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Home / Opinion / Rating agencies don’t make the investment grade cut

If you had to rate credit ratings agencies in India, what would be the outcome? Would they make the investment grade cut or would they fall in the junk category? If the past year is anything to go by, it would probably be the latter.

Issues with corporate credit ratings are neither new nor restricted to India. Over the past 12 months, though, there have been a number of cases that have reminded us that rating agencies are in need of an overhaul.

It started with the case of Amtek Auto Ltd in September 2015 when agencies like CARE Ratings downgraded the company steeply. Others like Standard and Poor’s simply withdrew their rating without explanation. The result was a redemption crisis at the JP Morgan Asset Management (India) Pvt. Ltd, which had invested heavily in debt securities issued by the company.

That incident brought to light the many instances where rating agencies had failed to act as an early warning system for investors. Ratings were being downgraded by multiple notches in one shot, suggesting that the initial ratings were higher than justified. Ratings were also being withdrawn without warning or explanation, leaving investors hanging.

Just as public attention had started to shift away from the loopholes revealed by the Amtek case, the story of Ricoh India Ltd has come to light.

While the case is one of alleged fraud, it begs the question of why the rating agency didn’t capture the deterioration in the company’s financials. A quick summary of the case. Ricoh India saw its revenues and liabilities jump sharply between fiscal 2011 and fiscal 2015. There was, however, no corresponding increase in fixed assets or profits. The company had also delayed declaring its September 2015 quarter earnings until last week. Despite this, India Ratings, in January 2016, upgraded the company’s non-convertible debentures. In March, it put the company on ‘Negative Watch’ but did not downgrade. India Ratings explains this by saying that their ratings “were largely reflecting the operational linkages and financial support from Ricoh Japan."

The view appears to be a highly blinkered one. Should the rating agency not have taken note of the uncomfortable debt metrics of the company even if it were to assume full support from the parent company?

In a note on Wednesday, J.N. Gupta, co-founder and managing director of Stakeholders Empowerment Services, a proxy advisory firm, also questioned the basis on which the January rating was assigned. “Did the agency issue an upgrade based on March 2015 accounts? Very unlikely, and if yes, it makes a mockery of the entire rating process," said Gupta. It once again brings the focus on the role of rating agencies in corporate frauds, wrote Gupta, adding that the regulator needs to ask the agency concerned how it upgraded the company’s rating without having access to updated financial information.

The regulator, the Securities and Exchange Board of India (Sebi), has been considering ways to strengthen governance of rating agencies since the Amtek fiasco. On Wednesday, Sebi chairman U.K. Sinha told journalists that new norms for rating agencies will be issued soon. As part of these, Sebi will clamp down on the practice of suspending ratings, said Sinha. Other changes, such as another level of checks on an assigned rating, may also be introduced.

Sebi, however, should also consider improving the rating disclosures made by an agency.

Deep N. Mukherjee, former head of corporate credit ratings (Western India) at India Ratings and now visiting faculty at IIM-Calcutta, suggests a disclosure matrix similar to what has been adopted overseas. This matrix should include a comparison of a company’s key financial parameters with the median level across the rating category in which the company falls. At the same time, the median across one rating category above and one rating category below should be disclosed. According to Mukherjee, this will help investors compare the rating of a company with its peers’, while also allowing investors to understand the level of stringency that each individual rating agency uses in its rating process.

In a paper published in IIM-Calcutta’s Artha magazine, Mukherjee had drawn a comparison between universities, auditors and rating agencies. Each of them has a user-pays model but in the case of a university, a student can’t refuse to use the grades issued by a university and the grades issued by each individual university will always be part of the student’s academic record. The regulator needs to ensure that similar market mechanism works for the rating industry.

At the same time, there are other malpractices that are coming to light. A number of people familiar with the sector speak of the mushrooming of “rating agents". Similar to loan agents, these intermediaries are helping companies “create" financial statements that will help get a good rating. Some of this may be legitimate but a lot may not be. The regulator must put a stop to any such dubious practices that have emerged over the years.

Ira Dugal is deputy managing editor, Mint.

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