The IL&FS debt paper fiascoes in the last one year have cast a serious spell of doubt and fragility about the rating agencies. Regulators have sought more information from rating companies on rating qualities, processes, and conflicts of interests. The first phase of Forensic Audit Report is very shocking. The forensic report listed the type of Perks given by IL&FS officials to the credit rating agencies for a favourable credit rating. 

The Current Crisis supports the proposition of skepticism on the creditability of CRA’s which did not properly disclose risk & thus contributed to pushing the global financial system to the verge of collapse. There is a conflict of interest, globally, in the rating process. The rating agency is paid by the issuer whereas it is consumed by the investor.

Introduction

IL&FS scandal opened a can of worms, already heads of two top credit rating agencies ICRA & CARE were sent on long leave till the investigation on the charges on them for assigning favourable credit score to IL&FS is completed. Director of another credit rating agency Ind-Ra was shunted out for his quid pro quo with IL&FS.

SEBI sought explanation from the five credit rating agencies on serious charges made by the forensic auditor Grant Thornton.

The forensic report exposed the involvement of all five credit agencies in meddling with the credit score. The government is seriously thinking to put stringent regulations on the functions of credit agencies.

How the Credit Rating Agency was originated?

Businessmen don’t hesitate to give credit for the goods you buy from him, provided if he knows you personally well and your ability to repay the debt. Selling goods on credit is also flourishing his business but he cannot expect that he should know every customer who seeks credit. When an unknown customer approaches him for credit sale, he will definitely hesitate because he is not sure about the repaying capacity of the new customer. At the same time, he will consider extending the credit facility to the new customer if a known, reputed and eminent person could vouch for the credit worthiness of the new customer, which led to the birth of credit rating agency.

When United States started expanding in leaps and bounds, the business trading activity also expanded. The merchants were selling goods on credit initially to the known persons only, but they started to get business from people who are not known to them, the trading community’s hesitation to extend credit to new customers led to the birth of credit reporting industry.

Credit Rating Agency how it works?

Credit Rating Agencies

Credit Rating Agency is popularly known as CRA. They give credit rating to companies; the credit rating will speak about ability of the company to repay the debt in time with interest. Banks and lenders don’t hesitate to give loan to the companies with high credit score. The lenders may reject the loan application of companies with poor credit score. It is not easy for the companies with poor or moderate credit score to get loan for the business.

These companies are always under financial stress till they improve the credit score. Companies with low credit score means they may become a defaulter in repaying the loan, this is the caution for the lenders. Lenders are immensely benefited with the credit ratings. These CRAs don’t do credit rating for individuals. Separate credit scoring agencies (CSR) do exist for rating the individuals, whose credential is stable.

CRAs do extensive study of companies, they thoroughly analyse the audited financial statements, future cash generation, various business & financial risk factors involved in the industry in general and for the company in particular and the various ratios, quality of the management, elaborate discussion with the management with the primary aim to find out the ability of the company to meet the future debt obligations.

In the bank, fund based loan ratings are assigned by CRA for External Commercial Borrowings (ECB), term loan, working capital loan, cash credit loan, bills discounting etc.

They do credit rating for manufacturing companies, banks, NBFCs, financial institutions, insurance companies, service providers, and for government & Municipal Corporation too.

In the capital market, CRAs assign ratings for long term instruments like Bonds, Dentures, Preference shares and short term instruments like Commercial Papers etc.

Ratings are given for Fixed Deposits of Corporates, Banks, Financial Institutions etc. to facilitate the investors to take wise decision before investing in FD.

They do credit rating for state government, local governments, NGOs or sovereign nations also. Hence credit rating is helpful for the lenders as well as for investors.

Big 3 International CRAs

Credit Rating Agencies

Credit Rating Agency (CRA) business is highly concentrated and dominated by the Big 3:

95% of the credit rating business is controlled by the Big 3. Moody’s and S&P are based at United States, Fitch is located in USA and in London. 80% of the global business is controlled by Moody and S&P and remaining 15% is controlled by Fitch.

CRAs in India

Six credit rating agencies are operating in India:

  1. CRISIL
  2. ICRA
  3. CARE
  4. India Ratings & Research (Ind-Ra)
  5. SMERA
  6. Brickworks

These six credit rating agencies are registered with SEBI, accredited by RBI & NHB. SMERA do ratings exclusively for Micro, Small and Medium Enterprises.

