Sikkim-Manipal University Of Health, Medical and Technological

SciencesManipal-576104.

PROJECT REPORTSubmitted in partial Fulfillment of Master of Business

Administration (MBA-Finance)Entitled

“CREDIT RATING IN INDIA-A CASE OF ACCOUNTABILITY’’

By

SACHIN GANGADHAR INGALERoll no: 511136453

Study Center: Eduway Academy Pvt. Ltd.CBD Belapur, Navi Mumbai (Center code-1736)

Sikkim-Manipal University of Health,Medical and technological Sciences

Distance Education WingSyndicate HouseManipal-576104.

Dec 2012

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Acknowledgements

I would like to take this opportunity to thank all those people without whom this project would have been impossible.

First and foremost, , for his expert guidance, and encouragement.

I would like to thank, for guiding me to prepare for this project.

I am extremely grateful to those who directly and indirectly helped me in completing my project work and making it successful.

Sachin Gangadhar IngaleRoll no:511136453MBA Student

Students Declaration

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I, Sachin Gangadhar Ingale student of MBA Programme, (Roll no. 511136453), Sikkim-Manipal University studying through Eduway Academy Pvt.Ltd (center code:01736) CBD Belapur hereby declare that this project entitled

“Credit Rating in India-A case of accountability’’

Submitted in partial fulfillment for the degree of Masters of Business Administration (MBA) to Sikkim-Manipal University, India is my original work and not submitted for the award of any Degree, Diploma, Fellowship or any other similar Title or Prizes.

All the above information provided from our institution is true to the best of my knowledge to fulfill and restrict this project work only and his information exceeds beyond. These facts and figures quoted here are true information but not to quote or publish else than outside of this project work.

Place: Eduway Academy Pvt Ltd, CBD Belapur SACHIN GANGADHAR INGALE

Roll no: 511136453 MBA Student

Date:

Sikkim-Manipal University

Bonafide Certificate:

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BONAFIDE CERTIFICATE

This is to Certified that this project report titled

“Credit rating in India- A case of Accountability”

is the bonafide work of SACHIN GANGADHAR INGALE

who carried out the project work under my supervision.

SIGNATURE SIGNATUREHEAD OF THE DEPARTMENT FACULTY INCHARGEDepartment: MANAGEMENT Department: MANAGEMENT Institution: EAPL Institution: EAPL

Study center: Eduway Academy Pvt. Ltd.

Project Assessment

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Examiner’s Certification

This MBA Project ReportBy

SACHIN GANGADHAR INGALE Roll no: 511136453

Of Sikkim-Manipal UniversityUndertaken through Eduway Academy, CBD Belapur

EntitledIs approved and Accepted in Quality and Form

Internal Examiner: Signature:

Name: Mohammed Arshad Qualification: MBADesignation: DIRECTORDepartment: MANAGEMENTInstitution: EDUWAY ACADEMY PVT. LTD.

External Examiner: Signature:Name: Mohammed Hanif Lakdawala Qualification:MPHILDesignation: HOD Department: ManagementInstitution: AP COLLEGE

University Guide’ Certification

This is to certify that this MBA Project Entitled

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Credit rating in India- A case of accountability

Is submitted in partial Fulfillment of the requirement Degree of

MASTER OF BUSINESS ADMINISTRATION (MBA)By

SACHIN GANGADHAR INGALERoll no: 511136453

UnderSikkim-Manipal University of Health, Medical and Technology

Sciences, Manipal.

Has worked under my supervision and guidance. I hereby state that no part of this report has been submitted for the

award of any Degree, Diploma, Fellowship or any other similar titles or prizes and that the work has not been

published in any journal or magazine.Certified By

Name:

Designation: DIRECTOR

Organization: EDUWAY ACADEMY PVT. LTD.

Signature:

Date :

The HR ManagerXYZ Pvt. Ltd. Date:

Dear Sir/Madam,

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___________ is a bona fide student of Sikkim Manipal University Department of Distance Education, currently enrolled in the third semester of the MBA program, with specialization in the area of _________________.

As part of the requirements of the MBA degree, he/she is required to complete a Project of approximately eight months’ duration in his/her area of specialization. This should ideally be a live Project on an ongoing problem faced by the organization, under the supervision of a company guide. The objective of the project is to enable the student to apply his/her theoretical knowledge, problem solving and analytical skills and to equip himself/herself to face the challenges of the real world. Evaluation of the project will be based on a written report, as well as an oral presentation, after which a certificate of completion should be given by the organization.

I would be grateful if an opportunity could be given to ________ to work on such a project in your esteemed organization. Please review his/her enclosed resume and let me know if a suitable project would be available in his/her area of specialization.

Looking forward to a positive response,

Sincerely,

Company HeadSignature with Seal

TABLE OF CONTENT Page NoPart I 1.1 Introduction

1.2 Origin

1.3 Meaning And Definition

9 -17

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1.4 Importance of Credit Rating

1.5 Factors Affecting Assigned Ratings

Part II

2.1 Nature Of Credit Rating

2.2 Instruments for Rating

2.3 Functions Of Credit Rating Agency

2.4 Advantages Of Credit Rating

A. Benefits to Investors

B. Benefits of Rating to the Company

C. Benefits to Intermediaries

2.5 Disadvantages of Credit Rating

18 - 35

Part III3.1 Indian Credit Rating in INDIA- A case

for accountability36 - 43

Part IV

Significance Of Credit Rating In India

4.1 Definition

4.2 Credit rating agencies

4.3 Rating Grades

44 - 52

Part V

5 Project Report On Significance Of Credit

Rating In India

5.1 CRA

5.2 AAA

5.3 CARE

5.4 Ratings use in structured finance

53 - 66

CTEDIT RATING

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1.1 Introduction –

A credit rating evaluates the credit worthiness of a debtor, especially a business

(company) or a government. It is an evaluation made by a credit rating agency of the

debtor's ability to pay back the debt and the likelihood of default.

Credit ratings are determined by credit ratings agencies. The credit rating represents

the credit rating agency's evaluation of qualitative and quantitative information for a

company or government; including non-public information obtained by the credit rating

agencies analysts. Credit ratings are not based on mathematical formulas. Instead, credit

rating agencies use their judgment and experience in determining what public and

private information should be considered in giving a rating to a particular company or

government. The credit rating is used by individuals and entities that purchase the

bonds issued by companies and governments to determine the likelihood that the

government will pay its bond obligations. A poor credit rating indicates a credit rating

agency's opinion that the company or government has a high risk of defaulting, based

on the agency's analysis of the entity's history and analysis of long term economic

prospects.

With the increasing market orientation of the Indian economy, investors value a

systematic assessment of two types of risks, namely “business risk” arising out of the

“open economy” and linkages between money, capital and foreign exchange markets

and “payments risk”. With a view to protect small investors, who are the main target for

unlisted corporate debt in the form of fixed deposits with companies, credit rating has

been made mandatory. India was perhaps the first amongst developing countries to set

up a credit rating agency in 1988. The function of credit rating was institutionalized

when RBI made it mandatory for the issue of Commercial Paper (CP) and subsequently

by SEBI. when it made credit rating compulsory for certain categories of debentures

and debt instruments. In June 1994, RBI made it mandatory for Non-Banking Financial

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Companies (NBFCs) to be rated. Credit rating is optional for Public Sector

Undertakings (PSUs) bonds and privately placed non-convertible debentures upto Rs.

50 million. Fixed deposits of manufacturing companies also come under the purview of

optional credit rating.

