Analysis: India’s ratings firms face reform pressure after failing to flag IL&FS woes

India’s credit rating agencies are set to come under intense pressure from the authorities and investors over their failure to proactively flag financial problems at one of the country’s biggest non-banking financial companies until after a subsidiary defaulted on some of its debt.

The government wants the markets regulator, the Securities and Exchange Board of India (SEBI), to examine the process for issuing ratings for corporate bonds and figure out why the rating agencies did not spot early signs of the crisis at Infrastructure & Leasing Finance Services (IL&FS), two senior finance ministry officials told Reuters.

“The rating agencies have to answer many questions,” one of the officials said. “After all, thousands of investors, mutual funds are putting their money (in these companies) based on their ratings,” he said, adding that there was a need to look into their standards and methodology, and fix accountability, in line with international best practices.

SEBI did not respond to a detailed list of questions from Reuters.

The Indian government on Monday took control of the IL&FS board, in a move it said was needed to protect the country’s financial system and markets from potential collapse as shockwaves from a series of IL&FS defaults triggered big declines in debt and equity prices at other shadow lenders.

Funded substantially by short-term debt, non-banking finance companies such as IL&FS – known as NBFCs or shadow banks – have played a major role in lending growth in India in the last two years, as Indian banks, saddled with roughly $ 150 billion of bad debt, slowed lending.

Three of India’s biggest and most prominent agencies, ICRA – which is majority owned by global ratings company Moody’s Investors Service, India Ratings & Research, which is owned by Fitch Ratings, and CARE Ratings, had granted IL&FS a AAA rating, indicating the highest level of creditworthiness. Those ratings were still in place when its subsidiary IL&FS Transportation Networks defaulted in June.

IL&FS was first downgraded only by a notch in mid-August and in just one month all three agencies dropped it dramatically to a rating of D, deep in “junk” territory. Almost overnight a finance company they had tagged a safe bet was re-rated a very high risk.

That, say financial market players, has created a massive loss of trust, with many echoes of the behaviour of Moody’s, Standard & Poor’s and Fitch in missing the troubles in the U.S. financial sector before the financial crisis in 2008-2009.

“People are now very suspicious of every credit because even a AAA is not safe,” said Mahendra Kumar Jajoo, head of fixed income at Mirae Asset Global Investments in India. Jajoo does not hold IL&FS debt, but has exposure to other debt in non-banking financial companies.

“They are combing every exposure in the portfolio to ascertain what is acceptable and what is not. This environment of uncertainty is causing a lot of unrest in the minds of investors,” he said.

TIGHT-LIPPED

The ratings agencies have made very little public comment on what went wrong.

“Every sharp downgrade is analysed and learnings are built into the rating system,” said T N Arun Kumar, executive director at CARE Ratings, in explaining how the agency – which has a strategic alliance with the Japan Credit Ratings Agency – responds to such events, though he declined to comment specifically on IL&FS. ICRA and India Ratings did not respond to requests for comment. CRISIL, a subsidiary of Standard & Poor’s, said it did not rate IL&FS, but learning from such episodes was used to “fine-tune rating criteria and processes so as to prevent relapse”.

Fitch and Moody’s did not respond to emails seeking comment. S&P said it would not respond as it did not rate IL&FS.

Some investors say the situation is even more worrying because they have seen this all before in India.

SEBI revamped rating rules following large and sudden downgrades of large debt-burdened companies, including auto parts company Amtek Auto, IDBI Bank, and telecoms company Reliance Communications in the past three years.

The regulator tightened disclosure norms for rating agencies to boost transparency and accountability and made it mandatory for them to closely monitor whether issuers are meeting their debt obligations. It also curbed cross-holdings between agencies to resolve issues around conflicts of interest.

BIGGER WAVES

The lack of confidence in the credit ratings is in danger of undermining India’s financial stability, leading to a drying up of credit lines for shadow lenders and wider concerns about the impact on the economy.

Calling the IL&FS crisis “India’s Lehman Brothers moment”, the main opposition party Congress last week sought a Supreme Court monitored multi-agency probe into the issue.

The uncertainty about how deep the credit stress is in India’s shadow banking sector is creating bigger waves than the knowledge of what has happened already.

India has about 11,000 shadow financing companies, out of which 248 are systemically important non-deposit taking institutions, according to the Reserve Bank of India.

“Credit rating agencies were blindsided – they never anticipated this default because they thought IL&FS had leading shareholders as a backstop,” said Shriram Subramanian, managing director at InGovern, a proxy advisory firm. IL&FS’s top shareholders include the government-backed Life Insurance Corp of India and state-owned State Bank of India.

“They need to be more accountable and step up sophistication,” added Subramanian in reference to the ratings agencies. Investors agree.

“The regulator needs to figure out how to have rating actions in a proactive manner rather than a reactive manner for appropriate rating actions so that they are able to assess these things before they happen,” said Lakshmi Iyer, chief investment officer, fixed income, at Kotak Mahindra asset management company.

Some bankers said investors should also take some of the blame for getting complacent and overconfident about the dramatic growth of these shadow banks and investing in their commercial papers.

According to a Credit Suisse note last week, mutual funds hold an estimated 60 percent of total NBFC commercial paper in a world where 41 percent of short-term debt of these companies is due to be refinanced in the next six months.

“There is no point in blaming only the credit rating agencies when mutual funds and many of us went ahead and bought all this paper out of greed for a good carry, overlooking the risks,” said a banker at a foreign bank, who has also invested in the paper, declining to be named as the matter was sensitive. ($ 1 = 73.71 Indian rupees)