commercial paper debt securities to 'default', quite a few notches from the earlier rating that gave no inkling to investors about the precarious situation. The DHFL rating action had happened hours after DHFL actually missed interest payments.
As per the Sebi norms, rating agencies now have to disclose the various factors that could potentially impact the rating of the instruments. Known as 'rating sensitivities', these include an assessment of financials. Agencies have to explain in a simple language which factors could trigger a rating change, both upward and downward.
The problems in rating accuracy have long plagued the financial sector. But, increasingly investors have questioned the efficacy of the ratings given the fact that they may not be any serving purpose as a lead indicator. Plus, rating firms have a huge conflict of interest they are paid by the issuers to rate their securities. After the recent misses by rating agencies, some reform initiatives were expected so that rating agencies shape up.
The Sebi has told rating companies, that in consultation with the regulator, there will be a uniform probability of default benchmark created for each rating category on their (CRA) website, for one-year, two-year and three-year cumulative default rates, both for the short-term and long-term. This move will help ensure that investors are able to make a better view of the ratings. Sebi also tweaked the methodology to arrive at those default rates.
Additionally, Sebi also defined terms that rating agencies would need to use to describe the liquidity position of the issuer—strong, adequate, stretched and poor. Despite credit rating agencies being an alert system for an instrument before it goes to actual default, such agencies have failed to detect early signs.