1.2 Origin –

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The first mercantile credit agency was set up in New York in 1841 to rate the

ability of merchants to pay their financial obligations. Later on, it was taken over

by Robert Dun. This agency published its first rating guide in 1859. The second

agency was established by John Bradstreet in 1849 which was later merged with

first agency to form Dun & Bradstreet in 1933, which became the owner of

Moody’s Investor’s Service in 1962. The history of Moody’s can be traced back

about a 100 years ago. In 1900, John Moody laid stone of Moody’s

Investors Service and published his ‘Manual of Railroad

Securities’.

Early 1920’s saw the expansion of credit rating industry when the Poor’s

Publishing Company published its first rating guide in 1916. Subsequently Fitch

Publishing Company and Standard Statistics Company were set up in 1924 and

1922 respectively. Poor and Standard merged together in 1941 to form Standard

and Poor’s which was subsequently taken over by McGraw Hill in 1966. Between

1924 and 1970, no major new rating agencies were set up. But since 1970’s, a

number of credit rating agencies have been set up all over the world including

countries like Malaysia, Thailand, Korea, Australia, Pakistan and Philippines etc.

In India, CRISIL (Credit Rating and Information Services of India Ltd.) was setup

in 1987 as the first rating agency followed by ICRA Ltd. (formerly known as

Investment Information & Credit Rating Agency of India Ltd.) in 1991, and Credit

Analysis and Research Ltd. (CARE) in 1994. All the three agencies have been

promoted by the All-India Financial Institutions. The rating agencies have

established their creditability through their independence, professionalism,

continuous research, consistent efforts, and confidentiality of information. Duff

and Phelps has tied up with two Indian NBFCs to set up Duff and Phelps Credit

Rating India (P) Ltd. in 1996.

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1.3 Meaning and Definition -

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Credit rating is the opinion of the rating agency on the relative ability and

willingness of tile issuer of a debt instrument to meet the debt service obligations

as and when they arise. Rating is usually expressed in alphabetical or

alphanumeric symbols.

Symbols are simple and easily understood tool which help the investor to

differentiate between debt instruments on the basis of their underlying credit

quality. Rating companies also publish explanations for their symbols used as well

as the rationale for the ratings assigned by them, to facilitate deeper

understanding.

In other words, the rating is an opinion on the future ability and legal obligation of

the issuer to make timely payments of principal and interest on a specific fixed

income security. The rating measures the probability that the issuer will default on

the security over its life, which depending on the instrument may be a matter of

days to thirty years or more.

In fact, the credit rating is a symbolic indicator of the current opinion of the

relative capability of the issuer to service its debt obligation in a timely fashion,

with specific reference to the instrument being rated. It can also be defined as an

expression, through use of symbols, of the opinion about credit quality of the

issuer of security/instrument.

1.4 Importance of Credit Rating-

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Credit ratings establish a link between risk and return. They thus provide a

yardstick against which to measure the risk inherent in any instrument. An

investor uses the ratings to assess the risk level and compares the offered

rate of return with his expected rate of return (for the particular level of risk)

to optimize his risk-return trade-off.

The risk perception of a common investor, in the absence of a credit rating

system, largely depends on his familiarity with the names of the promoters

or the collaborators. It is not feasible for the corporate issuer of a debt

instrument to offer every prospective investor the opportunity to undertake a

detailed risk evaluation. It is very uncommon for different classes of

investors to arrive at some uniform conclusion as to the relative quality of

the instrument. Moreover they do not possess the requisite skills of credit

evaluation.

Thus, the need for credit rating in today’s world cannot be over

emphasised. It is of great assistance to the investors in making investment

decisions. It also helps the issuers of the debt instruments to price their

issues correctly and to reach out to new investors. Regulators like Reserve

Bank of India (RBI) and Securities and Exchange Board of India (SEBI) use

credit rating to determine eligibility criteria for some instruments. For

example, the RBI has stipulated a minimum credit rating by an approved

agency for issue of commercial paper. In general, credit rating is expected to

improve quality consciousness in the market and establish over a period of

time, a more meaningful relationship between the quality of debt and the

yield from it.

Credit Rating is also a valuable input in establishing business relationships

of various types. However, credit rating by a rating agency is not a

recommendation to purchase or sale of a security.

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Investors usually follow security ratings while making investments.

Ratings are considered to be an objective evaluation of the probability that a

borrower will default on a given security issue, by the investors. Whenever a

security issuer makes late payment, a default occurs. In case of bonds, non-

payment of either principal or interest or both may cause liquidation of a

company. In most of the cases, holders of bonds issued by a bankrupt

company receive only a portion of the amount invested by them.

Thus, credit rating is a professional opinion given after studying all

available information at a particular point of time. Such opinions may prove

wrong in the context of subsequent events. Further, there is no private

contract between an investor and a rating agency and the investor is free to

accept or reject the opinion of the agency. Thus, a rating agency cannot be

held responsible for any losses suffered by the investor taking investment

decision on the basis of its rating. Thus, credit rating is an investor service

and a rating agency is expected to maintain the highest possible level of

analytical competence and integrity. In the long run, the credibility of rating

agency has to be built, brick by brick, on the quality of its services provided,

continuous research undertaken and consistent efforts made.

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1.5 Factors Affecting Assigned Ratings-

The following factors generally influence the ratings to be assigned by a

credit rating agency:

1. The security issuer’s ability to service its debt. In order, they calculate the

past and likely future cash flows and compare with fixed interest obligations

of the issuer.

2. The volume and composition of outstanding debt.

3. The stability of the future cash flows and earning capacity of company.

4. The interest coverage ratio i.e. how many number of times the issuer is

able to meet its fixed interest obligations.

5. Ratio of current assets to current liabilities (i.e. current ratio (CR)) is

calculated to assess the liquidity position of the

issuing firm.

6. The value of assets pledged as collateral security and the security’s

priority of claim against the issuing firm’s assets.

7. Market position of the company products is judged by the demand for the

products, competitors market share, distribution channels etc.

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8. Operational efficiency is judged by capacity utilisation, prospects of

expansion, modernization and diversification, availability of raw material

etc.

9. Track record of promoters, directors and expertise of staff also affect the

rating of a company.

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2.1 Nature of Credit Rating -

1. Rating is based on information: Any rating based entirely on published

information has serious limitations and the success of a rating agency will

depend, to a great extent, on its ability to access privileged information.

Cooperation from the issuers as well as their willingness to share even

confidential information are important pre-requisites. The rating agency

must keep information of confidential nature possessed during the rating

process, a secret.

2. Many factors affect rating: Rating does not come out of a predetermined

mathematical formula. Final rating is given taking into account the quality of

management, corporate strategy, economic outlook and international

environment. To ensure consistency and reliability a number of qualified

professionals are involved in the rating process. The Rating Committee,

which assigns the final rating, consists of specialized financial and credit

analysts. Rating agencies also ensure that the rating process is free from any

possible clash of interest.

3. Rating by more than one agency: In the well developed capital markets,

debt issues are, more often than not, rated by more than one agency. And it

is only natural that ratings given by two or more agencies differ from each

other e.g., a debt issue, may be rated ‘AA+’ by one agency and ‘AA’ or

‘AA-’ by another. It will indeed be unusual if one agency assigns a rating of

AA while another gives a ‘BBB’.

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4. Monitoring the already rated issues: A rating is an opinion given on the

basis of information available at particular point of time. Many factors may

affect the debt servicing capabilities of the issuer. It is, therefore, essential

that rating agencies monitor all outstanding debt issues rated by them as part

of their investor service. The rating agencies should put issues under close

credit watch and upgrade or downgrade the ratings as per the circumstances

after intensive interaction with the issuers.

5. Publication of ratings: In India, ratings are undertaken only at the

request of the issuers and only those ratings which are accepted by the

issuers are published. Thus, once a rating is accepted it is published and

subsequent changes emerging out of the monitoring by the agency will be

published even if such changes are not found acceptable by the issuers.

