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Key macro-economic, regulatory and industry issues p4/NPA lifecycle in banks and role
of early warning systems (EWSs) to mitigate credit risks p13/Role of CRA in credit risk
assessment and its impact in terms of information value p16/Feasibility of an umbrella
regulator p21/Regulatory role for improving efficacy of CRAs p23/ Conclusion p26
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Message Message
I am glad to know that ASSOCHAM is releasing Growing NPAs To the question, whether economics and
in banks: Efficacy of credit rating agencies at the National finance is science or art, somebody answered,
Conference on Growing NPAs in Banks: Efficacy of Ratings and science seeks to understand and art seeks to
Accountability and Transparency of Credit Rating Agencies. I do. To that extent, banking today is almost
heartily congratulate the organisers for putting together the a science and consequently, it is absolutely
conference, the subject of which is very relevant to the Indian critical that the long-term impact of bank
financial sector today. I also congratulate them for bringing out lending is seen as part of a larger ecosystem to
the knowledge report and wish them all the success. understand linkages among stakeholders in
this ecosystem.
Working with many of the stakeholders
enables us at PwC to attempt to unfold the
value chain of credit dispensation. This paper
written with help from industry reports, our
R Gandhi
own knowledge repository and ASSOCHAM
Deputy Governor, RBI
is a step in that direction. Our association
with ASSOCHAM has been on topical issues
and this time we have collaborated with them
on NPAs, which I liken to an albatross that
can bring down the profitability of banks and
Message impair their future
lending capabilities.
Non-performing assets (NPAs) are a key concern for banks
We thank ASSOCHAM for giving us this
in India. They are the best indicator of the health of the
opportunity and look forward to more such
banking industry. Public sector banks have displayed
collaborative ventures in the larger interest of
excellent performance and have beaten the performance of
the banking sector.
private sector banks in financial operations. However, the
only problem of these banks is the increasing level of non-
performing assets, year by year. On the contrary, the NPAs
of private sector banks have shown a decline. A reduction
in NPAs shows that banks have strengthened their credit
appraisal processes over the years. The increase in NPAs shows Munesh Khanna
the necessity of provisions, which bring down the overall Executive Director, Financial Advisory Services
profitability of banks. Therefore to improve the efficiency and Pricewaterhouse Coopers Pvt Ltd
profitability of banks, NPAs need to be reduced and controlled.
A high degree of NPAs suggests high probability of a large
number of credit defaults that affect the profitability and
liquidity of banks. Under the circumstances, the role of credit
rating agencies also needs to be relooked at and brainstormed
over. We need to devise a way forward to ensure that rating
agencies put forth an improved mechanism to keep a check.
The broad issues facing the modern day banking sector
have been exhaustively covered in our report prepared
in close association with our knowledge partner
PricewaterhouseCoopers India Pvt Ltd. The PwC team has done
full justice with the topic and I am sure the deliberations in
the conference will throw light on the strategies to counter the
issues affecting the bottom-line.
I wish the conference success.
D. S. Rawat
Secretary General , ASSOCHAM
Key macro-economic, regulatory and
industry issues
4 PwC
Gross NPA vs GDP in India
11.4%
10.4% 9.5% 9.6% 9.3%
8.8%
8.4% 8.4%
8.0%
7.0% 6.7%
7.2% 6.5%
5.4%
5.2% 4.9%
4.2% 4.5%
3.9% 4.5%
3.3% 3.6%
3.1%
2.5% 2.2% 2.3% 2.4% 2.5%
FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14E
GDP GNPA
155.1
54.0 54.1
43.2
27.9 40.2
23.2 21.3
27.9
11.5 18.0 16.8 6.0 16.6 15.1
(1.2)
(8.4) (13.9)
FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13
A period of downturn reverses this Stressed assets: How big is data we have on SRs, we have limited
trend of low SA levels and asset quality the problem? our definition of SA in India to only
concern increases as the growth in SA GNPAs and RAs. The true picture of
outpaces credit growth in the banking The problem is not only restricted to SA can be depicted by combining the
system. As a result, as the graph rising GNPA ratios. The rise in the GNPA and RA (as a percentage of total
depicts, growth in SA increased by percentage of RA and security receipts advances). This figure, as on March
40.2% in 2013 as against a 15.1% credit (SRs) issued by asset reconstruction 2013 is as high as 10.2% of the total
growth. companies (ARCs) are also a cause for banking credit.
concern. Owing to the lack of detailed
Source: Reserve Bank of India and Goldman Sachs Global Investment Research
The total banking credit outstanding as on 31 March 2013 was 57.90 trillion INR.
