DR.

RAM MANOHAR LOHIYA NATIONAL LAW

UNIVERSITY, LUCKNOW

Subject: Investment & Securities Law

Final Draft

“Credit Rating Agencies”

UNDER THE SUPERVISION OF: SUBMITTED BY:

Dr. Manoj Kumar Ashish kumar

Assistant Professor (Law) B.A. LL.B. (Hons.)
DR. RMLNLU, LUCKNOW SEC- ‘B’ Enroll- 130101034

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ACKNOWLEDGEMENT

The Project in World Legal System on the topic, “Credit Rating Agencies” has
been given shape and success by the effort of a lot of people who has
contributed in its completion.

I express my humble thanks to Dr. Manoj Kumar, my subject teacher under

whose supervision the whole project has been made and without whose
teachings and insights on this topic, this project could not have been fructified.

I also extend my heartiest thanks to my seniors for their insights into the
concerned final draft of the project and helping with me with everything I asked
them. The role of the Library Department is also noteworthy. All the staff
members helped me generously in getting the materials and information I
needed to complete this project.

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TABLE OF CONTENTS

1. Acknowledgment………………………………………………………………..2

2. Table of Contents………………………………………………………………..3

3. Introduction…………………………………………………………………..…5

4. Why there is need for regulation……… …………………………...………...…6

5. Regulatory regime in India for CRA……………………………………………..8

6. Concerns regarding CRA………………………………………………................9

7. Recommendations…………………………………………..…………….......….11

8. Review of literature …………………………………………………………… 11

9. Hypothesis ………………………………………………………………………12

10. Objective …………………………………………………………………………12

11. Research methodology …………………………………………………………..13

12. Findings…………………………………………………………………………..14

13. Bibliography………………………………………………………………..…….15

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INTRODUCTION:

Credit rating is an opinion of a recognised entity on the relative credit worthiness of an issuer

or instrument. In other words, it is an informed opinion “on the relative degree of risk

associated with timely payment of interest and principal on a debt instrument”.1 The business

of credit rating started in the early 1900s, with John Moody’s rating of rail bonds. Over the

last century, credit rating has evolved into a sophisticated business. Today, this involves

rating of not just simple and complex debt instruments of commercial entities, but also

sovereign debt.2 Globally, a vast majority of this business is conducted by three credit rating

agencies (‘CRAs’) - Moody’s, Standard & Poor’s and Fitch. In India, the business of credit

rating was first started in 1987 by large financial institutions and creditors through CRISIL.

In the last 30 years, seven CRAs have been established,3 with the most influential ones being

owned by Moody’s, Standard & Poor’s and Fitch.4 CRAs have now become an essential part

of the Indian financial system. They are regulated by the Securities and Exchange Board of

India (‘SEBI’) through the SEBI (Credit Rating Agencies) Regulations, 1999 and circulars

issued under it. “ However, in the last few years, the adequacy of this regulatory framework

has come into question. This project is aims to address this question. This project examines

the process and role of credit ratings in the financial system and analyses the regulatory

regime for CRAs in India. Thereafter, it highlights the main concerns regarding the regulation

of CRAs in India. Ultimately, this project collates international practice on the regulation of

CRAs, and makes recommendations to improve the regulation of CRAs in India.”

1
Ministry of Finance, Capital Markets Division, Report of the Committee on Comprehensive Regulation for
Credit Rating Agencies (2009).
2
Lawrence J. White, “Markets: The Credit Rating Agencies’, Journal of Economic Perspectives (2010).
3
SEBI, Name & Registered Addresses of Credit Rating Agencies, available at
http://www.sebi.gov.in/commondata/recognised/Registered-Credit-Rating-Agencies.pdf. (last visited on 10th
Oct, 2018)
4
Ministry of Finance, Capital Markets Division, Report of the Committee on Comprehensive Regulation for
Credit Rating Agencies (2009).

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Why there is need for Regulation?

Despite the immense utility of credit ratings, doubts have been cast on their reliability and
accuracy.