6. Right of appeal against assigned rating: Where an issuer is not satisfied

with the rating assigned, he may request for a review, furnishing additional

information, if any, considered relevant. The rating agency will undertake a

review and thereafter give its final decision. Unless the rating agency had

over looked critical information at the first stage chances of the rating being

changed on appeal are rare.

7. Rating of rating agencies: Informed public opinion will be the

touchstone on which the rating companies have to be assessed and the

success of a rating agency is measured by the quality of the services offered,

consistency and integrity.

8. Rating is for instrument and not for the issuer company: The

important thing to note is that rating is done always for a particular issue and

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not for a company or the Issuer. It is quite possible that two instruments

issued by the same company carry different ratings, particularly if maturities

are substantially different or one of the instruments is backed by additional

credit reinforcements like guarantees. In many cases, short-term obligations,

like commercial paper (CP) carry the highest rating even as the risk profile

changes for longer maturities.

9. Rating not applicable to equity shares: By definition, credit rating is an

opinion on the issuers capacity to service debt. In the case of equity there is

no pre-determined servicing obligation, as equity is in the nature of venture

capital. So, credit rating does not apply to equity shares.

10. Credit vs. financial analysis: Credit rating is much broader concept

than financial analysis. One important factor which needs consideration is

that the rating is normally done at the request of and with the active co-

operation Of the issuer. The rating agency has access to unpublished

information and the discussions with the senior management of issuers give

meaningful insights into corporate plans and strategies. Necessary

adjustments are made to the published accounts for the purpose of analysis.

Rating is carried out by specialised professionals who are highly qualified

and experienced. The final rating is assigned keeping in view the number of

factors.

11. Time taken in rating process: The rating process is a fairly detailed

exercise. It involves, among other things analysis of published financial

information, visits to the issuers offices and works, ‘intensive discussion

with the senior executives of issuers, discussions with auditors, bankers,

creditors etc.

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It also involves an in-depth study of the industry itself and a degree of

environment scanning. All this takes time, a rating agency may take 6 to 8

weeks or more to arrive at a decision. For rating short-term instruments like

commercial paper (CP), the time taken may vary from 3 to 4 weeks, as the

focus will be more on short-term liquidity rather than on long-term

fundamentals. Rating agencies do not compromise on the quality of their

analysis or work under pressure from issuers for quick results. Issuers are

always advised to. approach the rating agencies sufficiently in advance so

that issue schedules can be adhered to.

2.2 Instruments for Rating –

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Rating may be carried out by the rating agencies in respect of the following:

i. Equity shares issued by a company.

ii. Preference shares issued by a company.

iii. Bonds/debentures issued by corporate, government etc.

iv. Commercial papers issued by manufacturing companies, finance

companies, banks and financial institutions for raising sh0l1-term

loans.

v. Fixed deposits raised for medium-term ranking as unsecured

borrowings.

vi. Borrowers who have borrowed money.

vii. Individuals.

viii. Asset backed securities are assessed to determine the risk

associated with them. The objective is to determine quantum of cash

flows emerging from the asset that would be sufficient to meet

committed payments.

Rating Other than Debt Instruments-

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Credit Rating has been extended to all those activities where uncertainty and

risk is involved. Now-a-days credit rating is not just limited to debts

instruments but also covers the following:

I. Country Rating

A country may be rated whenever a loan is to be extended or some major

investment is to be made in it by international investors to determine the

safety and security of their investments.

A number of factors such as growth rate, industrial and agricultural

production, government policies, inflation, fiscal deficit etc. are taken into

consideration to arrive at such rating.

Any upgrade movement in such—ratings has a positive impact on the stock

markets. Morgan Stanlay, Moodys etc. give country ratings.

II. Rating of Real Estate Builders and Developers

CRISIL has started assigning rating to the builders and developers with the

objective of helping and guiding prospective real estate buyers. CRISIL

thoroughly scrutinizes the sale deed papers, sanctioned plan, lawyers’ report

government clearance certificates before assigning rating to the builder or

developer. Past experience of the builder, number of properties built by the

builder, financial strength, time taken for completion are some of the factors

taken into consideration.

MANAGEMENT OF FINANCIAL SERVICES

CRISIL before giving a final rating to the real estate builder/ developer.

III. Chit Funds

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Chit funds registered as a company are sometimes rated on their ability to

make timely payment of prize money to subscribers. The rating helps the

chit funds in better marketing of their fund and in widening of the

subscribers base. This service is provided by CRISIL.

IV. Rating of States

States of India have also approached rating agencies for rating. Rating helps

the State to attract investors both from India and abroad to make

investments. Investors find safety of their funds while investing in a state

with good rating. Foreign companies also come forward and set up projects

in such states with positive rating. Rating agencies take into account various

economic parameters such as industrial and agricultural growth of the State,

availability of raw material, labor etc. and political parties agenda with

respect to industry, labor etc., relation between Centre and State and

freedom enjoyed by the states in taking decisions while assigning final

rating to the states. States like Maharashtra, Madhya Pradesh, Tamil Nadu,

Andhra

Pradesh and Kerala have already been rated by CRISIL.

V. Rating of Banks

CRISIL and ICRA both are engaged in rating of banks based on the

following six parameters also called CAMELS.

C - C stands for capital adequacy of banks. A bank need to maintain at least

10 % capital against risky assets of the bank.

A - A stands for asset quality. The loan is examined to determine non-

performing assets. An asset/loan is considered non-performing asset where

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either interest or principal is unpaid for two quarters or more. Ratios like

NPA to Net Advances, Adequacy of Provision & Debt Service Coverage

Ratio are also calculated to know exact picture of quality of asset of a bank.

M - M stands for management evaluation. Here, the efficiency and

effectiveness of management in framing plans and policies is examined.

Ratios like RO!, Return on Capital Employed (ROC E), Return on Assets

(ROA) are calculated to comment upon bank’s efficiency to utilize the

assets.

L - L indicates liquidity position. Liquid and current ratios are determined to

find out banks ability to meet its short-term claims.

S - S stands for Systems and Control. Existing systems are studied in detail

to determine their adequacy and efficacy. Thus, the above six parameters are

analysed in detail by the rating agency and then final rating is given to a

particular bank.

Ratings vary from A to D. Where A denotes financial, managerial and

operational soundness of a bank, and D denotes that bank is in financial

crisis and lacks managerial expertise and is facing operational problems.

VI. Rating (Recommendation) for Equities

These days analysts specialised in equity ratings make a forecast of the stock

prices of a company. They study thoroughly the trend of sales, operating

profits and other variables and make a forecast of the earning capacity and

profitability position of a company. They use financial statement analysis

tools like ratio analysis, trend analysis, fund flow analysis and cash flow

analysis to comment upon company’s liquidity, solvency, profitability and

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overall efficiency position. Analysts suggest a target price of the stock

giving signal to the investor to swing into action whenever the stock hits that

particular price. The following are some of the recommendations made by

the equity analysts for its investors:

i. Buy: It shows the stock is worth buying at its current price.

ii. Buy on Declines: This recommendation indicates stock is basically good

but overpriced now. The investor should go for buying whenever the price

declines.

iii. Long-term Buy: This recommendation suggests that a stock should be

bought and held for a longer period at least a year in order to realise gains.

v. Out-performer: This recommendation shows that whatever may be the

mood of the stock market the stock will perform better than the market.

vi. Overweight: This refers to that investor can increase the quantum or

weight of that stock in his portfolio. This recommendation is applicable to

those investors who keep number of stocks in their portfolio.

vii. Hold: This recommendation is a suggestion to the investor to exit

because stock prices are not likely to be appreciated significantly from the

current price level.

viii. Sell/Dispose/Sub-Standard/Under-weight: It indicates to the investor

to sell/dispose off or decrease the weight of stock from its portfolio because

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stock is fundamentally overvalued at its current level and the investor’

should exit from it immediately.

