Credit Rating Agency- Role and Regulation

Credit Rating Agencies (CRAs) serve as vital intermediaries in the financial world, providing assessments of the creditworthiness of issuers and their debt instruments. These assessments guide investors, both institutional and individual, in making informed investment decisions, and contribute to the efficient allocation of capital within the market. However, the global financial crisis of 2008 underscored the need for comprehensive regulatory oversight of CRAs to ensure their impartiality, transparency, and accuracy. In India, the Securities and Exchange Board of India (SEBI) has taken significant strides in regulating CRAs to ensure the integrity of the capital markets and safeguard investor interests.

Role of credit rating in India

1. Borrowing Costs: Credit ratings directly impact the interest rates at which entities can borrow money financial institutions. Higher credit ratings perceive lower risk in lending to entities with strong creditworthiness typically leads to lower borrowing costs.
2. Investor Confidence: Investors, both domestic and international, use credit ratings as a key indicator to assess the risk associated with investing in various financial instruments. Higher credit ratings attract more investor confidence, leading to increased investments and better access to capital markets.
3. Public Issue: Entities raising funds through the issuance of bonds or other debt instruments need to have their creditworthiness evaluated. A higher credit rating can enable them to raise funds at more favourable terms and conditions. A good credit rating ensures easier access to financing options, essential for business expansion and capital requirements.
4. Corporate Governance and Transparency: Credit rating agencies assess the financial health and governance practices of businesses. Maintaining a good credit rating encourages companies to adhere to strong corporate governance standards and maintain transparency, which can ultimately benefit shareholders and other stakeholders.
5. Risk Management: Credit ratings help entities identify their own credit risk profiles and take necessary measures to mitigate risks. This includes improving financial management, reducing debt levels, and maintaining healthy liquidity positions.
6. Regulatory Requirements: In some cases, regulatory authorities may use credit ratings to set capital adequacy requirements for financial institutions, ensuring they hold enough capital to cover potential credit losses. Non-banking Financial Institutions (NBFC) and banks are required to secure ratings for every deposit or bond program they introduce, and they must achieve a specified minimum credit rating to sustain these programs. If the prescribed minimum credit rating is not attained, the funds collected through these programs must be returned.

Evolution of SEBI Regulation:

SEBI, established in 1988, was initially tasked with regulating the securities market. Over time, its mandate expanded to cover various aspects of the financial markets, including CRAs. The regulatory framework for CRAs was first established through the SEBI (Credit Rating Agencies) Regulations, 1999. However, recognizing the need for more stringent oversight, SEBI introduced the SEBI (Credit Rating Agencies) Regulations, 2018, which replaced the earlier regulations. These updated regulations aimed to reinforce the credibility and accountability of CRAs and enhance transparency in their operations.

Key Provisions of SEBI Regulation:

Registration and Eligibility Criteria: One of the pivotal aspects of SEBI’s regulation is the requirement for CRAs to obtain registration from SEBI before conducting rating activities in India. CRAs must meet strict eligibility criteria, including minimum net worth thresholds, track record, and governance standards. This ensures that only financially sound and credible entities operate as CRAs.

1. Code of Conduct: SEBI’s regulations mandate CRAs to adhere to a comprehensive code of conduct that encompasses ethical practices, professional integrity, and the avoidance of conflicts of interest. By following this code, CRAs maintain the impartiality and objectivity of their credit rating opinions.
2. Disclosure and Transparency: To enhance investor understanding and confidence, CRAs are obligated to disclose information about their rating methodologies, processes, and rating performance on their websites and annual reports. This transparency assists investors in comprehending the basis of credit ratings and assessing the reliability of the ratings provided.
3. Rating Process and Committees: The regulations necessitate CRAs to establish independent rating committees responsible for determining credit ratings. This setup ensures that the rating process remains uninfluenced and unbiased, as decisions are made collectively and independently.
4. Rating Review and Monitoring: SEBI’s regulations require CRAs to conduct periodic reviews and monitoring of credit ratings to ensure their accuracy and relevance. If new information emerges that impacts an issuer’s creditworthiness, CRAs are expected to adjust ratings accordingly.
5. Conflict of Interest Management: CRAs are required to have robust policies and procedures in place to manage and disclose potential conflicts of interest that could compromise the integrity of their ratings. This ensures that ratings remain objective and unaffected by external influences.
6. Regulatory Reporting: CRAs are required to submit regular reports to SEBI, detailing their financials, operations, and compliance with regulations. This enables SEBI to maintain a vigilant oversight of their activities, ensuring adherence to established standards.

Incentives to MSME for credit rating

The Ministry of MSME has designed a program to subsidize credit ratings for MSMEs through authorized rating agencies upto Rs. Rs. 40,000 This enhances their self-awareness, reinforces their operations, and enhances their creditworthiness. Improved access to credit, stakeholder trust, and government-backed subsidies for rating expenses are gained by MSEs. Enhanced risk evaluation speeds up lending choices, benefiting both MSEs and the financial domain.

Conclusion

SEBI’s regulation of credit rating agencies in India is a crucial pillar of the financial system’s integrity. By setting stringent registration criteria, enforcing codes of conduct, promoting transparency, and managing potential conflicts of interest, SEBI’s regulatory framework upholds the sanctity of credit ratings. This, in turn, contributes to a more informed and secure investment environment for all participants in the market. As the financial landscape continues to evolve, SEBI’s commitment to regulating CRAs ensures the continued reliability and credibility of credit assessments, reinforcing the overall stability of the Indian financial market.

(This article is written by Balaji. K, Audit Executive at RVKS and Associates)