'Review of rating firms' incentive structure needed'

At a time when the role of rating agencies globally is under the scanner, the Reserve Bank of India on Thursday said that there is a need to review their incentive structure in India to avoid a potential conflict of interest.

In its latest Report on Currency & Finance, while suggesting the review, the banking regulator pointed out that agencies are paid by the entities that they rate. RBI’s observation assumes significance as at the last meeting of the high-level committee on capital markets, the issue was discussed by financial sector regulators and the finance ministry. The Securities & Exchange Board of India has been asked to prepare a discussion paper since rating agencies are hitherto unregulated in India.

 

RBI’s report on Thursday also said that the limited penetration and absence of reliable ratings for different assets may act as a hurdle for the banking industry, which is implementing the Basel II guidelines. It suggested that the idea of a specific rating for liquidity risk should be explored.

Further, the rating methods and the overall role of rating agencies should be more transparent, in the securitisation process.

Again, the metric used for rating bonds and structured products should be different as the consequences of assigning a AAA rating to a collaterialised debt obligation (or CDOs that are asset-backed securities) and a corporate bond are not the same as the potential volatility of a structured product is much more than a traditional product.

At present, the metric used to rate these products is identical and, in order to distinguish the significance of the rating, the report prescribed a separate rating scale for structured products. The role of rating agencies has been scrutinised for the way they have handled structured products.