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2.3 Functions of a Credit Rating Agency-

A credit rating agency serves following functions:

1. Provides unbiased opinion: An independent credit rating agency is

likely to provide an unbiased opinion as to relative capability of the

company to service debt obligations because of the following reasons:

i. It has no vested interest in an issue unlike brokers, financial

intermediaries.

ii. Its own reputation is at stake.

2. Provides quality and dependable information:. A credit rating agency

is in a position to provide quality information on credit risk which is more

authenticated and reliable because:

i. It has highly trained and professional staff who has better ability

to assess risk.

ii. It has access to a lot of information which may not be publicly

available.

3. Provides information at low cost: Most of the investors rely on the

ratings assigned by the ratings agencies while taking investment decisions.

These ratings are published in the form of reports and are available easily on

the payment of negligible price. It is not possible for the investors to assess

the creditworthiness of the companies on their own.

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4. Provide easy to understand information: Rating agencies first of all

gather information, then analyse the same. At last these interpret and

summarise complex information in a simple and readily understood formal

manner. Thus in other words, information supplied by rating agencies can be

easily understood by the investors. They need not go into details of the

financial statements.

5. Provide basis for investment: An investment rated by a credit rating

enjoys higher confidence from investors. Investors can make an estimate of

the risk and return associated with a particular rated issue while investing

money in them.

6. Healthy discipline on corporate borrowers: Higher credit rating to any

credit investment enhances corporate image and builds up goodwill and

hence it induces a healthy/ discipline on corporate.

7. Formation of public policy: Once the debt securities are rated

professionally, it would be easier to formulate public policy guidelines as to

the eligibility of securities to be included in different kinds of institutional

port-folio.

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2.4 Advantages of Credit Rating-

Different benefits accrue from use of rated instruments to different class of

investors or the company. These are explained as under:

A. Benefits to Investors

1. Safety of investments. Credit rating gives an idea in advance to the

investors about the degree of financial strength of the issuer company. Based

on rating he decides about the investment. Highly rated issues gives an

assurance to the investors of safety of Investments and minimizes his risk.

2. Recognition of risk and returns. Credit rating symbols indicate both the

returns expected and the risk attached to a particular issue. It becomes easier

for the investor to understand the worth of the issuer company just by

looking at the symbol because the issue is backed by the financial strength

of the company.

3. Freedom of investment decisions. Investors need not seek advise from the

stock brokers, merchant bankers or the portfolio managers before making

investments. Investors today are free and independent to take investment

decisions themselves. They base their decisions on rating symbols attached

to a particular security. Each rating symbol assigned to a particular

investment suggests the creditworthiness of the investment and indicates the

degree of risk involved in it.

4. Wider choice of investments. As it is mandatory to rate debt obligations

for every issuer company, at any particular time, wide range of credit rated

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instruments are available for making investment. Depending upon his own

ability to bear risk, the investor can make choice of the securities in which

investment is to be made.

5. Dependable credibility of issuer. Absence of any link between the rater

and rated firm ensures dependable credibility of issuer and attracts investors.

As rating agency has no vested interest in issue to be rated, and has no

business connections or links with the Board of Directors. In other words, it

operates independent of the issuer company, the rating given by it is always

accepted by the investors.

6. Easy understanding of investment proposals. Investors require no

analytical knowledge on their part about the issuer company. Depending

upon rating symbols assigned by the rating agencies they can proceed with

decisions to make investment in any particular rated security of a company.

7. Relief from botheration to know company. Credit agencies relieve

investors from botheration of knowing the details of the company, its

history, nature of business, financial position, liquidity and profitability

position, composition of management staff and Board of Directors etc.

Credit rating by professional and specialised analysts reposes confidence in

investors to rely upon the credit symbols for taking investment decisions.

8. Advantages of continuous monitoring. Credit rating agencies not only

assign rating symbols but also continuously monitor them. The Rating

agency downgrades or upgrades the rating symbols following the decline or

improvement in the financial position respectively.

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B. Benefits of Rating to the Company

A company who has got its credit instrument or security rated is benefited in

the following ways.

1. Easy to raise resources. A company with highly rated instrument finds it

easy to raise resources from the public. Even though investors in different

sections of the society understand the degree of risk and uncertainty attached

to a particular security but they still get attracted towards the highly rated

instruments.

2. Reduced cost of borrowing. Investors always like to make investments in

such instrument, which ensure safety and easy liquidity rather than high rate

of return. A company can reduce the cost of borrowings by quoting lesser

interest on those fixed deposits or debentures or bonds, which are highly

rated.

3. Reduced cost of public issues. A company with highly rated instruments

has to make least efforts in raising funds through public. It can reduce its

expenditure on press and publicity. Rating facilitates best pricing and timing

of issues.

4. Rating builds up image. Companies with highly rated instrument enjoy

better goodwill and corporate image in the eyes of customers, shareholders,

investors and creditors. Customers feel confident of the quality of goods

manufactured, shareholders are sure of high returns, investors feel secured of

their investments and creditors are assured of timely payments of interest

and principal.

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5. Rating facilitates growth. Rating motivates the promoters to undertake

expansion of their operations or diversify their production activities thus

leading to the growth of the company in future. Moreover highly rated

companies find it easy to raise funds from public through new issues or

through credit from banks and FIs to finance their expansion activities.

6. Recognition to unknown companies. Credit rating provides recognition to

relatively unknown companies going for public issues through wide investor

base. While entering into market, investors rely more on the rating grades

than on ‘name recognition’.

C. Benefits to Intermediaries

Stock brokers have to make less efforts in persuading their clients to select

an investment proposal of making investment in highly rated instruments.

Thus rating enables brokers and other financial intermediaries to save time,

energy costs and manpower in convincing their clients.

2.5 Disadvantages of Credit Rating -

Credit rating suffers from the following limitations

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1. Non-disclosure of significant information. Firm being rated may not

provide significant or material information, which is likely to affect the

investor’s decision as to investment, to the investigation team of the credit

rating company. Thus any decisions taken in the absence of such significant

information may put investors at a loss.

2. Static study. Rating is a static study of present and past historic data of

the company at one particular point of time. Number of factors including

economic, political, environment, and government policies have direct

bearing on the working of a company. Any changes after the assignment of

rating symbols may defeat the very purpose of risk inactiveness of rating.

3. Rating is no certificate of soundness. Rating grades by the rating

agencies are only an opinion about the capability of the company to meets

its interest obligations. Rating symbols do not pinpoint towards quality of

products or management or staff etc. In other words rating does not give a

certificate of the complete soundness of the company. Users should form an

independent view of the rating symbol.

4. Rating may be biased. Personal bias of the investigating team might

affect the quality of the rating. The companies having lower grade rating do

not advertise or use the rating while raising funds from the public. In such a

case the investors cannot get the true information about the risk involved in

the instrument.

5. Rating under unfavorable conditions. Rating grades are not always

representative of the true image of a company. A company might be given

low grade because it was passing through unfavorable conditions when

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rated. Thus, misleading conclusions may be drawn by the investors which

hampers the company’s interest.

6. Difference in rating grades. Same instrument may be rated differently by

the two rating agencies because of the personal judgment of the investigating

staff on qualitative aspects. This may further confuse the investors.

