NISM study calls on credit ratings agencies to tweak operations

The present study by NISM is another attempt to assess the performance of CRAs, particularly in the light of the recent significant events in the global financial system and the criticism being faced by CRAs in the USA

The National Institute of Securities Markets (NISM) has called upon credit ratings agencies (CRAs) in India to tweak their operations so that the ratings can be more useful for investors.

In a report titled, 'Assessment of Long Term Performance of Credit Rating Agencies in India', the Institute said that there is a need for a framework to be agreed upon by all CRAs and regulators to have a standardised and operational definition of default.

CRAs have been operating in India since 1988. CRISIL, ICRA and Fitch India have collaborative arrangements with S&P, Moody’s and Fitch, respectively. CARE is promoted by IDBI and Canara Bank. Brickworks, the latest entrant, was established in 2008. Thus, a total of five major CRAs operate in India at present. Most of the ratings by CRAs relate to bank loans, on account of ascertaining the credit-related capital adequacy.

For a market like India, where financial literacy is at a nascent stage, multiple rating symbols could confuse the investing community and it could result in 'rating inaction' and foster unhealthy competition. Rating scales, brought under comparable bands, need to be hosted on the websites of the Securities and Exchange Board of India (SEBI), the Reserve Bank of India (RBI), the Insurance Regulatory and Development Authority (IRDA) and the Pension Fund Regulatory and Development Authority (PFRDA) and also on the sites of investors' associations, the NISM said.

Talking about the timeliness of ratings and its outlook, the report said since 'Rating Outlooks' (both positive and negative) and `RatingWatch' have a limited life, it must be replaced by a firm rating within a reasonable span of time, say a month.

Terming the policy of some CRAs to stay away from services other than credit ratings as a 'healthy sign', the NISM said that it needs to be ensured that the registered CRA, as a corporate entity, must not engage in any services other than ratings.

The report said that the presence of External Committee Members (ECM) brings with it a whole baggage of conflict of interest. Some CRAs have demonstrated that it is possible to develop the expertise either with full-time employees from domestic CRAs or in collaboration with overseas CRAs. Alternately, ECMs could be deployed for providing inputs, leaving the final ratings to an Internal Committee at the CRA, it added.

To curb the unhealthy practice of 'shopping for ratings', the NISM said that it is necessary to come to a stage where all ratings, including unaccepted ratings are published. In the 'shopping for ratings', issuers attempt to seek informal ratings from various CRAs and pass the final rating mandate to the agency that could offer the highest ratings, it clarified.

It said that young potential employees tend to gravitate towards merchant banking and investment management, leaving a paucity of talent in accounting, audit and credit appraisal, which are actually the backbone of financial systems. Calling for specialised training for due diligence review (DDR) and accounting & auditing systems, the report said that these skills, especially the DDR skill, are needed to assess the overall credit-worthiness of an entity. India is only two years away from the implementation of International Financial Reporting Standards (IFRS) and the preparedness is woefully lacking, amongst professionals as well as academics, the report noted. {break}

Along the lines of the compulsory Internal Audit for Stock Brokers, NISM said it is found necessary to stipulate an Operational Audit to ascertain that the rating processes leave a documentary trail. This could cover details of site inspections, management meetings, rating committee meetings, dissent notes, surveillance, monitoring schedules and minutes of the appeal process, it said. The audit will address the basic issue of good housekeeping and could be performed twice in a year. Some CRAs have taken the initiative to appoint a person with the task of Quality Control, and he is involved in all rating exercises, the report said.

Calling for inclusion of debt to equity ratio in interim financial reporting, the NISM said that there is a need to amend the accounting standards (AS25) and the listing agreement that can provide details of total debt alongside net worth and would help in computation of the debt to equity ratio at quarterly (90-day) intervals.

The report said that there is a need to educate people on the usage of ratings since there lies a danger of the rating being accepted blindly without a self-check or giving due importance to the time gap between two review dates. There is also the practice of issuers using ratings for marketing purposes—exhibited on all their business literature and office stationery. Hence people should use rating as one of the inputs in the decision-making process and not as a guarantee. Of course, this does not absolve the responsibility of the CRAs for negligence, the NISM report said.

There could be information gaps that arise due to factors beyond anybody’s control. In line with the Risk Factors highlighted on various products, CRAs also need to mention a disclaimer on all rating announcements as well as on the website. This is to bring to the mind of the reader (user) of ratings the fact that credit-related information is dynamic and subject to changes. Rating disclosures could also mention the latest review date, the report said.

The NISM report said that it is important for the members of the public to know that the relationship of the CRA is at arm’s length with that of the rated entity, in letter and spirit and hence, shareholding ownership patterns of all CRAs need to be made public.

There have been instances in the USA where S&P and Moody’s have deliberately given low ratings to various issues on an unsolicited basis. This was used as a means of arm-twisting the issuers. This is a classic instance of abuse of independence provided to CRAs. The NISM said that unsolicited ratings must not be permitted, in case the CRA community makes a representation to this effect in the future.

The NISM report said that bad governance can contaminate financial statements, and hence annul the entire credit-rating exercise. It is sad to know that CRAs heavily depend on the audited financial statements and do very little to gain the maximum from cross-verification from formal and informal sources. While this is a lacuna on the part of auditors and CRAs, much needs to be done on corporate governance, since a governance code works only on paper, it added.

Today, the entire edifice of corporate finance—shareholder wealth maximisation—is under question. The focus is shifting towards stakeholder satisfaction and societal wellbeing. Auditors and CRAs are the watchdogs of society as also the conscience-keepers of the nation; hence corporate governance is even more relevant as the first filter. It is often said, in credit wisdom, that balance sheets do not repay loans, it is the people behind the organisation (who do so), the NISM report concluded.
 

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