Of this, the stressed asset (GNPA + RA) size is 5.91 trillion INR (10.2% of total)
This can be further broken down into GNPA of 2.43 trillion INR (4.2%) and RA of 3.47 trillion INR (6.0%)
The biggest contributor to the 10.2% pool of GNPA is state-owned banks, where the stressed asset ratios (SA/total advances)
in some cases are already high percentages.
20
16.4
PSU banks
15
11.1
10.1 9.5
9.4
10 Private banks
5.3
5 3.7
3.0
2.1
1.3 1.4
0.5
0
YES HDBK INBK KTKM INGV AXIS ICBK FED SBI BOB OBC PNB
FY13 Q2FY14
Source: Company data, Goldman Sachs
6 PwC
Stressed assets as a percentage of equity
111.8%
105.7%
93.7%
96.0% 90.2%
89.4% 77.2%
76.8%
70.9% 65.8% 70.4% 71.4%
FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13
2.1%
2.1%
4.7%
4.1%
3.4%
1.8%
1.8% 3.7%
27.0%
23.0%
19.4%
17.4%
15.6% 15.0%
14.0%
9.0%
8.0%
4.5% 4.7% 4.0%
1.0% 1.8% 1.0% 2.0%
Aviation Textiles Power Infrastructure Telecom Iron & steel Mining Real estate
FY09 FY13
A closer analysis reveals that the Annual growth in GCF in the private sector
majority of stressed assets are in the
infrastructure segment, including
45%
power and telecom, as well as textile,
iron and steel. 33%
19% 19% 21%
Macro-economic, 16% 15% 17%
13% 15%
regulatory and industry 0% 6% -3%
0% -2% 2%
issues impacting SAs -12%
-29%
Macro-economic risks
FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13
Pre-2008, the positive market
sentiment and buoyancy in the Growth in private corporate sector GCF Growth in total GCF
economy led to huge capacity build-up
by Indian corporates, primarily funded Source: Reserve Bank of India, Jefferies
by debt.
8 PwC
Post the 2008 global financial
meltdown, India and the world
witnessed steep declines in growth
rates. To counter the aftermath of
the financial crisis and declining
growth, major central banks globally
adopted the easy money policy which
also resulted in easy liquidity in
emerging markets such as India. This
phenomenon pushed up asset prices
and led to inflation.
14.87%
11.44%
FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13 FY14
2.50 25.0%
2.00 20.0%
1.50 15.0%
1.00 10.0%
0.50 5.0%
0.00 0.0%
Source: Jefferies
800 732
100.0
700
600 80.0
500 444
60.0
400
276
300 228 40.0
204
200
84 20.0
100 60 48 30 30
- -
FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 FY11 FY12 FY13
10 PwC
Share of corporate debt failing Z-score levels
27.1% 25.7%
33.7%
40.6% 46.0%
62.2%
21.5%
28.0%
32.6%
30.7% 20.2%
23.5% 52.8%
44.9%
28.7% 33.8% 33.7%
14.3%
Source: Jefferies Performed on 414 companies out of the BSE 500 Index, making up almost 40% of the total banking system loans
27.0%
23.0%
19.4%
17.4%
15.6% 15.0%
14.0%
9.0%
8.0%
4.5% 4.7% 4.0%
1.0% 1.8% 1.0% 2.0%
Aviation Textiles Power Inf rastructure Telecom Iron & steel Mining Real estate
FY09 FY13
The high cost of jet fuel in India due to taxes has negatively
impacted the competitiveness of the Indian air transport
industry for over a decade. Domestic fuel taxes can be as
high as 30%, in addition to an 8.2% excise duty. As a result,
fuel for Indian airlines is about 45% of total operating costs,
compared to the global average of 30%. This results in
skewed operating margins and cash flows, thus causing stress
in the airline sector.
