Probability to be based on a 10-year marginal default rate and the economic cycle
This is the fifth change for rating agencies in the past three years to improve transparency and processes
Mumbai: The markets regulator on Thursday directed credit rating companies to start disclosing the probability of default for the issuers they rate, troubled by the raters’ track record of detecting defaults or near-defaults.
Rating agencies also have to disclose factors that could potentially impact the rating of the instruments, which include an assessment of financials, the Securities and Exchange Board of India (Sebi) said in a circular published on its website.
The credibility of rating agencies has been eroding since the global financial crisis in 2008 because of the conflict of interest arising from the fact that they are paid by the issuers to rate their securities and for their failure to downgrade troubled firms until they are on the verge of bankruptcy.
The recent defaults by Infrastructure Leasing and Financial Services Ltd (IL&FS) that led to a liquidity crisis among non-bank lenders in India has focused attention again on credit rating agencies.
According to the latest Sebi circular, rating companies, in consultation with the regulator, will now create a uniform probability of default benchmark for each rating category on their website, for one-year, two-year and three-year cumulative default rates, both for the short term and long term.
“More or less, it looks like the idea is to enhance disclosures. All these steps will ensure that investors are able to make a better judgement," an executive at a large rating agency said on condition of anonymity.
Sebi also tweaked the methodology to arrive at default rates. It will now be based on marginal default methodology. This would ensure that a three-year default rate is greater than the one-year rate.
“The current method could result in a three-year default rate being lower than a one-year default rate, which is counter-intuitive and erroneous," rating agency Crisil said in an emailed statement.
“Sebi’s suggestion to revise the methodology of computing default rates is to bring them in line with global best practices and increased disclosures for liquidity and rating sensitivity factors. We believe these will provide greater insights into the ratings of the companies and also help all stakeholders to evaluate performance of CRAs (credit rating agencies) on the basis of a more robust methodology," added Crisil.
Sebi also defined terms that rating agencies would need to use to describe the liquidity position of issuer—strong, adequate, stretched and poor.
This is the fifth change for rating agencies in the past three years to improve transparency and processes. Despite these changes, the agencies have been caught on the wrong foot on several occasions.
A case in point is the sudden downgrade of bonds sold by IL&FS and related entities after they defaulted on payment obligations in September.
In another case, non-convertible debentures of Dewan Housing Finance Corp. Ltd (DHFL) were cut from Care A to Care BBB- on 14 May.
“Credit rating agencies as a Sebi-registered intermediary are supposed to be an alert system of an instrument before the actual default," said Sumit Agrawal, founder of RegStreet Law Advisors and a former Sebi official. “After failing to detect early signs of the crisis, credibility of CRAs as an institution and their utility under the regulatory system are being questioned. I think these steps from Sebi are reformatory and some enforcement is not unexpected."
Tracking the probability of default is a departure from earlier practices and is also a step towards aligning Indian rules with global standards. So far in India, credit decisions have been more or less based only on assigned ratings. Globally, however, credit decisions are based on two more criteria—probability of default and tracking deviation of bond spreads.
Probability of default describes the likelihood of a default over a particular period. It provides the likelihood that a borrower will be unable to meet its debt obligations and is typically used globally in credit analyses and risk management frameworks.
The rating agencies would also be assessed based on probability of default. For an AAA-rated paper, for instance, the probability of default for a 1-year and 2-year paper should be zero; for a three-year paper, a 1% default probability would be accepted.
For AA, it will be zero for a one-year paper; for a two-year paper, the acceptable deviation is 2%. It will be 3% for an A-rated paper.
In line with global standards, the regulator in November had asked rating agencies to track deviation in bond spreads. The idea behind the move was to provide more information to bond subscribers and reduce reliance on assigned ratings.
Sebi has also asked rating agencies to disclose all factors to which ratings are sensitive.
“This is critical for the end-users to understand the factors that would have the potential to impact the creditworthiness of the entity," Sebi said in the circular.