This article has been written by Ms. Gayathri Manoj, a 5th year student of Presidency university, Bangalore 

 

Abstract:

The Securities and Exchange Board of India (SEBI) plays a crucial role in regulating credit rating agencies (CRAs), ensuring transparency and reliability in the financial markets. This article examines the effectiveness of SEBI’s regulatory framework concerning CRAs, considering its impact on market integrity, investor protection, and financial stability. Through an analysis of SEBI regulations, case laws, and industry practices, this article evaluates the strengths and weaknesses of SEBI’s oversight of CRAs. Additionally, it explores the challenges faced by SEBI in effectively regulating CRAs and proposes recommendations for enhancing regulatory effectiveness.

Introduction:

The role of credit rating agencies (CRAs) in the financial markets has been subject to increased scrutiny, particularly following the global financial crisis of 2008. CRAs play a vital role in assessing the creditworthiness of entities and financial instruments, thereby influencing investors’ decisions and market dynamics. In India, the Securities and Exchange Board of India (SEBI) is the primary regulatory authority responsible for overseeing CRAs and ensuring their adherence to regulatory standards.

Historical Development: The emergence of CRAs in India can be traced back to the late 1980s and early 1990s, coinciding with the period of economic liberalization and globalization. The need for reliable credit assessment services became apparent as India opened up its economy to foreign investments and witnessed rapid expansion across various sectors.

Factors Driving Growth: Several factors contributed to the growth of CRAs in India:

1. Economic Reforms: The economic reforms initiated in 1991 paved the way for increased foreign investments, leading to a surge in capital infusion across sectors such as banking, infrastructure, and manufacturing.
2. Investor Confidence: The presence of credible CRAs instilled confidence among investors by providing them with transparent and reliable information about the creditworthiness of issuers and their financial instruments.
3. Regulatory Mandates: Regulators such as the Securities and Exchange Board of India (SEBI) mandated the use of credit ratings for various financial transactions, including public offerings, debt issuances, and investment decisions by mutual funds and insurance companies.

Regulatory Framework: The regulation of CRAs in India is overseen by SEBI through a comprehensive set of guidelines and regulations. These regulations cover various aspects, including:

• Eligibility criteria for promoters and CRAs
• Registration process and compliance requirements
• Disclosure and transparency norms
• Periodic review of ratings
• Conflict of interest guidelines
• Accountability measures and penalties for non-compliance

SEBI periodically updates these regulations to address emerging challenges and ensure the integrity and reliability of credit rating services.

Industry Structure: The credit rating industry in India operates as an oligopoly, with a few dominant players holding significant market share. CRISIL and ICRA are among the leading CRAs in India, offering a wide range of rating services across sectors such as banking, infrastructure, power, and manufacturing. Despite the dominance of these players, efforts are underway to promote competition and diversity within the industry.

Major Regulatory Uses: Regulators such as SEBI, the Reserve Bank of India (RBI), and the Insurance Regulatory and Development Authority of India (IRDAI) rely on credit ratings for various regulatory purposes, including:

• Determining capital adequacy requirements for banks and financial institutions
• Setting investment guidelines for mutual funds and insurance companies
• Regulating debt issuances and public offerings
• Assessing the creditworthiness of borrowers and securities

 

Regulation of Credit Rating Agencies in India

 

Credit rating agencies (CRAs) in India operate under the oversight of the Securities and Exchange Board of India (SEBI) through the Credit Rating Agencies Regulations of 1999. These regulations outline various requirements and criteria for both promoters and the CRAs themselves.

 

1. Eligibility Criteria of Promoters of the CRA:

For a CRA to be eligible for registration with SEBI, it must be promoted by entities falling under specific categories, including public financial institutions, scheduled commercial banks, foreign banks operating in India with RBI approval, recognized foreign CRAs with at least 5 years of experience in rating securities, or any corporate entity with a minimum net worth of Rs. 100 crore over the past 5 years as per audited financial statements.

 

2. Eligibility Criteria of the CRA:

SEBI’s regulations specify eligibility criteria for CRAs, including being a registered company under the Companies Act, having credit rating activities listed in its Memorandum of Association (MOA), maintaining a minimum net worth of Rs. 5 crores, possessing necessary infrastructure, and ensuring that promoters, directors, and key personnel have professional competence, financial soundness, and integrity.

 

3. Periodical Review of Ratings:

CRAs are required to periodically review the ratings assigned to securities and disclose any changes or updates through press releases or on their websites, as per regulation 24 of the Regulations.

 

4. Disclosures:

Under regulation 18, CRAs must disclose rating definitions, symbols, information related to analysis factors, and rating methodology. Confidential information cannot be disclosed except as permitted by law, as per regulation 23.

 

5. Accountability:

CRAs must appoint internal auditors and maintain copies of auditor reports, as per regulations 21 and 22. SEBI retains the authority to call for information or conduct investigations into CRAs’ affairs as required (regulation 19).

 

6. Conflict of Interest:

Regulation III of the Regulations prohibits CRAs from rating securities where conflicts of interest exist, such as when the issuer is a promoter of the CRA or an associate or subsidiary company. Common independent directors may be allowed if they do not participate in the rating process, with disclosure.

 

7. Liability:

CRAs are held liable for any acts or omissions contravening regulations or other SEBI regulations under Chapter V of SEBI Intermediaries Regulations (regulation 34).

 

Credit Rating Information Services of India Limited (CRISIL):

CRISIL, the first CRA in India established in 1988, began with backing from public institutions. It later entered into a strategic alliance with Standard and Poor’s (S&P) in 1997, with S&P acquiring a majority stake in 2005. CRISIL has diversified its operations into advisory and research, with subsidiaries handling advisory services. Its research covers various sectors and economic analyses, catering to domestic and international clients.