12 PwC
NPA lifecycle in banks and role of early
warning systems (EWSs) to mitigate cred-
it risks
NPA lifecycle in banks
Stressed assets
Sub-asset category (SMA) NPA Measure
creation Identification of default Consolidate and apply
Incipient stress detection borrowers income recognition
Provisioning acceleration Classification of NPAs policy
Non- cooperative borrower Record of recovery monitoring Execute write offs and
identification Assessment of collaterals and appropriation of P&L
Board oversight degree of credit weakness Regulatory reporting
Formation of JLF and creation Management reporting
of Corrective Action Plan (CAP)
and JLF
Identification Insight
Strategy and planning
Forecasting
Stressed assets NPAs Me Business activity
Crisis management a su monitoring/alerting
Inv
e s ti
gation
Revitalise
In
assets so
lu t
Restructuring of NPAs io n
Sale or divesture of business
Application of new equity fund
Change management Key enablers:
Regulatory
Internal policies Business models Technology Process
framework
Lien release requests Current ratio and debt-equity ratio/annually during reviews
14 PwC
The key to success for EWS lies in identifying
the triggers and customising them. The idea is
to develop proactive monitoring across the asset
portfolio lifecycle with continuous monitoring
of assets from sanction till loan closure through
development of a system by taking data-based
cues from the early signs and red flags:
The benefits of EWS
Definite process to govern credit monitoring,
ensuring a standardised bank-wide approach
to detect and escalate EWSs
Implementation of a knowledge
management system to retain the
organisations learning of each type of
customer
Relationship managers time freed up to
make him or her capable to handle more
responsibilities at the ground level
Better compliance to regulatory
requirements and audits
Irregularity in installment Information about Use for personal comfort, Changes in government
and insufficient borrower initiating the stocks and shares policies
payments process of winding up or by borrower
Death of borrower
not doing the business
Irregularity of operations Avoidance of contact
Competition in the market
in the accounts Overdue receivables with bank
Bouncing of cheque due External non-control- Problem between partners
to insufficient balance in lable factor like natural
the accounts calamities in the city
where borrower conduct
Unpaid overdue bills
his business
Declining current ratio
Frequent changes in
Diversion of funds plan and nonpayment of
wages
Information value of As banks develop their internal ratings 2008 financial crisis. The regulation
credit ratings model as mandated by the Advanced has brought many smaller firms within
Basel framework, they can validate the the fold of credit rating. In this paper,
credit rating for a particular borrower we have only considered exposures of
In the last couple of years, as NPA levels
generated from that model with that of banks for corporate loans greater than
and SAs have grown considerably in
the publicly available ratings by CRAs. 5 crore INR as any loan upto 5 crore
the economy, a significant proportion
Banks can also seek information from INR is considered as retail exposure.
is skewed towards corporates.
CRAs if there is wide variation in its Borrowers can benefit from the rating
Consequently, credit risk assessment,
credit assessment vis-a-vis the rating exercise as this can help them tone
credit administration and monitoring
agencies. Banks and CRAs should be up their management systems and
has come increasingly into focus.
able to contribute to developing an business models. Banks also provide
The suitability of current credit risk
ecosystem where credit assessments loans as social obligation to institutions
assessment has often come into
become more effective. with a weak balance sheet like such
question.
