Credit Rating

Introduction

Overall credit worthiness of a borrower measured on a predefined scale, assessed by an independent agency and informed to lenders is called as Credit Rating.

Thus, credit rating is an evaluation of the likelihood of a borrower to default on a loan which is an expression of creditworthiness based upon the present financial condition and past credit history.

Credit ratings are expressed as letter grades such as A- or B or C+ which are based on various factors like borrower’s payment history, foreclosures, bankruptcies and charge-offs.

There is no exact science to rate a particular borrower’s creditworthiness or risk-profile and so different lenders may assign different grades to the same borrower.

Definition

As per SEBI, Credit Rating means an opinion regarding securities, expressed in the form of standard symbols or in any other standardized manner, assigned by a credit rating agency and used by the issuer of such securities, to comply with a requirement specified by SEBI regulations.

Credit Rating Agencies

A CRA is a company that assigns credit ratings for issuers (companies, non-profit organizations or national governments) of certain types of debt and other obligations who issue debt securities that can be mostly traded on a secondary market.

A credit rating measures credit worthiness, the ability to pay back a loan and affects the interest rate applied to loans.

A company that issues credit scores/ratings for individual creditworthiness is usually called a credit bureau or consumer credit reporting agency.

Functions of Credit Rating Agency

CRAs reduce the information asymmetry between lenders and investors, on one side, and issuers on the other side, about the creditworthiness of companies or countries.

Credit Ratings determine the eligibility of debt and other financial instruments for the portfolios of certain institutional investors due to national regulations that restrict investment in speculative-grade bonds.

CRAs assess creditworthiness of the issuer of bonds and certain other financial instruments.

In a way, regulators have outsourced to CRAs much of the responsibility for assessing debt risk.

CRAs’ role has expanded with financial globalization and has received an additional boost from Basel 2 which incorporates the ratings of CRAs into the rules for setting weights for credit risk.

Supplementary Functions of CRAs

Indian CRAs offer varied services like mutual consulting services which comprises of operations upgradation and risk management

CRAs provide training to the employees and executives of the companies for better management

CRAs examine the risk involved in a new project, chalk out plans to fight it successfully and thus lessen the percentage of risk largely for which they carry on a thorough research and development into the respective industry

CRAs have started offering services to the mutual funds sector through the application of fund utilization services

Basics of Rating

Scales should be uniform and ratings should not create any bias in favor or against any particular company’s securities.

The rating agency must be an independent entity. The borrower or the entity to be rated should not have any interests in the rating agency.

The rating process should be transparent and consultative and it should consider all the realities which affect the creditworthiness of the entity to be rated.

Rating is a dynamic process. All the happenings and decisions that affect credit worth or entity obviously change the ratings also. So, once rated, it is valid for a limited time period and so a periodical review in rating is always necessary.

Rated Entities & Instruments

Corporate Borrowers and Borrowing Instruments

Equity Ratings (IPOs) Industry Ratings Country Ratings

Objectives of Credit Rating

Investor Information and Protection Common Scale of Comparison Time Efficiency Corporate Image Lower Cost of Risk Assessment Regulation Reduce Information Asymmetry

History of Credit Rating

Credit reporting firms were credibility investigators and were established and popularized in the US in late 1800s.

Rating as a commoditized service mainly started with the establishment of the 3 rating majors.

Standard & Poor’s - Henry Varnum Poor first published the "History of Railroads and Canals in the United States" in 1860, the forerunner of securities analysis and reporting to be developed over the next century. Standard Statistics formed in 1906, which published corporate bond, sovereign debt and municipal bond ratings. Standard Statistics merged with Poor's Publishing in 1941 to form Standard and Poor's Corporation, which was acquired by The McGraw-Hill Companies, Inc. in 1966. Standard and Poor's has become best known by indexes such as the S&P 500, a stock market index that is both a tool for investor analysis and decision making and a U.S. economic indicator.

History of Credit Rating

Moody’s - John Moody and Company first published "Moody's Manual" in 1900. The manual published basic statistics and general information about stocks and bonds of various industries. From 1903 until the stock market crash of 1907, "Moody's Manual" was a national publication. In 1909, Moody began publishing "Moody's Analyses of Railroad Investments", which added analytical information about the value of securities. Expanding this idea led to the 1914 creation of Moody's Investors Service, which, in the following 10 years, would provide ratings for nearly all of the government bond markets at that time. By the 1970s, Moody's began rating commercial papers and bank deposits, becoming the full-scale rating agency that it is today.

History of Credit Rating

Fitch - John Knowles Fitch founded the Fitch Publishing Company in 1913. Fitch published financial statistics for use in the investment industry via "The Fitch Stock and Bond Manual" and "The Fitch Bond Book." In 1924, Fitch introduced the AAA through D rating system that has become the basis for ratings throughout the industry. With plans to become a full-service global rating agency, in the late 1990s, Fitch merged with IBCA of London, subsidiary of Fimalac, S.A., a French holding company. Fitch also acquired market competitors Thomson BankWatch and Duff & Phelps Credit Ratings Co. Beginning in 2004, Fitch began to develop operating subsidiaries specializing in enterprise risk management, data services and finance industry training with the acquisition of Canadian company, Algorithmics and the creation of Fitch Solutions and Fitch Training. It is currently dual-headquartered in New York and London.