Critics argue that CRAs suffer from heavy conflicts of interest since they are hired by issuers
themselves, to rate their instruments. This is exacerbated by their heavy reliance on the
information provided by issuers,5 which means that CRAs are not able to provide
independent opinions on the actual credit worthiness of the instruments rated. It is also
argued that CRAs often lag behind market indicators. They believe that while initial ratings
tend to be accurate, CRAs do not maintain adequately updated ratings. However, CRAs argue
that this is because they present a more long-term view of the prospects of repayment in
comparison to market indicators, such as the price of bonds.6 Moreover, critics argue that
since credit ratings can provide regulatory licenses, they tend to create distortions in the
market.7 For instance, some argue that CRAs may provide minimum required ratings to
issuers, for their issues to be valid to maintain long-term relationships.8 Despite inherent risks
with credit ratings, CRAs were not comprehensively regulated in developed countries till the
advent of the global financial crisis in 2007.9 In the aftermath of the crisis, there was
widespread recognition that CRAs were complicit in the advent of the crisis. Critics argued

5
Dimitar Rafailov, “The Failures of Credit Rating Agencies during the Global Financial Crisis- Causes and
Possible Solutions”, Economic Alternatives (2011).
6
National Institute of Securities Market, Assessment of Long Term Performance of Credit Rating Agencies in
India (2009) (http://www.sebi.gov.in/sebi_data/attachdocs/1288587929503.pdf). (last visited on 10th
oct,2018).
7
Aline Darbellay & Frank Partnoy, Credit Rating Agencies and Regulatory Reform , Legal Studies Research
Paper, No.12-083, 2012), 20.
8
National Institute of Securities Market, Assessment of Long Term Performance of Credit Rating Agencies in
IndJonathan Katz, Emanuel Salinas, and Constantinos Stephanou, “Credit Rating Agencies: No Easy Regulatory
Solutions”, 8 Crisis Response: Public Policy for the Private Sector, 1, 2.ia (2009)
(http://www.sebi.gov.in/sebi_data/attachdocs/1288587929503.pdf). (last visited on 12th oct,2018)

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that CRAs failed to estimate the market risk associated with the structured credit products
correctly and thus, were unable to adjust the credit ratings accordingly. This made regulators
in developed markets review the regulatory framework governing CRAs, and introduce more
stringent regulation of CRAs since the crisis. In the aftermath of the global financial crisis,
SEBI also set up a Committee to review the regulatory framework for CRAs in India. Given
that in 2009, India still had one of the most extensive regulatory frameworks for CRAs, and
since there was little evidence of systemic misconduct by CRAs in the country, the
Committee did not suggest large-scale reforms to this framework.10

However, in the period after, concerns have been raised regarding the regulation of CRAs in
the country. One recent case that has brought CRAs under the scanner is the case of Amtek
Auto. Here certain CRAs allegedly suspended and withdrew the ratings of Amtek as it was on
the verge of defaulting in repayment of bonds, without following due procedure. Before this
Amtek had highest ratings in bonds and overnight these securities lost much of their value,
adversely affecting the investors?11 Moreover, one study analysed 248 companies of the BSE
and concluded that a gap existed between the credit ratings issued to different companies and
their financial ratios, raising doubts regarding the correctness of these ratings. Critics blame
this on the competition among these CRAs and the virtual rating shopping that issuers
indulge in.12 Another study indicates that problems in ratings could have contributed to the
rising non- performing assets (NPA) crisis of India. The study analysed the ratings of 10
corporate groups which were responsible for 20% of all distressed loans from FY 11 to FY
16. In FY 10 the total debt for these corporate groups amounted to Rs 3 lakh crore which
jumped to Rs 7 lakh crore by FY 14. During FY 11 to FY 13, each one of these corporates
were given a rating in the ‘No Risk’ or ‘Low Risk’ category and it was only in FY14 that the
rating was downgraded for some of them, when they had already started defaulting. Thus,
this study concluded that the inaccuracy of these ratings could have contributed significantly
to the NPA crisis in India.13 Such incidents have raised concerns for the need to regulate

