With a market cap close to $2.5 trillion, India is now the seventh largest stock market by capitalisation, ahead of even Germany. It is time our rating agencies play their part in ensuring credibility to bring liquidity and depth to our bond markets, writes SALIL DATAR.
India has so far taken the right steps to ensure its capital markets flourish and provide access to funds to companies wishing to access them. However, over the past 12 months, on the debt side, there have been a series of mishaps in the form of ILFS, DHFL, ADAG, Cox & Kings and Altico Capital, leading to a complete collapse in the debt market and a crisis of confidence. For their part, rating agencies have failed to play a proactive role in monitoring and providing advance warning to investors. Instead, they have been rerating papers after issuers announce a default.
Now, the time has come to ensure similar liquidity and depth to bond markets, which are yet to come up to expectations. For this to happen, rating agencies have a crucial role in ensuring credibility by providing investors information on the bonds/paper wishing to access the capital markets.
Purpose of rating
Large and complex investment projects or businesses are financed by way of a combination of equity and debt. The equity leverage could be 1:2 or 1:3/1:4 or 1:5 depending on the type of activity and the gestation period for commissioning the project. Similarly, banks and finance companies raise resources in the ratio of 1 x 10 to fund their lending activities. In earlier times, development financing agencies (DFIs) like ICICI, IFCI or IDBI would employ an army of financial analysts to pore over the details to understand the project under consideration or the business model of the client, cashflows, financial leverage, liquidity and sustainability of business model and cash flows, and run a sensitivity analysis to arrive at a decision before taking the plunge or advising investors or financiers on investment grade.
As industrialisation and private enterprise picked up, so did the pace of growth and the need for financiers to scale up the resource-raising exercise. However, as banks and DFIs failed to keep pace with the growth in companies wanting to raise resources, companies started reaching out to the public to access larger pools of money. This accelerated the pace of disintermediation. The traditional model naturally became an inefficient, time-consuming and non-scalable option. Rating agencies stepped in to fill this gap by providing rating services to assess the financials as well as surveillance or monitoring. As investors started relying on rating agencies to evaluate the risk associated with the financing of projects and businesses enterprises as well as to price the RoI at which the investment would yield a risk adjusted return, the dependency risk for financiers, based upon the rating from agencies, also went up.
Credit-rating agencies in association with global rating agencies such as Standard & Poor, Moodys and Fitch Ratings can also provide a ‘neutral’opinion on the instruments to be rated. Similarly, leading Indian rating agencies, being subsidiaries of global agencies, have access to sophisticated, scientific models that can gauge the financial health of the entity to be rated.
As the need to provide liquidity to these instruments started to build, exchanges, in order to improve the marketability of bonds, non-convertible deposits (NCDs), perpetual bonds, certificate of deposits and commercial paper, started insisting on having the investment paper rated before allowing it to be listed for trading. What’s more, in addition to the initial rating of the instruments, credit-rating agencies undertake the surveillance of rated instruments till they mature.
Conflict of interest
As a result of this, while raising resources, companies started to proactively enrol rating agencies to get their bond/paper rated in order to attract investors. The rating agencies would be appointed for a fee by the company planning to raise resources. This fee would be a percentage of the amount being rated. Here, the conflict of interest starts.
Instead of completing thorough due diligence, to expedite the rating process, agencies started relying on declarations and management representations, which in turn diluted the rigour of the screening process.
Can a rating agency, which is being paid for by the company, afford to give a true, fair and independent view of the company paying for the exercise?
The outcome of this is open in front of the public, in the form of cases like ILFS and IDBI Bank in India, and Enron, AIG and Lehman overseas, to name a few.
How do we overcome this conflict of interest?
It is essential to be able to segregate the roles of the agency, the entity being evaluated and the entity who pays for this exercise. Typically, the entity commissioning the rating exercise should be a third party, which has a larger interest in playing the role of market maker.
It is here that listing agencies like the stock market or exchanges have a crucial role to play. As the role of the listing entities is to build trust by ensuring equal information is made available to all those interested and freely available across various investor classes, it is in their interest to resolve the conflict of interest.
At present, the exchanges require the entities wanting to raise resources to accept their listing rules and regulations, which cover areas of financial disclosures, management best practices, disclosures about arm’s length transactions and so on. They charge them enrolment and listing fees as well as renewal fees every year and hold them subject to scrutiny by their compliance committee or board. Besides this, regulatory agencies such as SEBI also have a role to play. They set up guidelines and regulations for companies accessing the capital markets. To facilitate investor education and dissemination of best practices across companies and investors, SEBI has set up an Investor Protection and Education Fund (IEPF), which is funded by way of contributions from unclaimed dividends and penalties on companies flouting regulations.
The balance in this fund currently stands at over Rs.12 billion.
As independent entities and providers of a platform to investors, exchanges should take on the role of empanelment of rating agencies as eligible to rate the paper or instrument being listed. As part of the enrolment process/listing fees, the exchanges should charge rating agencies as well as the company whose paper is being rated an annual fee or per instrument, which could act as an investor protection fund in cases of default. Besides the exchange-empanelled rating agency, companies should also be allowed to appoint a rating agency of their choice as well if they desire. This will provide free and independent information to investors to arrive at a decision.
Indeed, India must embrace the change to provide the much-needed credibility and trust to bring liquidity and depth to the bond markets, which in turn can turbocharge economic activity.
About the author:
Salil Datar, COO, Essel Finance, is a finance professional with more than 25 years of industry experience in leadership roles across consumer banking, finance, marketing and sales, cross selling, and operations. He has been observing the BFSI space for over two-and-a-half decades.