Panel seeks strict regulation of rating agencies

A committee appointed by financial regulators has recommended an overhaul of regulatory norms governing credit rating agencies (CRAs) and sought a host of disclosures from them to make the system more transparent.

The panel, headed by KP Krishnan, a joint secretary in the finance ministry, has suggested that the Securities and Exchange Board of India be designated as the lead regulator with whom rating agencies should be registered.

The registered agencies would also require accreditation from other regulatory bodies such as the Reserve Bank of India and insurance and pension regulators for rating instruments that came under their domain, said the committee, whose report was made public on the finance ministry website today. In addition, the regulators should also conduct joint inspections of the agencies, it added.

The regulators have already decided to make internal audit mandatory for rating agencies. Besides, the Krishnan committee said while only five agencies were registered with Sebi, a few others were using the words credit rating agency in their names. It has called for an immediate ban on non-registered entities from using credit rating in their names.

The other focus area is potential conflict of interest. To avoid this, the committee has advocated stringent disclosure norms for subsidiaries floated by rating agencies. These disclosures should include the details of the fee received from a company by it, its subsidiaries or its promoters over the preceding three years.

“CRAs should not be allowed to enter into any business that may directly or indirectly have conflict of interest with the job of rating. Internal Chinese Walls are porous mechanisms to prevent such conflict of interest, as other businesses such as consultancy and advisory services should not be undertaken by CRAs,” the committee said.

Agencies such as Crisil and Icra have floated subsidiaries providing advisory services.

There is special reference to structured finance and structured products, which had triggered a review of the rating mechanism. The committee suggested that an agency or its subsidiary should be barred from providing advisory services — either formal or informal – on the design of a structured finance instrument and also rate the product.

Also, if the recommendations are accepted, the entities will have to differentiate the ratings for structured products, improve their disclosure of rating methodologies and assess the quality of information provided by the originators, arrangers and the issuers of such structured products. “It may be made mandatory that the CRAs make a clear distinction between credit ratings of structured finance instruments and other credit ratings,” the committee said.

After reviewing the issuer pays payment model, it has suggested that the system be continued, though the system be made more transparent by mandating disclosure of the compensation arrangements with the rated entities. Analysts should not be part of any fee discussion with the issuer, and added that employee involvement in the rating process should not come into conflict with ownership pattern.

There are suggestions to also publish the information about the assumptions underlying their rating methodologies and the committee said that internal records, including working paper, should be retained by the agencies.