10
Ministry of Finance, Capital Markets Division, Report of the Committee on Comprehensive Regulation for
Credit Rating Agencies (2009).
11
‘NPA crisis: Given rating agencies track record, odd that RBI looks to add to their credibility” Financial
Express (25 May 2017) (http://www.financialexpress.com/opinion/npa-crisis-given-rating-agencies-
trackrecord-odd-that-rbi-looks-to-add-to-their-credibility/684452/). (last visited on 12th oct,2018)

12
Krishna Kant, “How reliable are companies’ credit ratings?” Business Standard (Mumbai, 27 August, 2014).)
(http://www.business-standard.com/article/companies/how-reliable-are-companies-credit-ratings-
114082600845_1.html).
13
Praveen Chakravarty, “The Silent Role of Credit Ratings in India’s Bad Loan Crisis” Bloomberg Quint (8 July,

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CRAs better. In the following chapters, we will evaluate the regulatory regime for CRAs in
India and attempt to shed light on the concerns that should be addressed.

Regulatory regime in India for CRA

In India, CRAs are regulated by the Securities Exchange Board of India. SEBI was one of the
first regulators globally, to put forth a comprehensive framework for the regulation of CRAs
through the SEBI (Credit Rating Agencies) Regulations, 1999. The CRA Regulations cover
the following areas-

• Registration: Broadly, the CRA Regulations require that CRAs should be companies
promoted by persons who have experience in the field of credit rating i.e., by financial
institutions or by persons who have a net-worth of more than 100 crore rupees.14
Additionally, registration would only be granted if it registering the applicant is in the interest
of investors and the securities market.

• Obligations: The CRA Regulations envisage that CRAs need to carry out their activities in
accordance with the terms of their engagement with the issuer, and the baseline principles in
the Regulations. CRAs have to comply with the Code of Conduct prescribed by SEBI, which
requires that they discharge their duties with integrity, professional competence,
independence and confidentiality. In addition, CRAs are required to monitor their rating
throughout the lifetime of the securities rated and carry on periodic reviews of their rating as
well.

• Disclosure: The CRA Regulations require CRAs to maintain and disclose their ratings in a
specified manner. They require that CRAs should maintain copies of their rating notes,
ratings issued, terms of engagement, records of decisions of rating committees and fees
charged for ratings for at least five years.

• Conflict of Interest: The Regulations attempt to reduce conflicts of interest. They require
that CRAs may not rate securities that are issued by their promoters or their associates. In

2016) (https://www.bloombergquint.com/opinion/2016/07/08/the-silent-role-of-credit-ratings-in-indias-
badloan-crisis). (last visited on 12th oct,2018)

14
Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999, reg 4.

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addition, CRAs must also maintain an arm’s length relationship between credit rating
activities and other activities.

• Accountability and Enforcement: The Regulations require that CRAs should have an
internal audit, submit information to SEBI whenever required, and be open to inspection and
investigation by SEBI. They also specify that CRAs may be held liable for any contravention
under the SEBI Act, or any of the Rules or Regulations as specified in them. Alternatively,
they may be held liable under Chapter V of the Securities and Exchange Board of India
(Intermediaries) Regulations, 2008. In 2010, SEBI issued circulars overhauling its regulatory
framework, on taking note of the pivotal role of CRAs in the financial markets and the
importance of transparency by CRAs. SEBI issued circulars laying down detailed
requirements for the internal audit of CRAs and prescribing enhanced disclosures to be made
by CRAs. SEBI required CRAs to disclose default matrices of securities as well as preserve
explanatory notes for each rating or surveillance conducted by them.15 Thus far, SEBI
regulated only the rating of debt securities. “However, CRAs rated a vast variety of
instruments, including bank loans, overdraft facilities, and letters of credit. All of these rating
activities remained unregulated. However, in 2012, SEBI issued a circular stating that that
CRAs would “follow the applicable requirements pertaining to rating process and
methodology and its records, transparency and disclosures, avoidance of conflict of interest,
code of conduct, etc., as prescribed in the Regulations and circulars issued by SEBI from time
to time” “for rating of other instruments as well.”16 “In 2016, SEBI issued a circular laying
down guidelines to enhance the standards followed by CRAs and improve transparency in
their policies.” “This circular requires CRAs to publicly disclose their rating criteria and
rating processes, standardise press releases for rating actions.”