Current RBI regulations stipulate as state electricity boards, etc. The
Credit rating agencies across the
that if a bank has decided to use the credit risk on the balance sheet of the
world are increasingly becoming an
ratings of chosen credit rating agencies lending banks and institutions could
important component in the value
for a given type of claim (loans), it be far higher than what is declared,
chain of credit risk assessment. Credit
can use only the ratings of the same considering the weak financials of
rating is an indicator to measure the
credit rating agencies (for subsequent those companies. CRAs could play a
creditworthiness of borrowers and
reviews), despite the fact that some vital role in assessing these risks.
acts as an intermediary between the
of these claims may be rated by other
issuer (borrower) and investor (banks)
chosen credit rating agencies whose
to minimise information asymmetries
ratings the bank has decided not to use.
about the riskiness of investment
In respect of exposures and obligors
products on offer.
having multiple ratings from chosen
In general, credit rating provides credit rating agencies, for risk weight
a third party with independent calculation, banks will use higher
information on default risk i.e. the risk weight if there are two ratings
likelihood of default of an issuer on accorded by chosen credit rating
a debt instrument, relative to the agencies that map into different risk
respective likelihoods of default of weights. Similarly, if there are three or
other issuers and therefore becomes a more ratings accorded by chosen credit
useful ready-to-use tool for assessing rating agencies with different risk
credit risk. weights, the ratings corresponding to
In the case of sanctioning loans, banks the two lowest risk weights should be
use ratings as a filter and sometimes referred to and the higher of those two
perform an additional check through risk weights should be applied.
an independent due diligence review RBI guidelines also stipulate that as a
or credit matrix. So, banks may use general rule, banks need to use only
the credit rating issued by CRAs to solicited ratings from chosen credit
the debtor as important information rating agencies and cannot consider
during the credit appraisal. The any ratings given on an unsolicited
RBIs regulatory framework requires basis by CRAs for risk weight
banks to have their own credit risk calculation as per the standardised
assessment framework for lending and approach.
investment decisions and not rely only
While external credit rating for
on ratings assigned by credit rating
corporate loans is not compulsory
agencies. The Indian banking systems
under Basel II, banks have to assign
mandated reliance on external credit
100% for unrated corporate claims
ratings is limited to capital adequacy
(both long- and short-term) which was
computation for credit risk and general
relaxed from 150 to 100% during the
market risk under standardised
approach of Basel II.
16 PwC
Banks can also use credit rating for loans to conserve capital as illustrated below.
Rating Basel I Basel II (standardised approach for credit risk)
Risk weight Capital* required (mn) Risk weight Capital required (mn) Capital saved (mn)
AAA 100% 90 20% 18 72
AA 100% 90 30% 27 63
A 100% 90 50% 45 45
BBB 100% 90 100% 90 0
BB and below 100% 90 150% 135 (45)
Unrated 100% 90 100% 90 0
*Capital required is computed as loan amount x risk weight x 9%
Source: CRISIL and RBI
The informational value of credit to confidential information, they have Corporates may approach credit
rating is being debated globally. The not been able to assess the borrower or rating agencies to get their bank
important question is whether the financial instruments effectively from a loans rated as this will help them
rating agencies are being able to predict credit risk perspective. explore alternate source of funds
the default risk better than the markets. However, credit rating information and also provide an information
It has been argued that markets are in can be important due to the following base for banks and other investors
a better position to process information reasons: about default risk. Corporates can
than conduct the credit rating exercise then optimally price their bonds
which is dependent on historical data It can be particularly suitable for and equity issues.
and is essentially backward-looking. It corporates or financial instruments
which do not trade in the markets, Also, as mentioned earlier,
does not take into account the dynamic computation of regulatory
market environment that includes thus providing a significant
information challenge for banks capital based on Basel II and III
market risk factors. This can have a regulations by the RBI will require
significant impact in times of recession too.
external rating of the borrower (till
or downturn as has been observed Good credit rating may reduce the time internal rating models are
in the Indian economy. The financial information asymmetry and thus accepted by the regulator).
crisis has demonstrated that in spite enhance more liquidity in the
of credit rating agencies having access market by increased trading as
investors become more confident.
