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New biz model on cards for rating companies

Mumbai: The Securities and Exchange Board of India (Sebi) is planning to overhaul the manner in which the credit rating business works — scrapping the issuer-pays model that’s prevalent across the world and moving to one where the investor pays, said people aware of the matter. The immediate trigger for the move is the Infrastructure Leasing & Financial Services (IL&FS) default — which the rating agencies missed — that sparked a crisis in the non-banking finance sector.

The thinking is that such a move will resolve the conflict of interest inherent in rating agencies being compensated by the issuers who raise debt, which has led to allegations of entities shopping around for a favourable grading. The regulator has sought feedback from market participants on its plan before coming up with the final rules, said the people cited above.

“The alternative to such a conflicted model is to move towards a user-pays model,” said one of the persons.

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The parliamentary standing committee on finance had also called for an end to the practice. Those who use the ratings are institutional investors such as mutual funds, insurance companies, pension funds, banks and corporate treasuries.

Under the proposed regime, an issuer will file a draft prospectus with the stock exchanges. Credit rating agencies will make their assessment of the paper. Investors will pay to see those ratings, based on a predetermined fixed rate. The initial and subsequent fees may have to be paid through the exchange platform. If the debt paper is traded, then the new investor can continue with the same agency’s rating or choose a new one from the platform.

“This will ensure the issuer bias is addressed and there is transparency and consistency in credit ratings,” said another person familiar with the proposal.

Credit rating agencies that had assessed IL&FS came under scrutiny after they failed to identify the financial trouble brewing. Before that, rating agencies were also blamed for not being able to predict the global financial crisis that stemmed in part from dubious debt securities based on subprime housing loans.

Sebi is planning to amend its listing regulations, credit rating agencies regulations and other guidelines to bring the new rules into effect, said the people cited above. A ratings company executive said that, apart from the business model, agencies often don’t have enough information to take a call.

“Many times issuers pay a huge fee to rating agencies because of which rating agencies are reluctant to downgrade,” he said. “Issuers also don’t provide complete information to rating agencies.”

Source: Economic Times