What are the Concern Regarding CRA?

A. Removing Conflict of Interest

Typically, “CRAs are hired by issuer entities to rate the securities being offered, and are
remunerated once this task is completed. This model of remuneration is called the ‘issuer

15
“Securities and Exchange Board of India, Internal Audit for Credit Rating Agencies (CRAs),
SEBI/MIRSD/CRA/Cir-01/2010; Securities and Exchange Board of India, Guidelines for Credit Rating Agencies,
CIR/MIRSD/CRA/6/2010.”
16
“ Securities and Exchange Board of India, Guidelines for Credit Rating Agencies, CIR/MIRSD/3/2012.”

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pays’ model. Since CRAs are dependent on issuers for the payment of their fees, although
their main role in the market is to serve investors, a greater possibility of a conflict of
interests arises.” “This is because the there are incentives for credit rating agencies to issue
complacency ratings on the issuer in order to secure a long-standing business relationship in
order to guarantee revenues or to secure additional work and revenues.”17 While “the issue of
conflict of interest, due to the ‘issuer-pays’ model, may arise in respect of other gatekeepers
in the financial markets, the potential of conflict and associated harms is likely to be higher in
case of CRAs.”

B. Reducing Rating Shopping

Rating shopping occurs when an issuer solicits ratings from multiple CRAs but only pays for
and discloses the highest rating(s).18 Studies in the wake of the 2008 global financial crisis
have noted the prevalence of this practice in the period leading up to the crisis. One study
examining the trends during this period notes that rating shopping by issuers and securitizers
added to the competitive pressures on CRAs to retain clients. This led to CRAs issuing
inflated ratings and deviating from their rating models in “a competitive race to the bottom.”
With increase in the complexity of financial instruments, there may be greater incentives for
issuers to shop for credit ratings. As a study notes: “When assets are simple, agencies’
ratings are similar and the incentive to ratings shop is low. When assets are sufficiently
complex, ratings differ enough that an incentive to shop emerges. Thus, an increase in the
complexity of recently-issued securities could create a systematic bias in disclosed ratings,
despite the fact that each ratings agency produces an unbiased estimate of the asset’s true
quality. Increasing competition among agencies would only worsen this problem.” 19

C. Increasing Accountability towards Investor

CRAs lend significant reputational capital to the debt instruments rated investment grade by
them. In addition, since they act as gatekeepers and are allowed to give regulatory licenses,

17
Recital 11, Council Regulation 462/2013 of 21 May 2013 amending Regulation (EC) No 1060/2009 on credit
rating agencies [2013] OJ L146/1.
18
International Monetary Fund, Global Financial Stability Report- available at
https://www.imf.org/en/Publications/GFSR/Issues/2016/12/31/Navigating-the-Financial-Challenges-Ahead at
83 (last visited on 12th oct,2018)

19
See Vasiliki Skreta and Laura Veldkamp, Rating Shopping and Asset Complexity-A Theory of Ratings Inflation,
available at http://people.stern.nyu.edu/lveldkam/pdfs/ratings.pdf. (last visited on 13th oct,2018)

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some investors mandatorily rely on their decisions.20 Since CRAs have a “significant impact
on investment decisions”, they owe a responsibility to investors to ensure that their ratings
are “independent, objective and of adequate quality”.21 Traditionally, it was believed that
reputational constraints would ensure that CRAs perform their duties with diligence and
independence. However, the force of reputational constraints has not been as successful as
was hoped, since rating agencies can use the “opaqueness of ratings” as a cover for
inaccuracy. This has brought forth the need to ensure that CRAs are made legally responsible
to investors, issuers, and the markets, much like auditors, security analysts and merchant
bankers.

