InvestorQ : Can you tell me what did the SEBI make changes regarding credit enhancement in the case of credit rating agencies?
Niti Shenoi made post

Can you tell me what did the SEBI make changes regarding credit enhancement in the case of credit rating agencies?

ishika Banerjee answered.
1 month ago

In the week just concluded, SEBI announced a new framework for credit rating agencies with special reference to ratings with explicit credit enhancement (CE) features. A credit enhancement is any factor that reduces the risk of the lender and makes the borrower more attractive. These rules would be applicable from January 2023 to all rated securities irrespective of whether such securities are listed or unlisted. As per the modified regulations announced by SEBI, to give a clearer and more transparent picture, the rating agencies can attach the suffix CE where there is explicit credit enhancement available.

Here is what we understand by credit enhancement or CE. It comprises of all factors that reduce the risk of a loan. For instance, the promoter of the company offering personal shares as a pledge is a classic instance of credit enhancement. Not to forget, a personal guarantee of the promoter would also be a credit enhancement. SEBI has been specific that such personal guarantees must be unconditional and irrevocable. Hence a letter of comfort alone would not classify as credit enhancement. Similarly, guarantees by the government or financial institution or a strong parent company can also be an enhancement.

Such credit enhancements would be subject to certain caveats. The company would have to disclose the unsupported ratings without factoring in credit enhancement also, apart from the rating with credit enhancement. The company must clearly disclose all the covenants with explanation so as to give a transparent picture. The onus would still be on the CRA to conduct a due diligence and satisfy itself that such CE is valid and actually meaningful. Ideally, the CRA must also get independent legal opinion to ascertain the robustness and heft of the credit enhancement. Above all, such CEs must be legally enforceable.

As per SEBI, the main condition is that the credit enhancements should be actually capable of mitigating the risk of the security. Conditional enhancements cannot be accepted. In the case of guarantees given, the CRA must convince itself that the guarantor leads to credit enhancement. That means; the guarantor should be in a position to deliver on the promise and should have a sounder financial position than the borrower. It is a thin line. The borrower must get the benefit of credit enhancements, but there are too many legal ambiguities to worry about. CE is in, but it is not going to come easy.