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06/15/2019

THE NEWS

Markets watchdog, the Securities, and Exchange Board of India (SEBI) has finalized a strict disclosure framework for credit rating agencies (CRAs) in the country, wherein they will be required to provide the probability of default for various rated instruments.

KEY-HIGHLIGHTS:

  • The decision of a strict disclosure framework comes against the backdrop of rising instances of debt defaults and concerns over the role of credit rating agencies in assessing the possible risks.
  • Also, the credit rating agencies have come under the scanner in the IL&FS case.
  • Infrastructure Financing and Leasing Services Ltd (IL&FS) is a major infrastructure financing and construction company, which sent shockwaves through the NBFC sector when it defaulted on some of its debt obligations.
  • IL&FS and its subsidiaries have a combined debt of more than Rs 91,000 crore and have also defaulted on multiple loan repayments.

WHAT’S IN THE CIRCULAR?

  • Disclosing Default: As per the circular, the credit rating agencies (CRAs), in consultation with SEBI, will prepare and disclose standardized and uniform probability of default (PD) benchmarks for each rating category on their website, for one-year, two-year and three-year cumulative default rates, both for short-run and long-run.
  • Uniform SOP: Issuing guidelines for enhanced disclosures by CRAs, the regulator has called for having a uniform Standard Operating Procedure (SOP) for tracking and timely recognition of default. Each CRA has to disclose the same on their websites.
  • Rating Sensitivity: It has also mandated a specific section on ‘rating sensitivity’ from the agencies to indicate possible trigger for an upward or downward rating change in a simple language rather than like a general risk factor.
  • Meaningful Disclosure: Besides, SEBI expects the CRAs to make meaningful disclosures about liquidity conditions by using simple terms such as superior or strong, adequate, stretched or poor, with proper explanations to help the end users understand them better.
  • Tracking Deviations: Also, the CRAs will have to devise a model to track deviations in bond spreads.

NEED TO REGULATE CRA(S):

  • A Credit Rating Agency is a company which assigns credit ratings. Credit ratings rate a debtor’s ability to pay back debt by making timely interest payments and the likelihood of default.
  • The “big three” CRAs are Moody’s Investors Service, Standard & Poor’s, and Fitch Group. Domestic credit rating agencies include Care, ICRA and India Ratings and Research.
  • They play a critical role in the financial sector, its stability and efficient functioning.
  • Therefore, effective regulation of CRAs is necessary to encourage high-quality credit ratings and increased accountability for CRAs.

NON-PERFORMING ASSETS & BANKING SYSTEM:

  • A non-performing asset (NPA) refers to a loan or advance for which the principal or interest payment remained overdue for a period of 90 days.
  • Banks are required to classify NPAs further into the following types:
    • Substandard Assets: Assets which has remained NPA for a period less than or equal to 12 months.
    • Doubtful Assets: An asset would be classified as doubtful if it has remained in the sub-standard category for a period of 12 months.
    • Loss Assets: As per Reserve Bank of India, “Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted, although there may be some salvage or recovery value.”

REASONS FOR GROWTH IN NPA(S):

  • Using for another Purpose: Diversion of funds by companies for purposes other than, for which loans were taken.
  • Lack of Diligence:Due diligence not done in the initial disbursement of loans. For example, loans are given to road sector even before the acquisition of land by the contractors.
  • Absence of Governance Mechanisms:In the absence of adequate governance mechanisms, double leveraging by corporates, as pointed out by RBI’s Financial Stability Report, is also a reason for increasing bad loans.
  • Riskless Capitalism:Prevalence of “riskless capitalism” wherein the time of economic swing, the corporate make hay, but when they face problems, resort to legal route, leveraging, etc. leading to problems galore for the banks.
  • Crony Capitalism:Crony capitalism is also to be blamed. Under political pressure, banks are compelled to provide loans for certain sectors which are mostly stressed.
  • Absence of Proper Laws:In the absence of proper bankruptcy law, corporate faced exit barriers which led to piling up of bad loans. Corporate often take the legal route, which is time-consuming, leading to problems for the banks.

IMPACT OF NPA ON BANKS:

  • Declining Gross Capital Formation: For the economy, it is disadvantageous as banks become more circumspect in giving loans, which affect the credit of taking in the economy. This leads to declining Gross Capital Formation affecting economic growth.
  • Crisis of Confidence: Rising of NPAs will lead to a crisis of confidence in the market. The price of loans, i.e. the interest rates will shoot up.
  • Impacting the Investors:The shooting of interest rates will directly impact investors who wish to take loans for setting up infrastructural, industrial projects, etc.
  • Retail Customers: It also impacts the retail consumers like us, who will have to shell out a higher interest rate for a loan.

CONCLUSION:

The decision to tighten disclosure norms for the credit rating agency has come in the wake of the recent credit default debacle. CRAs have off late come under criticism for failing to timely identify the stressed assets of IL&FS, which saw a series of defaults in loan repayments. It is a positive move in a bid to boost more transparency and accountability and will help investors take an informed investment decision. Moreover, the new guidelines will standardize the rating criteria and method of public disclosures and would lessen irregularity of information about the financial health of the company being rated.

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