Indian Credit Rating in INDIA- A case for accountability

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If there is one business in this world that is minting money without

being accountable, responsible or answerable to any one, it is the

business of credit rating. Whether the economy is in good shape or

bad, whether companies are making profits or not, whether investors

are earning or losing money, the rating companies are there to make

money for themselves, thanks to the wise men in power all over the

world, who have given them unfettered freedom to say what they

want, without any accountability for their actions.

Otherwise how do you reconcile to the fact that different rating

agencies give diametrically opposite rating to the same country, same

product, or same sector with same facts and figures. In the first week

of August 2011, Standard & Poor’s (S&P), a global rating agency

downgraded United States’ sovereign rating by one notch from

‘AAA’ to ‘AA+’ and millions of investors all over the world lost

billions of dollars for no fault of theirs. Around the same time, two

other international rating agencies, namely Moody’s Investors Service

and Fitch Ratings affirmed triple A (AAA) rating of the US

government based on the same data, same facts and same figures.

Nearer home, on 9 November 2011, Moody’s Investors Service

downgraded India’s banking sector to ‘negative’ from ‘stable’,

creating ripples not only in the capital market but also in the corridors

of power in our country. But strangely, on the very next day, S&P

upgraded the country’s banking sector from group ‘6’ to group ‘5’,

citing “high level of stability,  core customers’ deposits, which limit

dependence on external borrowings, and that Indian government is

highly supportive of the banking system.” Curiously, within a week

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thereafter, another rating agency, namely Brickwork Ratings has

maintained a “stable” outlook for the Indian banking sector based on

“rational view of past performance of the banking industry, the

positives and the challenges faced by banks, the regulatory

environment and the implications of the Euro zone crisis”      

                 

The three rating agencies have given three different ratings for our

banking sector all at the same time, based on the same facts and

figures, which proves how subjective is the rating system and how

much reliable is the rating mechanism, causing a sense of concern

among the people of this country.      

             

There is more to rating than meets the eye. On 11th November this

year, S&P committed a blunder by accidentally sending messages to

some of its subscribers that it had lowered France’s Triple A

sovereign rating. Fortunately this mistake happened just after the Paris

bourse had closed and that saved the day for the French investors from

a catastrophe. Within two hours, the agency sent out another message

saying that it was a technical error and that the rating of the French

Republic was unchanged and continued to be Triple A. In the wake of

this goof-up, the European Union Internal Market Commissioner had

called for a rigorous, strict and solid regulation for credit rating

agencies.

During the global financial crisis of 2008, the agencies admitted that

they did make mistakes in their ratings, which partly led to the crisis

and caused the collapse of the world markets then. The rating agencies

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gave their best ratings to borrowers before the housing crisis in

America. It turned out that many were not able to pay their debts

back, resulting in failure of renowned housing finance companies

there.

Are the rating agencies indispensable?

Over a period of time, rating agencies have become a part and parcel

of the economy of the developed and developing countries—either by

design or by default. They are expected to perform certain useful but

onerous functions like educating investors in the art of investment,

protecting the interests of gullible consumers, guiding industries to

raise capital and most importantly serve as a guardian of the country’s

economy by periodically emitting appropriate signals as to where the

economy is headed during both good and bad times for the benefit of

the people of the country and of the world, as well. But recent

developments all over the world show that these rating agencies are

not infallible. Being manned by human beings they make not only

mistakes but blunders, too. Hence there is a need to make them

accountable, responsible and answerable for their actions and their

activities need to be monitored, guided and supervised so that they do

the job expected of them objectively with a sense of purpose and great

responsibility towards the people whom they are supposed to serve.

Following the financial crisis of 2008, the Obama administration

quickly enacted a law called Dodd-Frank Wall Street Reform &

Consumer Protection Act on 21 July 2010. It is an omnibus law with

an aim to create a sound economic foundation to grow jobs, protect

consumers and investors, rein in Wall Street and big bonuses, end

bailouts of too-big-to-fail, and prevent another financial crisis.

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While the Act was touted as the most sweeping change to financial

regulation in the US since the great depression, it contains several

provisions to protect investors by codifying new rules for

transparency and accountability of credit rating agencies, as well. The

Act provides for creation of Office of Credit Ratings (OCR) within

the Securities and Exchange Commission (SEC) to ensure oversight

over Nationally Recognized Statistical Rating Organizations and

enhanced regulation of such entities.

There are 76 rating agencies globally in different countries with 10

rating agencies (eight of US, one each of Canada and Japan) approved

by the SEC. The big three rating agencies are S&P with ratings

revenue of $1.70 billion, Moody’s Investor Services with revenue of

$1.47 billion and Fitch Ratings with a revenue of $554 million for the

year 2010. Seven other agencies have combined revenue of $196

million, as reported in the media. 

                                                   

In India there are seven rating agencies at present, which are approved

by different authorities and different wings of the central government,

depending upon the rating work they undertake. At present, those

agencies active in the capital market are approved by the Securities

and Exchange Board of India (SEBI), those which are active in rating

of bank loans, etc are approved by the Reserve Bank of India (RBI),

and others by NABARD, National Housing Bank and by different

ministries of the government. However, there are no uniform rules for

such approval, nor is there any co-ordination between different

authorities to ensure that the rating agency approved by them has the

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requisite competence to do the job expected of them. To streamline

the entire operations of rating agencies and to keep track of the new

rating companies coming into India, it is necessary to put in place a

regulatory mechanism through a suitable enactment as early as

possible. Here are a few important steps required to be initiated by the

government in the interest of safeguarding the integrity of the

securities market in our country.          

                                                         

1    There must be an independent regulator for the rating agencies,

who should formulate rules and regulations for centralized

registration, reporting, monitoring and ethical functioning of all the

rating agencies in the country. And all other regulators should go by

such registration, instead of doing registration independently.

2    The rating agencies should have complete transparency in their

operations, and periodical reporting of all aspects of rating to the

regulator should be made mandatory.

3    The rating agencies’ promoters, directors and the top management

should be screened by the regulator for their credentials, competence

and their antecedents to ensure that only the deserving and competent

people run this business.

4    Only by putting your money where your mouth is you can be

made accountable for your actions. For this reason, the government

should set up a Bondholders’ Protection Fund (BPF) to compensate

certain type of investors (like senior citizens, etc) in rated bonds,

debentures, etc. when there is a default by the issuers. The rating

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agencies should contribute funds to this BPF on a pre-determined

ratio, and such a fund should be managed independently by trustees

appointed by the regulator. The detailed mechanism of managing the

fund can be decided by the regulator.

5.    The rating agencies should mandatorily communicate to the

investors holding the rated bonds, whenever they downgrade an issuer

or the bonds concerned, thereby helping the investor to take a decision

to hold or sell the bonds and thus protect their interest.

                                                                       

6.    The regulator should put a cap on the fees charged by the rating

agencies, and the fees charged for each rating should form part and

parcel of the rating report to ensure transparency in their dealings.

7.    Every rating agency should set up a separate independent rating

committee, whose members should not only be experts in the

respective fields, but should not have any pecuniary relationship either

with the rating agency or the issuer concerned whose instruments are

rated in order to ensure that there is no conflict of interest.

8.    There should be complete ‘Chinese walls’ between the rating

activity and non-rating activity handled by the agency and any non-

rating business handled by the agency for a client should be clearly

mentioned in the rating report on the said client.

9.    Whenever the rating agency downgrades an issuer or a bond, it

should be given enough publicity in the national dailies with the

largest circulation to serve as a communication to the general

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investors about the revised rating allotted to the issuer or the

instrument.

10.    All rating agencies should publish their profit & loss account

and balance sheet annually with all the data that goes along with the

annual report. They should comply with all the requirements complied

with by a listing company, like quarterly results, shareholding pattern,

changes in directors, etc even though they are not listed, with a view

to ensure transparency and better corporate governance.