 Indian CRA in collaboration with Big 3

  • ICRA have joint venture with Moody
  • CRISIL have joint venture with S&P  
  • Ind-Ra is the Indian arm of Fitch Ratings

Whether Big 3 credit rating agencies are always correct?

Not always, Enron fall off is a classic example. On 2nd December 2001, Enron declared bankruptcy but still up to 28th November 2001 that is just 4 days before bankruptcy, the Big 3 credit rating agencies rated Enron as an “Investment grade”. Credit Rating Agencies, the so called watch dogs failed to prevent or at least warn the investors from Enron collapse.

The Sarbanes – Oxley Act 2002 was enacted in response to Enron debacle to avoid future corporate calamities.

Again during the 2008 subprime mortgage crisis in USA, the Big 3 drew the criticisms for giving high credit ratings for debt instruments which later become high-risk investments, they failed to raise the red-flag and failed to protect the interest of the investors. As a result, the three giant investment bankers Lehman Brothers, Merrill Lynch and Bear Sterns collapsed

Credibility of the Credit rating Agency in India is under stake

The IL&FS scandal is a real can of worms. The role of five credit rating agencies ICRA, CARE, CRISIL, Brickworks and Ind-Ra in IL&FS are thoroughly exposed.

A whistle-blower has alleged that ICRA boss had meddled with the ratings assigned to IL&FS. ICRA assigned high ratings of AAA to IL&FS but contrary to its ratings IL&FS defaulted in its debt payment, which triggered a liquidity crunches in the financial services market. As a result, in June 2019, Naresh Takkar MD and CEO of ICRA, Moody’s Indian affiliate, was sent on long leave by ICRA Board till the investigation against by him by a whistle-blower is completed. Takkar was in the helm of ICRA for a long time.

In the IL&FS fallout CARE Ratings too sent its MD Rajesh Mokashi on long leave citing the reason that the anonymous complaint received by the Securities and Exchange Board of India for meddling with the credit score assigned to IL&FS.

One of the Director of Ind- RA, Fitch Ratings Indian arm, has resigned in July 2019. He was accused of receiving financial help from bankrupt IL&FS to purchase a house for giving favourable credit score to doomed IL&FS for many years.

Government sacked IL&FS Board

Credit Rating Agencies

The Central Government sacked IL&FS board for its “mismanagement” and for “compromising corporate governance norms” by invoking Sec 241 (2) of The Companies Act, 2013 and constituted a new board on 1st Oct. 2018 with the approval of National Company Law Tribunal (NCLT). The new board is headed by Vice Chairman and MD of Kotak Mahindra Bank Mr. Uday Kotak to rescue IL&FS from its current crisis.

Legal Binding

In India, Credit Rating Agencies are not liable for the losses incurred by the investors. But in USA, they are liable for any losses incurred, if they are due to inaccuracy in the ratings and only if it is proved that they knowingly release the false credit score. After the 2008 financial crisis, US imposed civil liabilities on the credit rating agencies. In UK, investors can sue the credit rating agency in case of gross negligence or damage to the investors.

SEBI’s action

Since The Grant Thornton report has given adequate evidence for the possible quid pro quo between the credit rating agencies and IL&FS bosses, SEBI has sought explanation form all the five credit rating agencies on the serious charges made in the forensic report by Grant Thornton.

Who will give Credit Scoring for Individuals

There are four Credit Scoring Agencies (CSA) for individuals and their score is in numerical expression –

  1. TransUnion CIBIL
  2. CRIF Highmark
  3. Equifax India
  4. Experian

CIBIL is widely operated in India, CIBIL issues a comprehensive credit report for individuals. CIBIL has a strong member base including Banks, NBFCs, HFCs, credit card companies, state finance corporations. CSA have millions of update data, with this wider and strong data base, they will analyse the individual borrowing from different lenders which will help the lenders to identify the risk and to arrive at a fast decision in accepting or rejecting the loan application. Current credential crisis is with CRA, not with CSA.

Difference between Credit Rating Agency and Credit Scoring Agency

Credit Rating Agencies

Conclusion

Since credit rating agencies drew criticism from all the corners and the credibility of credit rating agencies is under stake, the government is planning to create a post similar to public interest director in SEBI, also intend to rate all the debt instruments and would like to bring major transparency in the credit rating process.

The CRAs should work with more responsibility and accountability. Their biased ratings will affect the investment of millions of aam aadmi, they should not do injustice to investors.

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