18 PwC
Business models of credit Apart from their core business of A few benefits of the Issuer Pays Model
rating agencies and their ratings, the CRAs have diversified in are listed below:
the areas listed below:
impact Free availability of ratings:
Research: Some Indian CRAs have Investors can compare the
It is imperative that the business set up research arms to complement credit quality of a wide array of
model of the CRAs need to ensure their rating activities and carry out instruments, choose the ones that
that credit ratings are of high quality, research on the economy, industries best fit their risk preferences, and
accurately measure creditworthiness and specific companies, and make the continuously monitor the credit
and should be the product of a strong same available to external subscribers quality of their investments.
and independent process. A possible for a fee. Access for rating agencies to high-
inaccuracy in ratings can pose a threat Consulting and advisory: The CRAs, quality information
to financial stability by underestimating by virtue of assessing credit risk has Keeping the cost to the system low
the riskiness of investments of expertise in risk consulting which they
regulated entities. In case of a bank carry out separately. They offer various The principal risk to manage the
loan rating of a borrower, the problem kinds of advisory services, usually risk of conflict through:
of underestimation of risk can lead through dedicated advisory arms. Multilevel rating processes
to inaccurate capital calculation due
Knowledge process outsourcing: Strict separation of the analytical
to inflated ratings and could pose
Some Indian CRAs have KPO arms and marketing functions
a significant threat to the financial
that leverage their analytical skills
stability of individual financial Delinking compensation from level
and other process capabilities to serve
institutions as well as the whole of rating
clients outside India. Most of the
financial system. Conversely, ratings The other models include:
CRAs in India are subsidiaries of the
that overestimated risk will impose
International CRAs. Issuer Pays Model: The investor
excessive capital requirement on banks,
increasing costs to the economy as Funds research: Some CRAs have pays for the rating and this may have
a whole and reducing shareholder diversified from mutual fund ratings the benefit of freedom from issuer,
returns. into mutual fund research. however the risks include higher cost
for the investor, not publicly available.
Functions of CRAs and associated The advisory and consulting practices
Also this model does not eliminate
business models: Post the sub-prime provide an inherent area of conflict of
the conflict of interest; it only shifts
crisis in 2008, the CRAs have come interest. However, CRAs have often
the source of conflict from issuer to
under fire for their inability to detect argued that advisory or consulting
investors. Under the investor-pays
the flaws in the system and also conflict services are offered by different
model, CRAs could give lower ratings
of interest in their business models. legal entities with whom physical,
than indicated by the actual credit
organisational and functional
In India, most of the credit rating quality of the rated debt, so that
separation is maintained.
agencies have rating and non-rating investors will get a higher yield than
businesses. CRAs in India rate a large warranted.
number of financial products including Associated business models
Government or Regulator Pays Model:
the following: Issuer Pays Model: Globally the CRAs In this model the government funds
1. Bonds and debentures follow Issuer Pays Model, where the the rating costs. There is no structural
entity that issues the security also incentive for bias in either direction
2. Commercial paper pays the rating agency for the rating. except for PSEs. However, potential
3. Structured finance products Similarly for bank loans where the risks include moral hazard as this
corporate gets itself rated but pays may appear to be an approval of the
4. Bank loans
rating fees to the CRAs. The current government policies and also use of
5. Fixed deposits and bank certificate of issuer pays model suffers from a public money where the issuer may be
deposits fundamental conflict of interest as able to afford.
6. Mutual fund debt schemes CRAs are paid by issuers for rating
them and this may encourage ratings Exchange Pays Model: The exchanges
7. Initial public offers (IPOs) pay for the ratings and recover the cost
shopping and the inflation in ratings.
CRAs also undertake customised credit through an additional trading fee. This
CRAs follow a reputational model model is one of the best as it eliminates
research of a number of borrowers
and so they have a responsibility of bias but it can be only for traded
in a credit portfolio, for the use of
maintaining high quality ratings. entities.
the lender. Their to understand the
However rating shopping may lead to
business and operations coupled with
unhealthy competition and there is a
the expertise of building frameworks
danger of inflating ratings.
for relative evaluation puts them in
good stead.
