SEBI’s New Credit Rating Rules: Creating A More Transparent Market
SEBI’s new guidelines will make rating agencies more accountable. But it is important that all players pull in the same direction.
The Securities and Exchange Board of India published its ‘guidelines for enhanced disclosures by credit rating agencies,’ on June 13, 2019. These are focused on disclosures relating to the computation of cumulative default rates and introducing the probability of default benchmarks.
The guidelines also emphasise liquidity indicators, which are usually taken for granted. These guidelines introduce the suffix ‘credit enhanced’, ask rating agencies to focus on credit spreads and disclose at a broad level of operating and/or financial performance matrices that could trigger a rating change.
Finally, SEBI said it will engage with rating agencies regarding the definition of default – a perennial subject of debate.
Probability Of Default Benchmarks To Be Published
The biggest change is introducing the probability of default benchmarks.
Ratings symbols in a sense capture the relative credit risk. State Bank of India at ‘AAA’ is safer than Andhra Bank at ‘AA’ and both carry relatively lower risk than IDBI Bank at ‘A -’.
Analysts don’t look at companies to calculate the probability of default. Having arrived at a rating, credit rating agencies look at how companies assigned a specific rating over the years behaved to establish the ‘probability of default’.
But SEBI now wants ratings to communicate the probability of default.
They expect that an ‘AAA’, within bounds, should not default over three years, an ‘AA’ over two and an ‘A’ over a one-year period.
While ratings are said to be forward looking, a dominant share of their analysis relates to the past financials. Only a limited portion is based on expectations about the future. For equity markets, it is the reverse.
Now, credit rating agencies need to look at the future, but only through the prism of ‘probability of default’. This puts rating agencies in a pickle. When should the analyst bake in the expectations of a capital raise or the sale of a business into the leverage profile? Is it when commitments are received, when it is imminent or after money is in the bank?
This will reduce the element of discretion from the analysis and shrink the number of higher rated entities.
Computation Of Cumulative Default Rates
Credit rating agencies use the history of rating transitions to derive cumulative default rates. Therefore, how the rating agencies measure and publish rating transition is critical.
Most Indian rating agencies began publishing these matrices voluntarily, but these have now become mandatory.
The table below shows an example of a one-year transition matrix for 2018. It shows that of the 15 ‘AAA’ credits all remained in the category over a one-year period. And of the 1,222 ‘BBB’ credits, 0.16 percent were upgraded to ‘AA’ and 1.88 percent to ‘A’. Further 2.7 percent were downgraded to BB.
But do bear in mind that credit rating agencies put the data together based on the number of ratings and not the amount outstanding. Else, the IL&FS default could have played havoc with the statistics.
To ensure consistency across agencies, SEBI has specified how to calculate and present this data in a rather granular manner.
The broad changes are as under:
- Whether you invest in a ‘AAA’ rated mortgage-backed-security or a ‘AAA’ rated bank, it needs to communicate the same level of risk. Lending to an ‘AAA’ rated bank cannot be safer than lending to an ‘AAA’ mortgage-backed-security. Consequently, there will be only one study for each rating agency. This, however, is not a global practice where each segment (corporate, sovereign, structured, public finance etc.), has its own data-set. The rating agencies will do well to maintain and even publish separate studies, till the robustness and user case for an aggregate study is established.
- Some rating agencies showed a corporate ‘SO’ rating or structured obligation rating, as a part of the corporate default study and others as a part of the structured default study. Now only securitised paper will be in the structured data set. However, since this is only a study, it will help in maintaining the integrity of underlying data and in undertaking disaggregated studies if need be.
- For the longest time, withdrawing a rating and not capturing it in the default study improved the quality of the credit rating agency’s ratings. This is why defaulting companies from Credit Suisse’s ‘House of Debt’ report do not show up in the default data of rating agencies. Over the past many years SEBI has put in place guidelines for withdrawing ratings. The regulator has clarified that ratings that have been withdrawn in conformity with its guidelines, need not be included in the transition study.
- A company fearing a downgrade, may stop co-operating with a credit rating agency. A non-cooperative rating was not included in the transition and default study bolstering the quality of a credit rating agency’s ratings. Now it needs to be.
- SEBI has now restricted the number of ratings for each rated entity that can be included in the transition and default study to three. This reduces the number of ratings considered in the study, reducing the count of outstanding ratings in the denominator and the credit rating agency’s ability to massage the data.
Credit Enhancements
At times, a company’s rating may get bolstered on account of a guarantee. Right now, these ratings have a ‘SO’ suffix attached.
SEBI has proposed that the ‘SO’ suffix be restricted to securitised products and explicit guarantees be denoted by a ‘CE.’ The rating agency will need to give the stand-alone and the supported rating where there is explicit support.
Through this, the regulator is pushing the credit rating agencies to bring clarity to investors. It will also push credit rating agencies to spell out their assumptions for parental support.
At present, while a subsidiary’s rating may get an uplift because of the parental support, the parent’s rating was left unchanged, irrespective of the quantum of backing that it provides – implicitly or explicitly. Now, at least in cases of explicit support the subsidiaries ratings will get pulled-up while the parent’s’ is pushed-down or the two will remain at their stand-alone ratings.
Liquidity Indicators
Recognising that the absence of liquidity can have a marked impact on the realisable value of an asset at the time of its sale, SEBI asked credit rating agencies to comment on the liquidity available to a company. Based on the experience garnered over the last two quarters, SEBI has now specified liquidity indicators that need to be disclosed as:
- Superior/Strong
- Adequate
- Stretched
- Poor
These have been defined.
A high rating is not consistent with stretched or poor liquidity, but a lower-rated paper can have superior/strong liquidity.
Other Requirements
Credit rating agencies are now expected to track bond spreads and factor it into their rating calls. They are expected to have more explicit rating triggers defined in their rating announcements. They will also continue to work with SEBI to define default – a matter that surprisingly continues to elude consensus.
These guidelines are a welcome addition for the orderly development of the credit market. They will no doubt make rating agencies more accountable. But it is equally important that all players – regulators, auditors, trustees and even investors, pull in the same direction. That alone will give us the vibrant market we seek.
Amit Tandon is the founder and Managing Director at IiAS - Institutional Investor Advisory Services.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its Editorial team.