Why credit grades given by rating firms are under lens2 min read . Updated: 02 Jul 2019, 10:57 PM IST
- These firms had assigned high grades to corporate groups such as IL&FS and DHFL, only to see them default
- This has cost investors in terms of losses in mutual funds and other products that rely on credit ratings
The CEO of Icra Ltd has been sent on leave, bringing into focus the role of rating agencies in the ongoing debt crisis. These firms had assigned high grades to corporate groups such as IL&FS and DHFL, only to see them default or delay payments within months. This has cost investors in terms of losses in mutual funds and other products that rely on credit ratings. Mint analyses the problem.
What happened at Icra?
Icra, a local affiliate of Moody’s Investors Service, has sent CEO and managing director Naresh Takkar on leave, pending an inquiry. This followed the filing of an anonymous complaint with the Securities and Exchange Board of India (Sebi) alleging lapses in the grant of a AAA rating to IL&FS debt until August 2018. AAA is the highest rating assigned by credit agencies and denotes a high level of safety. IL&FS defaulted in September and several of its former top executives were arrested by government agencies, including the Enforcement Directorate and the Serious Fraud Investigation Office (SFIO).
What do credit rating agencies do?
They assign grades to the credit issued by companies, such as non-convertible debentures (NCDs), commercial papers and even bank borrowings. Their job includes monitoring the ratings assigned and revising them when the borrower’s financial position changes. This can mean moving to a higher rating (upgrade) or a lower one (downgrade). There are six major rating firms in India: Crisil, CARE Ratings, Icra, India Ratings and Research, Brickwork Ratings, and Small and Medium Enterprises Ratings Agency of India. Some of them have tie-ups with global rating firms such as S&P, Fitch and Moody’s.
What’s the problem with these agencies?
Credit rating agencies often make errors in their evaluation of borrowers, as the IL&FS case shows. The agencies seemed to have missed several warning signs such as rising debt levels, while assigning AAA ratings to the group even as it neared a default. They made similar errors with other groups such as DHFL. The agencies seem to wake up to the problem only when it is about to erupt or after that. CARE Ratings had assigned a AAA grade to DHFL’s NCDs until 3 February. Within four months of this, the company missed interest payments on some of its debt, thereby committing a default.
How do the ratings affect investors?
The ratings are used by mutual funds (MFs), pension funds and insurance firms to decide which bonds or debt paper to invest in. This money ultimately belongs to investors and any gains or losses in debt MFs, NPS and ULIPs are passed on to them. Besides, firms often raise money from investors by issuing NCDs. Investors subscribe to these NCDs relying on the ratings assigned to them.
What is Sebi doing to resolve the problem?
Sebi has initiated adjudication proceedings against the rating firms involved in IL&FS ratings. In June, Sebi made it compulsory for rating firms to disclose the “probability of default" of the issuers rated by them. For an AAA-rated paper, say, the probability of default for a one-year and two-year paper should be zero; for a three-year paper, 1% is acceptable. The probability disclosed can be used to evaluate the track record of the rating firm in question.