IL&FS crisis: What is the Sebi's latest diktat to credit rating agencies?

The IL&FS crisis exposed the chinks in the credit rating agencies' armour, catching the market off-guard. Market regulator Sebi's latest guidelines try to plug some of the loopholes

What exactly do credit rating agencies (CRAs) do?

A rating agency’s job is to monitor and analyse the relevant factors that affect the creditworthiness of an issuer — in other words, a borrower. Based on a number of underlying factors, such as business profile, macroeconomic and regulatory factors, the agency assigns a rating to the security or an instrument. The rating helps in pricing the security issued by a company. Higher the rating, lower is the coupon and vice versa. Typically, a rating is denoted in an alphanumeric symbol such as AA+ or A-. Every rating conveys the ability of the issuer to pay the interest and principal of the debt instrument. 

What are the factors that impact a credit rating?

Every rating agency follows its own process to rate a security. Typically, every credit rater does a comprehensive evaluation of the company fundamentals, which include its financials, strengthens and weakness. The rating agency also takes into account external factors such as industry profile, macro-economic conditions, regulatory and political environment. As most of these factors are dynamic in nature, an instrument’s rating could change. A credit rating agency would typically put the rating in public domain with an explanation about the factors that have resulted in the rating change. A downgrade typically means the ability of the corporate to repay has deteriorated, increasing the riskiness of the instrument. 

What is the Sebi’s latest diktat to the CRAs?

The Sebi last week issued a circular mandating “enhanced disclosures” by CRAs. The new requirements are aimed at helping investors understand the rating drivers better in order to make more informed investment decisions. As per the new guidelines, rating agencies will have to make disclosures on factors such as promoter support, linkages with subsidiaries and liquidity position for meeting near-term payment obligations. Going ahead, rating agencies will have to make these disclosures in the “analytical approach” and “liquidity” section of its press release that puts in public domain a rating action. Sebi has said when the rating factor is support from a parent company or the government, the names of the promoter and the rationale for any expectations shall be provided by the rating agency. Also, when the subsidiaries or group companies are consolidated to arrive at a rating, CRAs will have to list all such companies and state the rationale for consolidation. Further, the “liquidity” section of the press release will need to highlight parameters like liquid investments or cash balances, access to unutilised credit lines, liquidity coverage ratio, adequacy of cash flows for servicing maturing debt obligation. These are aimed at providing an insight into how a company is placed for meeting its near-term repayment obligations. 

What are the changes prescribed to the rating review process?

The Sebi has said while monitoring of repayment schedules, rating agencies will have to analyse if there has been any deterioration in the liquidity conditions of the issuer. The rating agency will also have to take into account any asset-liability mismatch. Further, rating agencies have been told to read signals given by financial markets. Sebi has said rating agencies should treat sharp deviations in bond spreads of debt instruments vis-à-vis relevant benchmark yield as a “material event”. The market regulator has also asked rating agencies to provide “average transition rates”— essentially historical changes in ratings for long-term instruments. Credit raters will have to publish their average one-year rating transition rate over a five-year period for an instrument. “In order to promote transparency and to enable the market to best judge the performance of the ratings, the credit rating agencies should publish information about the historical average rating transition rates across various rating categories, so that investors can understand the historical performance of the ratings assigned,” said Sebi.

What has triggered the latest changes? 

Many see the latest changes as the direct fallout of the IL&FS crisis. Many investors perceived the infrastructure financier to have government backing. As a result, despite IL&FS’ high indebtedness, investors took comfort in investing in its papers, which enjoyed top-notch rating ahead of the default. Also, IL&FS operates through a complex subsidiary structure, which made monitoring of end use of funds difficult. The new guidelines, therefore, mandate disclosures related to promoter/government backing and linkages with subsidiaries. 

How will the new guidelines help?

Experts say the enhanced disclosures will make the system more transparent and by helping investors see the warning signs. However, the additional disclosures will not entirely make the system, full-proof, they say. In the past, agencies have complained that their rating process gets hindered due to non-cooperation by the issuer, wherein a company isn’t upfront about the information sought by the issuer. Also, the rating action, often, is based on historical data and assumptions and opinion of the rating agencies, which could turn out to be different from the reality.