20 PwC
Feasibility of an umbrella regulator
Feasibility of an umbrella While SEBI currently regulates be looked into. While independent
regulator model credit rating, such ratings are much regulators can frame their guidelines
more used by other regulators where applicable to sectors they regulate, a
The multiplicity of regulators has rating advisory is often a part of the holistic regulatory framework needs
necessitated the need for inter- regulations. SEBIs jurisdiction over to be developed considering inputs
regulatory co-ordination. It has become the CRAs only covers securities as from all participants. Currently, a
necessary for policy makers to look at defined under the Securities Contract standing committee for CRAs has
the fact that there are apprehensions (Regulation) Act, 1956 and does not been constituted which comprises
about regulatory arbitrage taking cover the activities governed by other of representations from regulatory
advantage of lack of co-ordination regulators. Existing SEBI regulations bodies of the securities market (SEBI),
among various regulators. Policy may not be adequate to cover the banking sector (RBI), insurance sector
makers need to identify areas where issues and concerns put forth by (IRDA) and pension funds (PFRDA).
they could facilitate an optimal other regulators. The committee has met at several
environment for removal of asymmetric occasions to deliberate on various
information. It relates to the design, The SEBI report further suggests
the need for a lead regulator. In the regulatory issues.
structure and extent of the regulatory
structure pertaining to the operations awake of increasing NPAs in the
of CRAs, and an enquiry as to whether system, it needs an overhaul. The
the prevailing policy regulatory feasibility of forming an umbrella
regime has helped or harmed regulator with representations
their functioning. from respective regulators, SEBI,
RBI, IRDA, PFRDA and others can
22 PwC
Regulatory role for improving
efficacy of CRAs
Globally, the need for strong are used only in an auxiliary role in applied as a basis for differentiating
regulations governing CRAs has the calculation of final rating values. capital requirements according to risks,
come into focus post the 2008 sub- For the Standardised Approach, and not for determining the minimum
prime crisis. Subsequently, significant banks use alternatives to CRA as well required quantum of capital itself. The
regulatory changes have been observed as alternative standards for assessing CRD framework as a whole provides
in the developed economies (OECD). whether securities are of investment banks with an incentive to use internal
In USA, the Credit Rating Agency grade or not. rather than external credit ratings
Reform Act and Dodd-Frank Wall Street In Australia, major banks use (IRB) even for calculating regulatory capital
Reform and Consumer Protection Act approaches to assess credit risk and are requirements.
have enhanced the Security Exchange required to form their own views on In India, the question of improving the
Commissions (SEC) power to regulate creditworthiness of the borrowers even efficacy of CRAs needs to be looked
Nationally Recognised Statistical though external ratings may constitute from a holistic perspective where all
Rating Organisations (NRSROs) by an input in that view as opposed to participants in the ecosystem; the
adopting several rules. The areas relying solely on CRA ratings. The regulators, CRAs, corporates and
covered under the rules include banks are also subjected to continuous investors (banks) needs to work jointly
record-keeping, conflict of interest monitoring and review mechanism by towards a better system of credit risk
with respect to sales and marketing the Australian Prudential Regulation assessment and monitoring. From a
practices, disclosures of data and Authority (APRA). While other regulatory perspective it is important
assumptions underlying credit ratings, authorised deposit taking institutions that apart from putting up a strong
statistics, annual reports on internal (ADIs) use a more simplistic approach, regulatory framework, they also
controls and consistent application they are also required to supplement upgrade their skills for greater due
of ratings symbols. However, the law CRA ratings when determining the diligence to evaluate effectively the
prohibits the SEC from regulating credit risk exposures. ratings that are given by CRAs. The
an NRSROs rating methodologies. The EU has also formulated regulations banks need to move towards risk based
Banks having inter-state licences are on CRAs (CRA Regulation III) to pricing whereby they can use rating as
generally required to make assessments reduce reliance on external ratings. more than just a mandatory exercise by
of a securitys creditworthiness to The Capital Requirements Directive identifying greater incentives for them
determine its investment grade. (CRR) require credit institutions to adopt ratings. It has been observed
and remove references to external to have strong credit evaluation that globally, self-regulation for CRAs
credit ratings. The Federal Deposit framework and credit decision has not worked effectively due to
Insurance Corporation (FDIC) ensures processes in place irrespective of revenue and profitability pressures and
depository institutions using IRB whether they grant loans or incur loss of market share. Also, the fact that
(Internal Ratings Based) supplement securitisation exposures. However, there remains conflict of interest from
the use of CRAs with internal due for calculation of regulatory bank the Issuer Pay Model and the entire
diligence processes and additional capital requirements, rating agency gamut of non-rating services provided
analyses to demonstrate that CRAs assessments may be, in certain cases by the CRAs need to be evaluated.
