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The Securities and Exchange Board of India (Sebi) is working on a new set of guidelines to address the inherent conflict of interest in the functioning of credit rating agencies, according to a Press Trust of India news report. The market regulator first issued regulations for credit rating agencies in 1999, followed by amendments in 2006, 2010 and 2011.

Still, concerns about conflicts of interest prevail. Mint has periodically pointed out the problems facing the sector – highlighting recently that a large government company’s debt instrument was rated for a fee of only 1; questioning the high ratings of Deccan Chronicle Holdings Ltd just a few months before the company defaulted on repayments. What’s more, the head of Icra Ltd, one of the country’s large rating agencies, told this newspaper that some agencies are making compromises to win business.

In light of all this, it seems like it makes perfect sense for Sebi to review its regulations for the sector. But the solution may well be lesser regulatory involvement. Investors will be better served if Sebi and some other regulators do away with the requirement that debt instruments should be mandatorily rated.

But other than that, regulators should encourage investors and lenders to make their own independent appraisal of borrowers. The US Securities and Exchange Commission, for instance, had made a proposal that a rating would no longer be a required element in determining which securities are permissible investments for a money market fund. Former chairman Mary Schapiro had said at the time, “The focus of these efforts is to eliminate over-reliance on credit ratings by both regulators and investors, and encourage an independent assessment of creditworthiness." Professor Jayanth Varma of IIM Ahmedabad pointed out in a post-financial crisis blog post that UK does not use credit ratings at all in determining what securities a regulated entity can or cannot invest in. He added that India must do a hard rethink on the use of credit ratings and eliminate all use of them.

In India, Sebi’s rules require mutual funds to invest mainly in bonds with an investment grade rating, and restrict investments in unrated bonds to 25%. Entities overseen by the insurance sector regulator as well as the pension sector regulator also face ratings-based restrictions on their debt investments.

Sebi has mandated rating for all public bond issues, capital protection oriented schemes. In the equity space, it has mandated ‘IPO Grading’ by credit rating agencies. The central bank has mandated rating of commercial paper, as well as fixed deposits by non-banking financial companies and housing finance companies. Even a government-appointed committee on Comprehensive Regulation for Credit Rating Agencies had considered doing away with mandatory rating. The committee, which was set up by the High Level Coordination Committee on Financial Markets, had said, “Regulators need to enhance their due diligence and investors need to strengthen their own information processing systems…. Over reliance on ratings by market participants has to be avoided." But sector regulators had rejected this suggestion, saying that Indian investors are still largely financially illiterate and that ratings help them make informed choices.

However, it must be noted here that Indian investors are making similar as well as more complex choices when it comes to investing in equity and equity mutual funds. Many of their choices as consumers of technology and automobile products, for instance, involve decisions for which they are seemingly ill-equipped.

But rather than encouraging investors to do their own due diligence, Indian regulators are doing the opposite. By keeping entry barriers for rating agencies high and mandating ratings, the message that is sent to investors is that these ratings are highly reliable. Now while it’s true that cases such as Deccan Chronicle are few and far between, they go to prove that investors must not base investment decisions primarily on ratings. Of course, the global financial crisis gave ample proof that investors who relied on rating agencies for their investments decisions were among the worst hit. Needless to say, if regulators do away with mandatory ratings, all companies offering these services will be hit. However, their services will still be sought after by investors and companies, which will lead to a situation where the best in the business thrive. Alongside, regulators should remove the bar on unsolicited ratings. This is far better than the current situation, in which issuers can practically shop for agencies that will give favourable ratings and reject agencies that give unfavourable ratings. Such a model is already in existence in the mutual fund space, where a number of entities provide unsolicited ratings on funds based on various parameters. Some of these entities such as Value Research have created a viable business model by providing primarily mutual fund research and ratings.

Doing away with mandatory ratings for debt instruments is, therefore, not as inconceivable as regulators currently think.

Your comments are welcome at mintmoney@livemint.com

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