Recommendations

The recommendations are based on India‘s own experience with the CRAs till now. India has
been proactive in introducing effective and comprehensive regulations for CRAs as early as
1999. In contrast, the US market saw substantial regulations only recently in 2007, and the
European Union is still in the process of framing its regulations. SEBI‘s CRA regulations
have been used as a model by other regulators in emerging economies. SEBI‘s code of
conduct for CRAs addresses some of the basic issues relating to conflicts of interest. “The
Code of Conduct is designed to ensure transparent and independent functioning of CRAs.
These regulations have been reasonably effective in ensuring that credible players operate in
the industry and there is widespread investor access to ratings. Nevertheless, given the recent
global experiences and emerging trends in regulation there is undoubtedly a case for a re-look
at the CRA business models and strengthening of regulations. Regulators also need to
enhance their due diligence and investors need to strengthen their own information
processing systems. Moreover, market participants need some time for such a migration to
the world of no mandatory rating, particularly because of the low levels of financial literacy.
Accordingly all regulators felt that rating is an essential tool in the current context.”

“Therefore a number of steps for enhancing the transparency of the functioning of the CRAs
through greater disclosure requirements, reducing the conflict of interest in their business
models and in improving their rating methodology and process. These recommendations will

20
Aline Darbellay & Frank Partnoy, Credit Rating Agencies and Regulatory Reform (Legal Studies Research
Paper, No.12-083, 2012)), 1.
21
Council Regulation 462/2013 of 21 May 2013 amending Regulation (EC) No 1060/2009 on credit rating
agencies [2013] OJ L146/1.

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also provide another window of opportunity, both to the CRAs to show their capability to
assimilate and absorb their fiduciary role as well as for the policy makers to see how these
work which will help charting the future policy trajectory itself. The recommendations below
are designed to strengthen provisions related to conflicts of interest, and improve
transparency, disclosures and accountability.”

1. SEBI‘s jurisdiction over the CRAs is with respect to their activities in Securities market
and dealings of CRAs specifically in instruments categorized as ―securities and does not
cover the activities governed by other Regulators. Credit rating is regulated by SEBI as the
primary users of credit rating are the investors in securities markets. In practice, credit rating
is much more used by other regulators where rating advisory is often a part of the regulations.
SEBI needs to factor in those users and regulators whose use impacts a larger group of
investors. “Therefore, prior to formulating any regulation SEBI needs to consult other
regulators. Under this model, SEBI would be the lead regulator and all entities carrying out
the activity of credit rating would need to be registered with SEBI.” The CRAs so registered
with SEBI would be required to acquire further accreditation with other regulators (RBI,
IRDA, PFRDA etc.) if felt necessary by them, for rating products that come in the regulatory
domain of the other regulators. The respective regulators may independently frame guidelines
in respect of the activities coming under their purview to help decide on the skill set
requirements of the CRAs. Inspections of CRAs should be carried out by only one team,
which should have representations from all concerned Regulators to oversee the area of
activities governed by such Regulators.

2. Restricting the scope of usage of the term” credit rating”

Currently, there are five CRAs registered with SEBI. However, it is understood that there are
other agencies such as ONICRA, SMERA etc. which also claim to provide rating services
(mainly in SSI assessment, Small and Medium enterprise rating, individual credit assessment
etc.) though not in securities. “In view of the lead regulator model that is proposed and the
need for increased inter-regulatory coordination as described above, it is proposed to restrict
the scope of usage of the term‖ credit rating‖ through appropriate legislation. It is proposed
that No entity shall bear a name having the words ―credit rating unless it is registered as a
CRA with SEBI.”

3. Greater due diligence by the Regulators Given the concerns with the rating based approach
regulators and stakeholders need to exercise greater due diligence in accepting rating

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‘mechanically. Accordingly, they should upgrade the skills/ capabilities for greater due
diligence.

4. Resolving the conflict of interest inherent in the “issuer pays model'‟

It has been alleged that this model in which the entity issuing debt pays the rating agency
compromises the quality of analysis and ratings assigned by the agencies. The other
alternatives are investor pays model ‘and regulator pays model’. Globally the 'issuer pays
model' is followed by CRAs.