24 PwC
SEBI is also revisiting the conflict of 3. Comparability of ratings and 5. Governance of CRAs: The
interest by CRAs and working on display on website: In India, since governance of CRAs is an
remedial measures required to tackle financial education is at a nascent important aspect and regulators
the issue of any possible maneuvering stage, it will be a good idea to should ensure that corporate
by CRAs favouring their major clients display ratings on a common governance is enforced in
through assigning inflated ratings to website for comparison. spirit. CRAs depend on audited
them and bad ratings for clients who 4. Compulsory separation of financial statements provided
have fallen out of favour. The global advisory services into separate by the companies, but also do
regulatory body IOSCO is also working companies: Currently, as per a limited cross-verification.
on a CRA code which is aimed to put regulations, a CRA cannot offer While inherently the auditor
in place a strong regulatory framework fee-based services to the rated is responsible for financial
including robust, practical measures. entities, beyond credit ratings statements, the CRAs need to dig
Pursuant to IOSCO guidelines SEBI and research. The regulations deeper to unveil any issues. While
may also take action in this regard. also mandate that a credit rating SEBI has mandated the CRAs
While SEBI has taken multiple steps agency shall maintain an arms to develop their own internal
to improve the efficacy of CRAs, the length relationship between its code of conduct for governing its
regulators may also consider other credit rating activity or any other operations, however, regulators
effective steps as listed below: activity. However, CRAs have need to ensure that this extends
floated subsidiary companies to the maintenance of professional
1. Holistic regulatory framework excellence and standards,
and improving regulatory due for undertaking other activities
such as consulting, software integrity, confidentiality,
diligence: A holistic regulatory objectivity, avoidance of conflict
framework encompassing development, knowledge process
outsourcing, research, etc. CRISIL of interests, disclosure of
participation from all stakeholders shareholdings and any interest in
in the credit rating ecosystem and ICRA, the leading players
have separated the advisory the issuer or borrower.
needs to be created. Apart from
looking at the feasibility of business into separate companies, 6. Remedial measures for the
creating an umbrella regulator, managed by separate teams with conflict of interest inherent in the
the agencies need to improve and separate organisation structures. Issuer Pays Model: It has been
update their skills to assess as However, with the proposed argued that there is a inherent
against accepting them easily. umbrella regulator, the conflict conflict of interest in the Issuer
of interest of the CRAs with their Pay model. However, globally the
2. Feasibility of a centralised subsidiaries can be looked into same model is currently followed,
platform for ratings: Regulators from a regulatory arbitrage point though greater transparency is
may look at creating a centralised of view. Also, the CRAs must needed. CRAs need to disclose
platform for ratings. Issuers can disclose all details of conflict of any existing conflict of interest
approach the centralised agency interest which impact their job of and process audit should be
to get their financial instruments ratings. mandated so that strict guidelines
or their company rated. The work are followed with Chinese walls
can be allocated to the registered being effected between the sales
CRAs based on their experience and ratings divisions.
in that type of rating, industry
experience, etc. CRAs may be
encouraged to develop industry
expertise, so that the agencies
can understand industry specific
dynamics better. The above
mechanism may prevent rating
shopping by the issuers and can
also lead to healthy competition
between CRAs.