11.    Every year a list of all companies and or instruments rated by

them along with the periodical upgrade or downgrade affected by

them should be published not only on their website, but also in

leading national dailies in the month of April every year.

12.    The rating agencies that rate housing projects should certify the

correctness of all claims and statements made by the builders after

thorough verification and any variance observed by them should be

communicated to the respective home buyers periodically.

13.    The rating agencies that rate educational institutions should be

answerable to the students of the rated institutions for any variation in

the claims and statements made by the managements of the

institutions concerned.

14.    The regulator should have the authority to levy penalty for any

wrong doing by the rating agency, including deregistration and

winding up of the company, if so warranted.

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15.    The regulator should periodically inspect the operations of the

rating agencies to ensure that their operations are run on sound lines

and that they are fit to continue to run the business of ratings.

 

16.     The rating agencies should lead by example whenever they rate

a company for corporate governance, so that the standards followed

by the rating company should form as a model for others to follow.

17.    The most important of all is that the aforesaid stipulations and

any other conditionality felt necessary to regulate this business should

be codified through a central enactment so that the business of rating

grows on healthy lines and the public at large, investors and the

consumers really benefit from their expertise and they in turn become

more responsible and accountable to the society in which they

operate.          

                                                               

These are some of the broad contours of the proposed legislation to

bring the rating agencies within the ambit of law, and the earlier it is

done, the better it is for the economy. We have had several scams in

our country recently. Two of them are cash-for-votes scam and cash-

for-loans scam. It is time for us to take preventive steps to the extent

possible to ensure that our country is free from any further scams, and

to pre-empt any possibility of cash-for-rating scam, the government

should initiate the steps suggested above early.

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4. SIGNIFICANCE OF CREDIT RATING IN INDIA

4.1 Definition

"Credit Rating Agency" means any commercial concern engaged in the

business of credit rating of any debt obligation or of any project or program

requiring finance, whether in the form of debt or otherwise, and includes

credit rating of any financial obligation, instrument or security, which has

the purpose of providing a potential investor or any other person any

information pertaining to the relative safety of timely payment of interest or

principal;

(Section 65(21) of Finance Act, 1994 as amended)

Big Three

The top three credit ratings agencies in the United States are:

Moody's

Standard & Poor's

Fitch Ratings

In the wake of recent credit-market turmoil, some niche agencies are picking

up market share or at least additional visibility. Among the niche agencies

are DBRS and Egan-Jones.

4.2 Credit rating agencies

Agencies that assign credit ratings for corporations include:

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M. Best (U.S.)

Bay corp. Advantage (Australia)

Dominion Bond Rating Service (Canada)

China Credit Information Service (China)

Fitch Ratings (U.S.)

Japan Credit Rating Agency (Japan)

Moody's Investors Service (U.S.)

Standard & Poor's (U.S.)

Rating Agency Malaysia (Malaysia)

Egan-Jones Rating Company (U.S.)

Reasons for the origin of credit rating agencies

The increasing role of capital and money markets consequent to

disintermediation.

Increased securitization of borrowing and lending consequent to

disintermediation.

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Globalization of the credit market.

The continuing growth of information technology.

The growth of confidence in the efficiency of the market mechanism.

The withdrawal of Govt. safety nets and the trend towards privatization

he increasing role of capital and money markets consequent to

disintermediation.

Increased securitization of borrowing and lending consequent to

disintermediation.

Globalization of the credit market.

The continuing growth of information technology.

The growth of confidence in the efficiency of the market mechanism.

The withdrawal of Govt safety nets and the trend towards privatization.

4.3 Rating Grades

Each rating agency has developed its own system of rating grades for

sovereign and corporate borrowers. Fitch Ratings developed a rating grade

system in 1924that was adopted by Standard & Poor's. Moody's grading is

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slightly different. Moody's sometimes argues that their ratings embed a

conceptually superior approach that directly considers not only the

likelihood of default but also these verities of loss in the event of default.

Long Term Credit Rankings

Fitch Ratings and Standard & Poor's use a system of letter sliding from the

best rating "AAA" to "D" for issuers already defaulting on payments.

Investment Grade

AAA

: best quality borrowers, reliable and stable without a foreseeable risk to

future payments of interest and principal

AA

: very strong borrowers; a bit higher risk than AAA

A

: upper medium grade; economic situation can affect finance

BBB

: medium grade borrowers, which are satisfactory at the moment

Non-Investment Grade

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BB

: lower medium grade borrowers, more prone to changes in the economy,

somewhat speculative

B

: low grade, financial situation varies noticeably, speculative

CCC

: poor quality, currently vulnerable and may default

CC

: highly vulnerable, most speculative bonds

C

: highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to

pay out on obligations

CI

: past due on interest

R

: under regulatory supervision due to its financial situation

SD

: has selectively defaulted on some obligations

D

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: has defaulted on obligations and S&P believes that it will generally default

on most or all obligations

NR

: not rated Moody's grading follows a different system

Investment Grade

Aaa

: Obligations rated Aaa are judged to be of the highest quality,with the

"smallest degree of risk"

•

Aa1, Aa2, Aa3

: Obligations rated Aa are judged to be of high quality and are subject to

very low credit risk, but "their susceptibility to long-term risks appears

somewhat greater".

•

A1, A2, A3

: Obligations rated A are considered upper-medium grade and are subject to

low credit risk, but that have elements "present that suggest a susceptibility

to impairment over the long term".

•

Baa1, Baa2, Baa3

: Obligations rated Baa are subject to moderate credit risk. They are

considered medium-grade and as such "protective elements may be lacking

or may be characteristically unreliable".

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Non-Investment Grade

•

Ba1, Ba2, Ba3

: Obligations rated Ba are judged to have "questionable credit quality."

•

B1, B2, B3

: Obligations rated B are considered speculative and are subject to high

credit risk, and have "generally poor credit quality."

•

Caa1, Caa2, Caa3

: Obligations rated Caa are judged to be of poor standing and are subject to

very high credit risk, and have "extremely poor credit quality. Such banks

may be in default..."

•

Ca

: Obligations rated Ca are highly speculative and are "usually in default on

their deposit obligations".

•

C

: Obligations rated C are the lowest rated class of bonds and are typically in

default, and "potential recovery values are low".

Others

•

WR

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: Withdrawn Rating

•

NR

: Not Rated

•

P

: Provisional

Credit rating agencies do not downgrade companies promptly enough .For

example, Enron's rating remained at investment grade four days before the

company went bankrupt, despite the fact that credit rating agencies had been

aware of the company's problems for months.

Some empirical studies have documented that yield spreads of corporate

bonds start to expand as credit quality deteriorates but before a rating

downgrade, implying that the market often leads a downgrade and

questioning the informational value of credit ratings.

This has led to suggestions that, rather than rely on CRA ratings in financial

regulation, financial regulators should instead require banks, broker-dealers

and insurance firms (among others) to use credit spreads when calculating

the risk in their portfolio.

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Large corporate rating agencies have been criticized for having too familiar

a relationship with company management, possibly opening themselves to

undue influence or the vulnerability of being misled.

These agencies meet frequently in person with the management of many

companies, and advise on actions the company should take to maintain a

certain rating. Furthermore, because information about ratings changes from

the larger

5 PROJECT REPORT ON SIGNIFICANCE OF CREDIT RATING

IN INDIA

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5.1 CRAs can spread so quickly (by word of mouth, email, etc.), the larger

CRAs charge debt issuers, rather than investors, for their ratings. This has

led to accusations that these CRAs are plagued by conflicts of interest that

might inhibit them from providing accurate and honest ratings. At the same

time, more generally, the largest agencies (Moody's and Standard & Poor's)

are often seen as agents of globalization and/or "Anglo-American" market

forces, that drive companies to consider how a proposed activity might

affect their credit rating, possibly at the expense of employees, the

environment, or long-term research and development. These accusations are

not entirely consistent: on one hand, the larger CRAs are accused of being

too cozy with the companies they rate, and on the other hand they are

accused of being too focused on a company's “bottom line" and unwilling to

listen to a company's explanations for its actions.

