New rating methodology means more downgrades, says Moody’s

In a recent note, the Indian arm of Moody’s Investor Services, ICRA, has cautioned the markets that the April circular from the RBI on guarantees on loans, if implemented, could entail a huge cost for the economy as a whole. According to ICRA, if the regulations of the RBI were implemented, then a total of 100 companies with aggregate debt of more than Rs35,000 crore could be impacted. In fact, ICRA expects that post the stringent norms for rating agencies announced by the RBI. There could also be downgrade by 2 notches.

We will come back to the details of the announcement later, but the moral of the story is that there should be uniformity in the way investments and guaranteed are dealt with and factored into rating measurements. However, the chunk of the problems will arise in specific industries like power, healthcare, engineering, construction and roads. Even without their credit profile changing, ICRA believes that there could be a slew of downgrades and that could seriously impact their fund raising ability, in the midst of tight markets.

The impact may be a little more serious for the Indian banking industry. It is estimated that these banks combined could have to set aside an additional Rs400 crore given the higher capital requirement for lower-rated companies. The idea is to address the wide divergence in the methodologies followed by the various rating agencies, which could result in disparity in ratings by different agencies. This will be addressed once the new norms are implemented for the borrowers to standardize rating agency inputs.

Main issue is in the treatment of debt guarantees

When lenders lend to a company, there are ways in which they try and minimize their risk by in insisting on a cover or a back-to-back asset to give comfort. One of the popular ways of enhancing the worth of the loan receivable is to get a guarantee. This can be a corporate guarantee, an individual guarantee or even a promoter guarantee. Essentially, there is someone who guarantees for a fee that the borrower will honour the loan commitment and if the borrower fails, then the guarantor will take charge of the liability. However, over a period of time, these guarantees started getting diluting, making the job tougher.

What does this RBI circular imply in particular? It explicitly prohibits considering any non-enforceable guarantees as a guarantee for the purpose of credit rating and for cost of funds. We recently saw in the case of zee Entertainment and the RCOM case, where the letters of comfort were given and could not be enforced. Most of these new-fangled ideas like letter of support or comfort, are not legally enforceable and, therefore, as per the RBI, and they do not constitute a proper guarantee. This will have to come into force within six months.

There is an exception that these RBI norms have made in the case of such letters. For instance, letters of comfort issued by central and state governments and which are legally enforceable, irrevocable and unconditional, can be considered as an input for the rating and can also be treated as a valid supporting structure for the rating purpose. While this is going to have its repercussions on the ratings, it is right that many of Indian rules are either too ambiguous and or too lax. A bit of tightening can go a long way in preventing mis-selling.