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SEBI in a notice last week modified rating withdrawal norms asking credit rating agencies to issue a rating downgrade to 'below investment grade' with an INC(Issuer not cooperating status) if firms they have been working with refuse to provide relevant information for more than 6 months. If the corporate remains non-compliant for another six months, no CRA is allowed to allot credit ratings to the firm until the current CRA resumes or issues a withdraw rating.
This was one of the two solutions we had recommended in response to the rating shopping issue that SEBI noticed with the credit rating agencies in our post about a week back, and should help bring in more transparency and accountability in the system. (One of the many reasons you should consider signing up for GSN Invest!) In today's post, we look at why this regulation becomes important, how it will impact corporate behaviour and rating agency-corporate relationships, and the implications of the same on the long term health of the market.
Why the move was necessary?
Credit rating agencies are responsible for coming out with ratings that give investors a good idea of the risk associated with the firm's bonds. As discussed last week, credit rating agencies were often late in disclosing potential issues with the clients they worked with, leading to huge amounts of wealth destruction as well as very real impacts on the broader economy. The current relationship between CRAs and corporates is also tremendously skewed with corporates wielding significant power, leading to upward biases in ratings. What the move does is put back some responsibility with the corporates, and gives power to rating agencies to act in case of management's unwillingness to disclose key information.
How will it affect corporate behavior and agency-issuer dynamic?
The move puts pressure on corporates via two methods. First, they need to make sure they provide the necessary information to the rating agencies on time, barring which the rating agency now can make a press release with the INC(issuer not cooperating), which could have very negative repercussions for the firm. The second, and perhaps most important, corporates can't switch between rating agencies with the ease they earlier did, given the power the rating agency will have after 12 months of lack of information. This should over time lead to an improvement in firm, and consequently credit rating agency disclosures. It also marks a slight positive shift in the dynamic between rating agencies and corporates.
What does it mean for the long term health of the market?
A healthier credit rating system leads to a reduction in the trust deficit, which would play a role in reducing incremental spreads that investors demand. This, however, is the first of many steps that would be needed to make the rating system more independent and transparent. Structural improvements, like the ones we discussed here, will be needed to deal with the "issuer paid" system in the long run, and while these would need to be planned out in great detail, and also entail some execution cost, the benefit of the move to the overall credit space would far outsize the cost.