“However, greater transparency to the public regarding disclosure of conflict of interest,

disclosure of fees received as described above would go some way to address these
concerns.”

5. Norms for governance of CRAs: Currently, the Code of Conduct prescribed in the SEBI
(CRA) Regulations stipulates, inter –alia, that a credit rating agency shall ensure that good
corporate policies and corporate governance practices are in place. “CRAs are also required
to develop their own internal code of conduct for governing its internal operations. such a
code may extend to the maintenance of professional excellence and standards, integrity,
confidentiality, objectivity, avoidance of conflict of interests, disclosure of shareholdings and
interests, etc.”

Review of literature
1. Bharati V. Pathak, The Indian Financial System – Markets, Institutions and Services‖,
Pearson Education, Third edition- 2008. The Indian Financial system written by Bharati
Pathak is a complex amalgamation of various institutions, markets, regulations and laws,
analysts, transactions, claims and liabilities. This book not only thoroughly engages with
these important aspects of financial system as the bedrock of the book, but also helps
students, academicians and professionals to survive and thrive in today's competitive business
environment.

2. Mamta Arora (2003), Credit Rating in India: Institutions, Methods And Evaluation, New
Century Publications. This book is unique because it not only examines the existing practices
of credit rating in India but also evaluates the performance of the Indian credit rating agencies
themselves.

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3."Credit rating companies and their impact on the economy". Available at
Forexpromos.com

4. Kaminsky G; Lizondo S and Reinhart CM (1998). Leading Indicators of Currency Crises,

Staff Papers, International Monetary Fund, Vol. 45, March. Graciela L. Kaminsky is
professor of Economics and International Affairs at George Washington University and
Research Associate at the National Bureau of Economic Research. She previously held
positions as assistant professor at the University of California, San Diego and staff economist
at the Board of Governors of the Federal Reserve System. She holds a Ph.D. in Economics
from MIT.

Hypothesis
“Credit rating agencies play an important role in assessing risk and its location and
distribution in the financial system. By facilitating investment decisions they can help
investors in achieving a balance in the risk return profile and at the same time assist firms in
accessing capital at low cost. CRAs can thus potentially help to allocate capital efficiently
across all sectors of the economy by pricing risk appropriately.”

Objective
The objective is to find out the answers to these questions.

“1. Examining scope of activities of Credit Rating Agencies and their systemic importance.
Is Credit rating just an opinion or the opinion? ”

2. Addressing conflict of interest’ inherent in Credit Rating Agencies ‘business model.

3. A lead regulator model for Credit Rating Agencies.

4. How greater transparency can address some of the concerns of CRAs?

Research Methodology

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The doctrinal method of research would be adopted according to the requirements of the
project. The researcher in the course of the data collection would rely on books, articles from
journals, internet data bases, International Conventions, statutes of various countries etc.

Findings
“The outcome is that the present regulatory framework regarding CRA are inadequate. It only
deal with securities and does not cover the activities governed by other Regulators. Credit
rating is regulated by SEBI as the primary users of credit rating are the investors in securities
markets. In practice, credit rating is much more used by other regulators where rating
advisory is often a part of the regulations. Apart from this, there is need to consider the
concern outline in this project and recommendations offers for it.”

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BIBLIOGRAPHY:

Reports

1. National Institute of Securities Markets (NISM) reports on CRA of India.

2. Bharati V. Pathak,‖The Indian Financial System – Markets, Institutions and Services‖,

Pearson Education, Third edition- 2008.

3. Mamta Arora (2003), Credit Rating In India: Institutions, Methods And Evaluation, New
Century Publications.

Web Resources:

1. "Credit rating companies and their impact on the economy". Available at

Forexpromos.com

2. Kaminsky G; Lizondo S and Reinhart CM (1998). Leading Indicators of Currency Crises,

Staff Papers, International Monetary Fund, Vol. 45, March.

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