In the last couple of years, as Indian Efficacy of CRAs being monitored The Financial Stability Board (FSB)
economy witnessed downturn trends, by the regulator through adoption which includes members from G20,
the banks have been straddled with of remedial measures for resolving had set up the Implementation Group
high NPAs and restructured assets. conflict of interest of CRAs on Credit Rating Agencies (CRAs)
Macro-economic dynamics may be Encouraging CRAs to develop to assess the position of compliance
a major contributor, however we industry specific expertise of regulatory framework in the
also believe that inadequate credit country vis--vis the FSB principles
assessments and monitoring during Banks moving towards true risk for reducing reliance on CRA ratings.
the upturn in the economy has based pricing thus encouraging The FSB in its progress report to the St
also contributed to the same. All borrowers to get themselves rated Petersburg G20 Summit titled Credit
participants in the ecosystem, the (solicited ratings). Currently banks Rating Agencies: Reducing reliance
banks, regulators, borrowers and CRAs also monitor market risks, however and strengthening oversight, states
need to take responsibility. it is imperative that banks use this that The Principles recognise that
information also in conjunction CRAs play an important role and their
Our view is while we cannot undo with credit assessment to have a
the mistakes or errors that have ratings can appropriately be used as an
true evaluation of the borrower. input to firms own judgment as part of
been committed in terms of credit
assessment and monitoring, effective Banks should also be encouraged internal credit assessment processes.
steps needs to be taken and a holistic to develop their internal rating But any use of CRA ratings by a firm
approach is the best way forward. All models and validate these ratings should not be mechanistic and does not
stakeholders in the ecosystem need to by comparing them with publicly lessen its own responsibility to ensure
proactively contribute towards a better available ratings and also seek that its credit exposures are based on
credit assessment and monitoring more information from the rating sound assessments.
framework with the regulator enabling agencies, if necessary to be doubly The FSB, in its recently published peer
such initiatives. sure of their credit assessment review report on national authorities
process. implementation of the FSB Principles
Some of our major recommendations
include the following: Feasibility of creation of a for Reducing Reliance on CRA Ratings
centralised platform for credit finds that Indian regulatory regime has
Effective use of early warning ratings, where issuers can approach put in place systems and procedures to
systems as the monitoring to get themselves rated and develop internal credit risk assessment
mechanism by the banks to allocation of the work can be done and due diligence by the market
proactively detect and resolve to CRAs based on industry expertise participants. We also strongly believe
issues related to the credit risk of and their previous experience with the participation and contribution
the borrower. For the resolution of amongst others. This will also of all stakeholders, a holistic credit
NPAs, an end to end NPA lifecycle reduce the conflict of interest and assessment and monitoring is the way
management can also help. can prevent rating shopping by forward to rein in the high level of
To create a holistic regulatory borrowers NPAs and restructured assets.
framework for credit ratings along CRAs also need to effectively use
with an umbrella regulator. market information in their credit
To minimise the opportunity of ratings methodology and put in
regulatory arbitrage place a strong corporate governance
so that conflict of interest can be
effectively resolved.
26 PwC
Glossary
Term Meaning
% Percentage
~ Estimate
'000 Thousands
ARC Asset reconstruction companies
AXIS Axis Bank
Bn Billion
BOB Bank of Baroda
c. Approximate
CAGR Compounded annual growth rate
CDR Corporate debt restructuring
CPI Consumer Price Index
EBITDA Earnings before interest, depreciation, taxes and amortisation
EWS Early warning signal
FED Federal Bank
FY Financial year
FYXXE Financial year expectation
FYXXP Financial year projection
GCF Gross capital formation
GDP Gross domestic product
GNPA Gross non-performing asset
HDBK HDFC Bank
ICBK ICICI Bank
INBK Indian Bank
INGV ING Vysya
INR Indian national rupee
JLF Joint lenders' forum
KTKM Kotak Mahindra Bank
LPG Liquefied petroleum gas
Mn Million
NA Not available
NNPA Net non-performing asset
No. Number
NPA Non-performing asset
Term Meaning
OBC Oriental Bank of Commerce
p.a. Per annum
PAT Profit after tax
PNB Punjab National Bank
PSU Public sector unit
RA Restructured asset
RBI Reserve Bank of India
RoE Return on equity
SA Stressed assets
SBI State Bank of India
SKO Superior kerosene oil
SR Security receipts
SMA Special mention accounts
Tn Trillion
USD United States dollar
YES Yes Bank
YoY Year-on-year
Improving efficacy of credit rating agencies 27
Notes
28 PwC
Improving efficacy of credit rating agencies 29
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