 

CRISIL’s operations extend to risk solutions and infrastructure advisory, contributing significantly to its revenue.

Challenges and Recent Advancements: While CRAs play a vital role in enhancing market efficiency and investor confidence, they also face several challenges, including:

• Conflict of Interest: The issuer-pays model creates potential conflicts of interest, as CRAs may feel pressured to provide favorable ratings to maintain issuer relationships.
• Rating Shopping: Some issuers engage in rating shopping by soliciting multiple CRAs and disclosing only the most favorable rating to the public, undermining the credibility of credit ratings.
• Lack of Accountability: Despite regulatory oversight, CRAs may not always be held accountable for inaccurate or biased ratings, leading to investor distrust and market inefficiencies.

Recent advancements in the regulatory framework aim to address these challenges and enhance the credibility and transparency of credit rating services. Measures such as stricter disclosure requirements, periodic review of ratings, and enhanced accountability mechanisms are being implemented to safeguard investor interests and promote market integrity.

 

Industry Structure of Credit Rating Agencies

The credit rating industry in India operates within an oligopolistic market structure, characterized by the dominance of seven major CRAs despite three decades since the inception of the first CRA. This market structure presents several challenges, including:

1. Lack of Competition: Limited competition among CRAs diminishes innovation and quality of service, hindering market efficiency.
2. Compromised Service Quality: With fewer players, there’s a risk of compromised service quality as CRAs may not be incentivized to improve or innovate.
3. Long-term Relationships: Oligopolistic markets often foster long-term relationships between issuers and CRAs, potentially leading to biased or influenced ratings.

To address these issues and restructure the industry, steps can be taken to reduce entry barriers, such as relaxing stringent eligibility criteria for CRAs and their promoters. Government intervention to encourage the establishment of new CRAs could also foster competition and improve market dynamics.

Major Uses of Ratings by Sectoral Regulators

Uses of Credit Ratings by SEBI:

• Guidelines for Mutual Funds: SEBI regulates mutual funds’ investments based on credit ratings, limiting exposure to below-investment-grade securities.
• Listing of Debt Securities: SEBI mandates credit ratings for public and rights issues of debt instruments with a tenure of more than one year.
• Investor Protection Guidelines: Public and rights issues of convertible debt instruments require credit ratings from SEBI-registered CRAs.
• IPO Guidelines: Issuers of convertible debt instruments for IPOs must obtain ratings from CRAs and disclose them in prospectuses.
• Collective Investment Scheme: Entities issuing agro or plantation bonds must obtain ratings from SEBI-registered CRAs.

Uses of Credit Ratings by RBI:

• NBFC Regulations: RBI mandates minimum investment-grade ratings for NBFCs to accept public deposits.
• Small and Medium Enterprises (SMEs): RBI encourages credit availability for SMEs through transparent rating systems like SMERA.
• Primary Dealers in Government Securities: RBI requires primary dealers to invest only in credit-rated non-government securities.

Uses of Ratings by IRDA:

• Insurance Regulations: IRDA mandates insurance companies to invest in securities rated ‘very strong’ by registered CRAs.

Development of CRAs in Recent Years

2010 Amendment: Introduced record maintenance, default history disclosure, and restrictions on consultancy services.

2011 Amendment: Introduced initial registration for five years and subsequent permanent registration for CRAs.

2018 Amendment: Imposed experience requirements for foreign CRAs and restrictions on shareholding in other CRAs.

2019 Amendment: Enhanced client cooperation requirements for review processes and information disclosure.

Challenges and Issues:

• Conflict of Interest: CRAs face conflicts of interest due to their issuer-paid model, compromising the objectivity of ratings.
• Effect of Non-CR Activities: CRAs engaged in non-rating activities may demonstrate biased ratings favoring such clients.
• Rating Shopping: Issuers soliciting multiple CRAs and disclosing only the highest rating may distort market perceptions.
• Lack of Accountability: Current liability mechanisms for CRAs may not adequately compensate aggrieved investors.
• Statutory Reliance: Regulators’ reliance on CRAs’ ratings increases the impact of biased or incorrect ratings.
• Market Structure: The oligopolistic market structure limits competition, hampers new entrants, and potentially affects market efficiency.

Addressing these challenges requires concerted efforts from regulators, market participants, and policymakers to ensure transparency, accountability, and competition within the credit rating industry.

 

Conclusion: The evolution and regulation of credit rating agencies in India reflect the country’s journey towards financial liberalization and market development. While CRAs play a crucial role in facilitating capital formation and risk management, regulatory oversight and industry reforms are essential to address emerging challenges and foster a robust and resilient credit rating ecosystem in India.

 

References:

1. Vijay Ranjan Committee Report on Credit Rating Agencies.
2. SEBI Credit Rating Agencies Regulations, 1999.
3. Amendments to SEBI’s Credit Rating Agencies Regulations.
4. “Credit Rating Industry in India: A Case of Market Failure?” by Rajesh Chakrabarti and Manpreet Singh Hora.
5. “Regulating Credit Rating Agencies: An Empirical Analysis” by Shubham Khare and Sanjay Kallapur.
6. “Oligopoly Power in Credit Rating Market and Rating Inflation: Evidence from India” by Balaji Vaidyanathan and Aditya Singh.
7. SEBI circulars and guidelines related to Credit Rating Agencies.
8. Research studies on the role and impact of Credit Rating Agencies in Indian markets.