In its continued effort to improve the functioning of credit rating agencies (CRAs), SEBI has recently came up with a fresh set of guidelines for enhanced disclosures on rating rationales.

SEBI’s regulatory approach –

  • Sebi’s regulatory approach to CRAs has been more inclined to a rule-based approach as opposed to a principle-based approach.
  • Under a principle-based approach, the regulator states the desired outcome, leaving it to the regulated firms to figure out the steps they need to take to achieve the regulator-mandated end-state.
  • In a rule-based approach, the regulator specifies the action to be taken by the firms to be considered compliant. Rule-based regulations, despite their appearance of regulatory micro-management, tend to be preferred by firms relative to principle-based regulations.

Why firms prefer rules based approach?

  • Firms prefer less ambiguity associated with the rule-based approach. Additionally, they are relieved of the burden of proof of being compliant, as may be required in a principle-based approach.
  • However, if there is a failure in a rule-based regulatory framework, it is the system that tends to bear the cost. Firms, to the extent that they remain compliant, do not share the downside and, arguably, have limited skin in the game.

What can be done?

While Sebi may not suddenly turn to the principle-based approach, it may still achieve the end objective by fine-tuning its latest, well-intentioned guidelines. To Sebi’s well-appreciated efforts, the following alterations and additions may be considered:

  1. Quantitative disclosure: Rules should be such that they do not commoditise the CRAs’ offerings. The CRA may be required to publish the median values of the critical ratio of their choice, for a specific industry, across various rating levels and for the last five years. This will allow an investor to compare whether the current rating is more or less stringent, and whether, over the period, the CRA’s standards have been consistent.
  2. Enhanced transition matrix: The transition matrix should track default rates over multiple years. Investors need to know the default rate of AAA/AA/A ratings over three to five years from issuance, and not just one year. Sebi may consider independently calculating the default transition matrix by accessing data from a commercial credit bureau or Reserve Bank of India’s central repository of information on large credits database and not depend on the CRAs at all.
  3. Cursory disclosure of all ratings: CRAs may be required to also summarily refer in the press release to the outstanding ratings of other CRAs for the same borrower and the previously withdrawn rating of the same borrower from other CRAs and the reason for the rating withdrawal.
  4. Legal protection for CRAs: The regulator should consider framing laws that allow CRAs to express their rating opinion without fear of being sued.

Conclusion –

Without some of these measures, it is possible that CRAs will continue to remain compliant, but frequent, high-investment-grade defaults will continue to erode investor confidence.

SourceLivemint

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