Rating the raters

Vigil matters more than rules

Rating agencies the world over should be experiencing some existential angst. Over the last decade and more — from the Asian crisis of 1997 to Enron, WorldCom and the most recent international financial crisis — they have failed to signal danger and changed their ratings only when overtaken by events. It is, therefore, natural for the Indian regulators to see if adequate systems are in place for Indian credit rating agencies to work and deliver right although they have not malfunctioned during the recent international crisis the way global leaders have, with structured products bearing triple A ratings falling precipitately in value and becoming illiquid. A relook at regulation is needed for two reasons. The Indian credit rating business is now the second biggest in the world and a growing number of Indian regulators are making it obligatory for financial instruments in their area to get mandatorily rated. Carefully regulating these agencies — there are five of them now — is essential as they don’t face much competition (new agencies are licensed very infrequently) and mandatory rating creates an assured flow of business to the sector.

The one recommendation of the government committee to look into the regulatory environment that will be unequivocally welcomed is the need to follow the system of lead regulator to prevent regulation shopping as there is a multiplicity of regulators now with a stake in rating (Sebi, RBI and the insurance and pension regulators).

Sebi, which is the current regulator, can become the lead regulator. The rating agency, once licensed by Sebi to get into the business, will then need to also get accredited with the sectoral regulator whose instruments it wishes to regulate. There are also sensible proposals to coordinate the activities of all the regulators so that an agency faces only one operating body like an inspection committee which has representation from all the regulators. The report has also made unexceptionable recommendations for greater disclosure, transparency and sound governance.

But the committee’s focus suffers from one flaw. It has looked foremost at conflict of interest issues which brought the house down, so to speak, in the West whereas in India, the foremost issue is rating shopping. Once a prospective issuer is indicated the kind of rating it is likely to get, it is free to, and sometimes does, go to another agency which offers a rating not just one notch higher but in quick time. Conversely, it is also more difficult for a newer agency to get the right kind of analysts and maintain credit discipline while surviving as a business venture. Thus, in this very specialised field, competition does not automatically ensure quality. It also does not help that if an issuer does not like the rating it is going to get and withdraws its mandate, the agency is not free to publicly disclose the rating. The committee is non-committal in recommending the disclosure of unsolicited ratings, only saying that such a rating should clearly be flagged as such. It is also necessary for an agency, which has rated an instrument once, to publicly declare that it is no longer reviewing its rating periodically if its mandate has been withdrawn. Overall, more than codified rules, the regulator has to keep its ear close to the ground to ensure healthy practices. The final customer for rating is not the issuer who pays but the investor.