The lowering of a credit score by a CRA can create a vicious cycle, as not

only interest rates for that company would go up, but other contracts with

financial institutions may be affected adversely, causing an increase in

expenses and ensuing decrease in credit worthiness. In some cases, large

loans to companies contain a clause that makes the loan due in full if the

Companies' credit rating is lowered beyond a certain point (usually a

“speculative" or " junk bond" rating). The purpose of these "ratings triggers"

is to ensure that the bank is able to lay claim to a weak company's assets

before the company declares bankruptcy and a receiver is appointed to

divide up the claims against the company. The effect of such ratings triggers,

however, can be devastating: under a worst-case scenario, once the

company’s debt is downgraded by a CRA, the company's loans become due

in full; since the troubled company likely is incapable of paying all of these

loans in full at once, it is forced into bankruptcy (a so-called "death

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spiral").These rating triggers were instrumental in the collapse of Enron.

Since that time, major agencies have put extra effort into detecting these

triggers and discouraging their use, and the U.S. Securities and Exchange

Commission requires that public companies in the United States disclose

their existence.

Agencies are sometimes accused of being oligopolists, because barriers to

market entry are high and rating agency business is itself reputation-

based(and the finance industry pays little attention to a rating that is not

widely recognized). Of the large agencies, only Moody's is a separate,

publicly held corporation that discloses its financial results without dilution

by non-ratings businesses, and its high profit margins (which at times have

been greater than 50 percent of gross margin) can be construed as consistent

with the type of returns one might expect in an industry which has high

barriers to entry.

Credit Rating Agencies have made errors of judgment in rating structured

products, particularly in assigning AAA ratings to structured debt, which in

a large number of cases has subsequently been downgraded or defaulted.

The actual method by which Moody's rates CDOs has also come under

scrutiny. If default models are biased to include arbitrary default data and

"Ratings Factors are biased low compared to the true level of expected

defaults, the Moody’s [method] will not generate an appropriate level of

average defaults in its default distribution process. As a result, the perceived

default probability of rated tranches from a high yield CDO will be

incorrectly biased downward, providing a false sense of confidence to rating

agencies and investors."

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. Little has been done by rating agencies to address these shortcomings

indicating a lack of incentive for quality ratings of credit in the modern CRA

industry. This has led to problems for several banks whose capital

requirements depend on the rating of the structured assets they hold, as well

as large losses in the banking industry.

AAA

AAA Rated mortgage securities trading at only 80 cents on the dollar,

implying a greater than 20% chance of default, and 8.9% of AAA rated

structured CDOs are being considered for downgrade by Fitch, which

expects most to downgrade to an average of BBB to BB-. These levels of

reassessment are surprising for AAA rated bonds, which have the same

rating class as US government bonds.

Most rating agencies do not draw a distinction between AAA on structured

finance and AAA on corporate or government bonds (though their ratings

releases typically describe the type of security being rated). Many banks,

such as AIG, made the mistake of not holding enough capital in reserve in

the event of downgrades to their CDO portfolio. The structure of the Basel II

agreements meant that CDOs capital requirement rose 'exponentially'. This

made CDO portfolios vulnerable to multiple downgrades, essentially

precipitating a large margin call. For example under Basel II, a AAA rated

securitization requires capital allocation of only 0.6%, a BBB requires 4.8%,

a BB requires 34%, whilst aBB (-) securitization requires a 52% allocation.

For a number of reasons (frequently having to do with inadequate staff

expertise and the costs that risk management programs entail), many

institutional investors relied solely on the ratings agencies rather than

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conducting their own analysis of the risks these instruments posed. (As an

example of the complexity involved in analyzing some CDOs, the Aquarius

CDO structure has 51 issues behind the cash CDO component of the

structure and another 129 issues that serve as reference entities for $1.4

billion in CDS contracts for a total of 180. In a sample of just 40 of these,

they had on average 6500 loans at origination. Projecting that number to all

180 issues implies that the Aquarius CDO has exposure to about 1.2 million

loans.)

Ratings agencies, in particular Fitch, Moody's and Standard and Poors have

been implicitly allowed by the government to fill a quasi-regulatory role, but

because they are for-profit entities their incentives may be misaligned.

Conflicts of interest often arise because the rating agencies are paid by the

companies issuing the securities — an arrangement that has come under fire

as a disincentive for the agencies to be vigilant on behalf of investors. Many

market participants no longer rely on the credit agencies ratings systems,

even before the economic crisis of 2007-8, preferring instead to use credit

spreads to benchmarks like Treasuries or an index. However, since the

Federal Reserve requires that structured financial entities be rated by at least

two of the three credit agencies, they have a continued obligation of Rs.

5343 crores. Cumulative number of instruments covering a debt volume of

Rs 17,638 crores. ICRA was set up by ICICI and other leading investment

institutions and commercial banks and financial services companies. Rating

Scales: Long Term (Debentures, Bonds, Pref. Shares):L AAA Highest safety

L AA+ }L AAA } High safety L AA- }LA+ }LA } Adequate safety LA- }L

BBB+ }L BBB } Moderate safety L BBB- }

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L BB+ }L BB } Inadequate safetyL BB- }L B+ }L B } Risk ProneL B- }L

C+ }L C } Substantial Risk L C- }L D Default- Extremely speculative.

Medium Term: (Cert. of Deposits & Fixed Deposits) M AAA to M D. Short

Term: (Including Commercial Papers)

A1+ / A1 / A2+ / A2 / A3+ / A3 / A4+ / A4 / A5

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5.3 Credit Analysis and Research Ltd. (CARE)

The CARE was promoted in1993 jointly with investment companies, banks

&finance companies. Services offered by CARE are – (1).credit rating (ii)

information service (iii)Equity research (iv)rating & parallel market of LPG

& kerosene. Since its inception till the end of march1995, CARE has rated

249 debt instruments covering a total debt volume of Rs 9729 crores. CARE

was promoted by leading financial institutions, banks and private sector

finance companies. Care prefixes CARE to the ratings given to the issue e.g.

CARE AAA or CARE AA to the Debenture or Bond issue to indicate High

safety. Similarly in case of Fixed / Short Deposit issue the rating issued is

CARE AAA (FD) or CARE AA (SD) and so on. CARE Rating Services

CARE provides rating services to the following debt instruments.

Debentures

Certificate of deposits

Commercial paper

Fixed deposit

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5.4 Ratings use in structured finance

Credit rating agencies may also play a key role in structured financial

transactions. Unlike a "typical" loan or bond issuance, where a borrower

offers to pay a certain return on a loan, structured financial transactions may

be viewed as either a series of loans with different characteristics, or else a

number of small loans of a similar type packaged together into a series of

"buckets" (with the "buckets" or different loans called "tranches"). Credit

ratings often determine the interest rate or price ascribed to a particular

tranche, based on the quality of loans or quality of assets contained within

that grouping. Companies involved in structured financing arrangements

often consult with credit rating agencies to help them determine how to

structure the individual tranches so that each receives a desired credit rating.