Worldwide Rating Agencies

There are 5 Nationally Recognized Statistical Rating Organizations in the US.

The top 3 are Standard & Poor’s, Moody’s and Fitch. The other two are A M Best (specializes in Insurance company

ratings for their ability to pay claims) and Dominion Bond Rating Service (based in Toronto, Ontario and having its operations in US and Canada, it is one of the largest CRAs in Canada which was founded in 1976).

Baycorp Advantage (Australia) is the largest credit bureau in Australia and New Zealand (Australasia).

Dun and Bradstreet or D&B (US) is among the leading providers of business information best known for its DUNS (D&B Universal Numbering System) identifiers assigned to over 2.7 million US companies.

UK Data Ltd (UK) provides fully qualified credit scores, directors’ information and financial data for most of the UK and Irish companies.

Regulations in India

Credit Rating in India is governed by “SEBI (Credit Rating Agencies) Regulations, 1999”

As per this regulation, only the following entities can apply to SEBI to start a CRA in India – public financial institution, scheduled commercial bank, foreign bank operating in India, foreign CRA or any company or body corporate having continuous net worth of a minimum of Rs.100 crores (private sector company-100 crores and public sector company-5 crores) as per its audited annual accounts for the previous 5 years prior to filing of the application.

The applicant should have adequate infrastructure, professional competence and the promoters should not have any legal case against them pending in any courts of law or they should not have any history of conviction under the Indian Law.

Every CRA should enter into a written agreement with each client whose securities it proposes to rate and such agreement should specify rights and liabilities, fees, etc.

Every CRA should, during the lifetime of securities rated by it continuously monitor the rating of such securities and take periodic review.

Regulations in India

A CRA should not withdraw a rating so long as the obligations under the security rated by it are outstanding except where the company whose securities were rated is wound up or merged or amalgamated with another company.

Every CRA shall frame appropriate procedures and systems for monitoring the trading of securities by its employees in the securities of its clients.

Every CRA should make public the definitions of the concerned rating, along with the symbol and make available to the general public information relating to the rationale of ratings, which cover an analysis of the various factors justifying a favorable assessment as well as factors constituting a risk.

Every CRA should maintain proper books of accounts. Every CRA should treat, as confidential, information supplied to it by the

client and no CRA shall disclose the same to any other person, except where such disclosure is required or permitted by under or any Law.

As per the regulations, the client should obtain a rating from at least 2 different CRAs for issue of debt securities whose size is equal to or exceeds Rs.100 crores.

Credit Rating Process

Rating Request Collection of Information Management Meeting Rating Committee and Assignment of Rating Advice to the Client (Issuer) Appeal Publication Surveillance and Review

Rating Considerations

Ratings are based on an in-depth study of the industry as also an evaluation of the strengths and weaknesses of the company.

The factors considered are as follows:- Marketing Strategies Competitive Edge Level of Technological Development Operational Efficiency Competence and Effectiveness of the Management Hedging of Risks Cash Flow Trends and Potential Liquidity and Financial Flexibility Government Policies Past Record of Debt Servicing Sensitivity to possible changes in Business/Economic

circumstances

SEBI approved CRAs in India

Credit Rating Information Services of India Limited (CRISIL)

Investment Information and Credit Rating Agency of India (ICRA)

Credit Analysis and Research Limited (CARE) Fitch Ratings India Private Limited (Fitch) SME Rating Agency of India Limited (SMERA) For Individual Credit Rating (Credit Bureaus) ONICRA Credit Rating Agency of India Limited Credit Information Bureau of India Limited (CIBIL)

Benefits of Credit Rating to the Investors

Information regarding the relative ranking of the default loss probability for a given fixed income investment in comparison with other rated instruments.

Independent and professional judgment of the credit quality of the instrument.

It is a low cost supplement to the in-house appraisal system of organized institutional investors.

Ratings can be used by the investor to optimize risk return preference.

Benefits of Credit Rating to the Issuers

There is faith placed by the market on opinions of rating agencies.

Credit rating could be a useful benchmark for issue pricing and result in savings in costs.

Intermediaries such as merchant bankers or regulators use ratings for pricing and governance.

Limitations of Credit Ratings

They are only opinions and not recommendations to invest. They do not take into account many aspects (reasonableness

of issue price, possibilities for capital gains or liquidity in secondary market) which influence an investment decision.

Ratings can only be changed periodically and thus they cannot change in immediate response automatically.

Ratings are based on some events, news or happenings. Thus, they follow market happenings which ideally should be the other way round. Thus, ratings have a drawback of lagging markets.

Ratings overreact when they do change. CRAs’ overreaction may have aggravated financial crisis in the recent past contributing to financial instability.

Ratings also do not take into account the risk of prepayment by the issuer.