The Securities and Exchange Board of India (Sebi) has done well to turn down a consent application by ratings agency ICRA relating to the IL&FS case. The fact is that ICRA, together with other ratings agencies, is guilty of failing to assess the financial crisis at the NBFC and not alerting the markets in time. Had the regulator agreed to the consent request, ICRA would not have needed to admit to the lapse. In other words, it would have got away with a ‘not guilty’ tag, which it does not deserve. Unless agencies are castigated, the system will remain weak.
The fact is, ratings agencies have been way too casual in their approach, failing investors and lenders. Much like the stable door being bolted after the horse has bolted, the downgrades came in in too late. Some of the blame for this must lie with the regulator since there seems to be no penalty whatsoever for the poor assessments or the delayed alerts. Which is why, it is important that, this time around, Sebi cracks the whip.
For the system to reform, the business model of ratings agencies needs to be revisted. If companies are able to pay their way to a good rating, it is a flawed model. Sebi must explore a model in which the investors pay for the ratings; that way the agencies will earn their revenues without having to compromise on the quality of their assessments. However, this too might not work because wholesale investors —fund managers—and lenders would also want any negative news to be delayed or not announced at all. That would help them maintain the value of the asset on their books—so the NAV wouldn’t fall—and, in the case of banks, it would mean they need to provide less capital. In these days of cut-throat competition, there are few bankers and fund managers who are willing to take a hit, unless it is inevitable. To be sure, this is a conspiracy theory and, if there are enough checks and balances, Sebi can get investors to fall in line. It is, of course, important to ensure ratings agencies are able to generate adequate revenues so as to cover their costs and stay profitable.
One suggestion is that companies continue to pay for the ratings and that a pool of funds be created from the fees; the rating agencies would then be paid from this corpus but the amount paid would be decided by an accredited panel of investors. The ratings agencies will say this is unworkable since they will have no control whatsoever over their revenues. That is a fair point because, to ensure the quality of its ratings, an agency must invest. Also, there is no guaranteeing the investors will be unbiased while allocating the fees to the ratings agencies. Perhaps investors—bankers, insurance companies, mutual funds, EPFO—should commission ratings assessments and pay for them jointly. That would ensure that no one fund manager influences the rating and, at the same time, the ratings agency would be assured of its fee.