Credit Ratings shall support Credit Enhancement: SEBI

Nikhil Mogha

03 Oct, 2022

To reduce the risk to investors over structured financial assets, the SEBI, on 28^th September 2022, issued a framework for credit rating agencies on ratings of securities for Credit Enhancement. The framework provides that the credit rating agencies shall involve explicit credit enhancement features along with security credit ratings.The framework is issued to provide transparency and an improved rating process so the investor can make an informed decision.

What are Credit Ratings and Credit Enhancement?

A credit rating is generally allocated to security. It is the process of analysing the Credit Risk of any financial instrument or an entity. The rating is given to an entity or the security based on its past borrowing and lending performances in the market. It is a detailed report based on the previous borrowing and lending activities of any financial instruments and is used to determine the creditworthiness of any financial entity. The credit rating helps determine any financial entity’s ability to meet its debt obligations.

Credit Enhancement is a technique the company uses to improve their credit ratings in the market. It can be done through external and internal sources to enhance their creditworthiness in the market and determine the capacity to repay the debt.

Applicability of the Framework

The Framework on Credit enhancement rating shall be effective from 1^st January 2023, and it shall be applicable on the securities that are:

1. Listed
2. Proposed to be listed on RSE( Recognised Stock Exchange).
3. Other Credit Ratings are required under SEBI regulations.

Reporting of Credit Rating agencies

The framework has stated that the Credit Rating agencies shall, within one quarter from 1^st January 2023, submit the report of the compliance with SEBI.

Credit Rating shall suffice “CE”

The framework has provided that credit ratings for securities that are listed and are proposed to be listed on the Recognised Stock Exchange shall carry the suffix “CE” if a third party does the credit enhancement, provided that the security rated is not bankruptcy remote of the issuer or originator.

Measures to be appointed by the Credit Rating Agencies

The framework aims to provide transparency in the rating process of security. It provides that wherein any specified support considerations for Suffix “CE” mentioned below is used for the credit rating shall have to follow measures specified in the framework.

1. Guaranteed Bond
2. Covered Bonds which primarily serviced by the issuer
3. Partially Guaranteed Bond
4. CMBS (Commercially Mortgage Backed Securities)^[1]
5. SBLC (Standby Letter of Credit) backed securities.
6. Debt backed by Pledge of Shares or other Assets
7. Guaranteed PBI ( Pooled Bond Issuance)
8. Obligor or co-obligor structures
9. Cross-default guarantee structures
10. Debt backed by Payment Waterfall or DSRA etc.
11. LOC (Letter of Comfort)

The measures adopted by the credit rating agencies for Credit Enhancement are:

1. There shall be a press release for the credit ratingswith or without the suffix “CE”, which shall contain the following disclosures:
2. Unsupported ratings without factoring in the explicit CE or support considerations.
3. Supported factoring after the explicit CE or supported considerations.
4. A detailed explanation ofall the covenants of security
5. The Credit Rating Agencies(CRA) shall independently conduct due diligence on the supported considerations before assigning ratings to security. The CRA can also obtain any legal opinion for ascertaining the strength of CE.
6. The Credit Rating Agencies shall verify the documents related to the supported considerations and shall ensure that:
7. The support is unconditional, legally enforceable and irrevocable till all the obligation is paid to the investors.
8. The Credit agencies shall independently conduct an examination of the service provider to ascertain the possibility of paying all the obligations of the
9. Verificationof service provider to ascertain the ability tosupport the obligations guaranteed by the service provider.

Monitoring

The framework provides that there shall be a half-yearly Internal Audit of the Credit Rating Agencies to monitor whether the provisions of the framework are followed or not.

Conclusion

The current framework is established to determine the credit enhancement ratings of the security and provides for a transparent and improved rating process. The credit rating agencies are required to independently conduct the examination of any credit enhancement by the third party and shall appoint an external legal consultant when warranted. The framework aims to provide security to the investors so they can make an informed decision about the financial entity and any financial instrument. It is also necessary that the Credit Rating Agencies shall, while rating the security, also suffix “CE” when the third party determines the rating.

Read our Article: SEBI Enhances Disclosures by CRAs and Norms on Rating Withdrawal