SEBI discussed functioning of Credit Rating Agencies

The Sixth meeting of the International Advisory Board (IAB) of the Securities and Exchange Board of India (SEBI) was held on December 21 & 22, 2015. The following major issues were inter alia discussed during the meeting:

i.        Implementation of OECD Principles of Corporate Governance

While discussing the new OECD Principles of Corporate Governance, the IAB took note of the important global shifts in the market structure (e.g. growing significance of private markets vs. public markets, decline in the number of listed companies etc.) and their implications for the corporate governance.

The IAB commended the impressive degree of India’s compliance with the new OECD Principles. It was noted that India is by and large compliant with the revised principles and it might not be necessary to immediately try to be compliant on one or two remaining areas.

The IAB also observed that while the new OECD code recognizes variation in the Equity Markets in different jurisdictions, an advanced code however may not be a guarantee for a well-functioning corporate sector. Further, the cost of compliance also has to be kept in mind while deciding on the framework.

It was also deliberated that perhaps there is too much focus on external governance whereas the internal governance of corporations is equally important. Also, different corporations may have to be treated differently in terms of corporate governance norms keeping in view the complexity and their ownership structure. It was also pointed out that good corporate governance is an outcome of a combination of self discipline at the level of corporates, regulatory discipline and market discipline.

The IAB was of the considered view that a 100 % compliance with the OECD principles, though desirable, may not be absolutely necessary. It was further agreed that effective enforcement of prescribed standards is also important. It was therefore suggested that SEBI may have a strategy to implement its existing policies on the ground.

The IAB further observed that the new OECD code reflects on the lessons arising out of the global financial crisis and the recent scandals. IAB was of the view that SEBI should complement the new code with a forward looking approach and consider the emerging trends and role of the corporate sector in the 21st century in its policy making.

ii.      Spot Price Determination of Commodities

The IAB was apprised of the fact that SEBI has recently taken over the regulation of the commodities derivative markets within its ambit. It was pointed out that alignment of future to spot prices, though challenging, is a must for a well-functioning commodity futures market. In this context, the IAB deliberated on the price polling mechanism for the determination of spot prices of commodities. The IAB suggested that it needs to be ensured that the rules are fair, that nobody is manipulating the markets and that if somebody speculates, it should not put the markets at risk.

Observing that some researchers have indicated poor correlation between spot prices and future prices of commodities in India, the IAB suggested that –

• The present price polling mechanism to determine spot prices may need to be suitably reviewed.
• There may be some regulation and financial obligations on the agencies participating in the price polling framework so as to ensure better accountability.
• Some sort of close watch on the physical markets may also be necessary to reduce asymmetry between the polled and the actual spot price.
• Both physical and cash settled contracts may be continued.

iii.     Issues with respect to functioning of Credit Rating Agencies

The IAB deliberated on the prevalent mechanism on functioning of Credit Rating Agencies (CRAs). It was highlighted that the rating business involving giving of opinions follows asymmetric processes. IAB felt that rating is a public good and therefore the independence and credibility of CRAs in this context assumes special significance. While acknowledging the Code of Conduct for CRAs prescribed by the International Organization of Securities Markets (IOSCO), the IAB also noted the emphasis laid on reducing reliance on CRAs by international standard setters. Some specific recommendations given by the IAB include the following:

• The composition of the rating committee may be left to the CRAs given that the market may be able to factor in the credibility of credit rating process. What may be required for SEBI is to work towards improving rating processes, enhancing transparency and removing conflict of interest.
• The disclosures of ratings of an issuer by CRAs may also include the rating transition of the issuer in the past as a track record of the rated issuer and also to reflect on the consistency of ratings by the CRAs.
• On withdrawal vs. suspension of ratings in cases where information required for rating is not forthcoming from the issuer, suspension with reasons thereof may be the first step and this could be followed up with withdrawal of ratings where necessary.
• On the disclosures of ratings, the issuers should disclose all ratings obtained by them even in case of non-public issues so as to curtail the scope of ‘rating shopping’.

iv.     Market Conduct 

IAB discussed the issue of conduct risk in the context of Libor crisis and the consequent global regulatory focus on strengthening the conduct regulation particularly at the individual level.  It was noted that the root of the problem is that the financial markets are ‘too big to understand’ and not typically transparent. It was agreed that while this is an extremely complex matter, it is the regulator’s responsibility to take active measures for ensuring good behavior and appropriate conduct in the markets. The recommendations made by the IAB included the following:

• There is a greater evolving focus on the micro prudential risks rather than the macro prudential risk. Also there is a greater need for securities market regulators to work closely with central banks in dealing with systemic level macro prudential risks.
• There is need for a more granular regulatory approach to both market activities and also the conduct of individuals in the market.
• Both individuals and firms should be held accountable for misconduct.
• Regulators have limited resources. Therefore, as a part of the conduct regulation,  regulator should follow the money and look for toxic behavioral elements at all levels right from product design to execution of transactions.
• Experience shows that fines have limited impact. Therefore, changing the culture of firms is becoming more important rather than regulating only in the traditional ways of setting the rules and levying fines.
• Drive towards conduct regulation should be inter alia guided by the kind of market structure regulator would like to have, need for transparency and need for competition.
• Increasing impact of technology (e.g. algo trading) on market is a grey area and has to be factored in while evolving strategy for conduct regulation.
• For ensuring the integrity of benchmark determination by market, the regulator may need to monitor transaction level data.
• Cross jurisdictional market manipulation is an emerging grey area and would require more cooperation between regulators.  

v.      Bankruptcy Mechanism in India – Issues and Concerns

IAB discussed the current Bankruptcy framework in India, various measures that have been taken in the past to address revival of sick companies, and recovery of debts due to banks and financial institutions and the proposed Bankruptcy Bill. The IAB found the proposed Bill to be in the right direction as it is expected to streamline the insolvency process and bring quicker resolution.

Further, with a view to strengthen the various Tribunals under the proposed Bill, it was suggested that adequate infrastructure may be provided. Also, a clear segregation of clients’ assets may be recognized and they should not from part of debtor’s estate.

SEBI had constituted the IAB in September, 2011, as part of the measures initiated by SEBI to respond to the challenges arising out of the global financial crisis. The role of IAB is to guide SEBI with its advice on future direction for the organization, taking into account relevant global experiences, emerging challenges and latest developments in the regulatory space.

Meetings of IAB are organized by SEBI in India. Its previous five meetings were held in January  2012, November 2012, November 2013, July 2014 and May 2015.

The current Members of the IAB, in addition to Chairman, SEBI are Prof. Viral Acharya, Ms. Jane Diplock, Mr. Russell Loubser, Prof. Colin Mayer, Mr. Blair Pickerell and Dr. Andrew Sheng (arranged alphabetically by their surnames).Prof. Mayer has recently joined the IAB.

Prof. Acharya is the C.V. Starr Professor of Economics in the Department of Finance at New York University Stern School of Business and a Member of Advisory Scientific Committee of European Systemic Risk Board.

Ms. Diplock is presently an Independent Director of Singapore Exchange Limited, Australian Financial Services Group Pty Limited, International Integrated Reporting Committee Board and Member of Public Interest Oversight Board (PIOB). She is also the former Chairman of both the Executive Committee of IOSCO and of the New Zealand Securities Commission.

Mr. Loubser, former CEO of Johannesburg Stock Exchange, has been one of the prime movers of modernization and development of stock exchange business in South Africa. He was a member of the team that started the Futures Industry in South Africa in 1987. He has served as Chair, Working Committee of World Federation of Exchanges and as Deputy Chair of South African Futures Exchange. Mr. Loubser was also a member of the prestigious King Commission on Corporate Governance.

Prof. Mayer is the Peter Moores Professor of Management Studies at Saïd Business School, and the former Peter Moores Dean of the School between 2006 and 2011. He is an expert on all aspects of corporate finance, governance and taxation, the regulation of financial institutions and the role of the corporation in contemporary society. has served on the editorial boards of several leading academic journals and assisted in establishing prestigious networks of economics, law and finance academics in Europe at the Centre for Economic Policy Research and the European Corporate Governance Institute.

Mr. Pickerell has been a leader in the Asian investment management industry for the past 30 years. He is Chairman, Asia of Nikko Asset Management Co. Prior to this, Pickerell was Chief Executive of Morgan Stanley Investment Management for three years. Before that he was Chief Executive, Asia Pacific, of HSBC Asset Management Ltd. and Chairman of Jardine Fleming Funds (now JP Morgan Funds).

Dr. Sheng, the former Chairman of the Securities and Futures Commission of Hong Kong, is well known in global financial circles as a former central banker and financial regulator in Asia and a commentator on global finance.  As President of the Fung Global Institute, Dr. Sheng is responsible for its operations and for driving its research agenda and thought leadership. He is also the Chief Adviser to the China Banking Regulatory Commission and a Board Member of the Qatar Financial Centre Regulatory Authority.

Mr. Prashant Saran, Mr. Rajeev Kumar Agarwal & Mr. S. Raman – Whole Time Members of SEBI, and the Executive Directors of SEBI also participated in the deliberations.

Mumbai

December 23, 2015