For example, a firm may wish to borrow a large sum of money by issuing

debt securities. However, the amount is so large that the return investors

may demand on a single issuance would be prohibitive. Instead, it decides to

issue three separate bonds, with three separate credit ratings —A (medium

low risk), BBB (medium risk), and BB (speculative) (using Standard&

Poor's rating system). The firm expects that the effective interest rate it pays

on the A-rated bonds will be much less than the rate it must pay on the BB-

rated bonds, but that, overall, the amount it must pay for the total capital it

raises will be less than it would pay if the entire amount were raised from a

single bond offering. As this transaction is devised, the firm may consult

with a credit rating agency to see how it must structure each tranche—in

other words, what types of assets must be used to secure the debt in each

tranche—in order for that tranche to receive the desired rating when it is

issued. There has been criticism in the wake of large losses in the

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collateralized debt obligation(CDO) market that occurred despite being

assigned top ratings by the CRAs. For instance, losses on $340.7 million

worth of collateralized debt obligations (CDO) issued by Credit Suisse

Group added up to about $125 million, despite being rated AAA or Aaa by

Standard & Poor's, Moody's Investors Service and Fitch Group.

The rating agencies respond that their advice constitutes only a "point in

time “analysis, that they make clear that they never promise or guarantee a

certain rating to a tranche, and that they also make clear that any change in

circumstance regarding the risk factors of a particular tranche will invalidate

their analysis and result in a different credit rating. In addition, some CRAs

do not rate bond issuances upon which they have offered such advice.

Complicating matters, particularly where structured finance transactions are

concerned, the rating agencies state that their ratings are opinions (and as

such, are protected free speech, granted to them by the "personhood" of

corporations)regarding the likelihood that a given debt security will fail to be

serviced over a given period of time, and not an opinion on the volatility of

that security and certainly not the wisdom of investing in that security. In the

past, most highly rated (AAA or Aaa) debt securities were characterized by

low volatility and high liquidity—in other words, the price of a highly rated

bond did not fluctuate greatly day-to-day, and sellers of such securities could

easily find buyers. However, structured transactions that involve the

bundling of hundreds or thousands of similar (and similarly rated) securities

tend to concentrate similar risk in such away that even a slight change on a

chance of default can have an enormous affection the price of the bundled

security. This means that even though a rating agency could be correct in its

opinion that the chance of default of a structured product is very low, even a

slight change in the market's perception of the risk of that product can have a

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disproportionate effect on the product's market price, with the result that an

ostensibly AAA or Aaa-rated security can collapse in price even without

there being any default (or significant chance of default). This possibility

raises significant regulatory issues because the use of ratings in securities

and banking regulation (as noted above) assumes that high ratings

correspond with low volatility and high liquidity.

Since the rating agencies receive a sizable fee from the companies for

awarding ratings, a tendency to inflate the ratings may develop.

Investment which have the same rating may not have identical investment

quality However, the problems with the credit rating system are several, and

it would be unfair to say that these problems are to be found only in the

Indian CRAs as they plague CRAs all over the world. Some of them are

listed below:

There is often a possibility of biased ratings and misrepresentation on

account of the lack of accountability in the process and the close nexus

between the agency and the issuer (at least in the Indian context).

Rating only represents the past and present performances of the company

and therefore future events may alter the nature of the rating.

Rating is based on the material provided by the company and therefore, there

is always a risk of concealment of information on the part of the latter.

Rating of a debt instrument is not a guarantee as to the soundness of the

company.

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Ratings often on the debt instruments of different agencies.

Small differences in degrees of risk are usually not indicated by CRAs. Thus

issues with the same rating may actually be of differing quality.

Similarly, default probability need not be specifically predicted. Calculations

are usually done in relative terms.

CRAs cannot be used as recommendations to buy, sell or hold securities as

they do not comment on the adequacy of market price, suitability of any

security for an investor or the taxability of the payments.

The information is obtained from issuers, underwriters, etc. and is usually

not checked for accuracy or truth. Thus ratings may change on account of

non-availability of information or unavailability of adequate information.

Ratings use in structured finance

Changes in market considerations may result in loss that will not be reflected

in CRAs. In India the chief problems in the context of CRAs arises on

account of the fact that they are not the independent and autonomous entities

that their international counterparts are. The three primary CRAs in India,

viz., ICRA promoted by IFCI and other financial institutions and banks,

CRISIL, promoted by ICICI, Asian Development bank and others, and

CARE promoted by IDBI are all promoted by lending institutions. Further

most corporate borrowers are clients of these institutions in terms of

borrowing. Further, institutions like ICICI, IDBI also have stakes in such

client companies. Thus it is very important for these agencies to distance

themselves from their promoters if they want to gain credibility. Thus,

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needless to say, the system of CRAs needs some amount of relooking and

overhauling in order to make it effective and viable in the future. A positive

step has been taken in this regard by the SEBI (Credit rating Agencies)

Regulations,1999, which has attempted to resolve some of the aforesaid

problems, but much still remains to be done make fair, objective and

unbiased ratings. Further it shall ensure that no conflict of interest exists

between any member of its rating committee participating in the rating

analysis, and that of its client.

A credit rating agency shall not make any exaggerated statement, whether

oral or written, to the client either about its qualification or its capability to

render certain services or its achievements with regard to the services

rendered to other clients.

A credit rating agency shall not make any untrue statement, suppress any

material fact or make any misrepresentation in any documents, reports,

papers or information furnished to the board, stock exchange or public at

large.

A credit rating agency shall ensure that the Board is promptly informed

about any action, legal proceedings etc., initiated against it alleging any

material breach or non-compliance by it, of any law, rules, regulations and

directions of the Board or of any other regulatory body.(b) In case an

employee of the credit rating agency is rendering such advice, he shall also

disclose the interest of is dependent family members and the employer

including their long or short position in the said security, while rendering

such advice.]

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A credit rating agency shall maintain an appropriate level of knowledge and

competence and abide by the provisions of the Act, regulations, and

circulars, which may be applicable and relevant to the activities carried on

by the credit rating agency. The credit rating agency shall also comply with

award of the Ombudsman passed under the Securities and Exchange Board

of India (Ombudsman) Regulations, 2003.

A credit rating agency shall ensure that there is no misuse of any privileged

information including prior knowledge of rating decisions or changes.

(a) A credit rating agency or any of his employees shall not render, directly

or indirectly any investment advice about any security in the publicly

accessible media.

(b) A credit rating agency shall not offer fee-based services to the rated

entities, beyond credit ratings and research.

A credit rating agency shall ensure that any change in registration status/any

penal action taken by board or any material change in financials which may

adversely affect the interests of clients/investors is promptly informed to the

clients and any business remaining outstanding is transferred to another

registered person in accordance with any instructions of the affected

clients/investors.

A credit rating agency shall maintain an arm’s length relationship between

its credit rating activity and any other activity.

A credit rating agency shall develop its own internal code of conduct for

governing its internal operations and laying down its standards of

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appropriate conduct for its employees and officers in the carrying out of

their duties within the credit rating agency and as a part of the industry. Such

a code may extend to the maintenance of professional excellence and

standards, integrity, confidentiality, objectivity, avoidance of conflict of

interests, disclosure of shareholdings and interests, etc. Such a code shall

also provide for procedures and guidelines in relation to the establishment

and conduct of rating committees and duties of the officers and employees

serving on such committees.

A credit rating agency shall provide adequate freedom and powers to its

compliance officer for the effective discharge of his duties.

A credit rating agency shall ensure that the senior management, particularly

decision makers have access to all relevant information about the business

on a timely basis.

A credit rating agency shall ensure that good corporate policies and

corporate governance are in place.

A credit rating agency shall not, generally and particularly in respect of issue

of securities rated by it, be party to or instrumental for—

(a) creation of false market ;

(b) price rigging or manipulation; or

(c) Dissemination of any unpublished price sensitive information in respect

of securities which are listed and proposed to be listed in any stock

exchange, unless required, as part of rationale for the rating accorded.

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