Credit Rating

Prepared byProf. Rahul Mailcontractor

Assistant Professor,KLS’s Institute of Management Education and Research,

Belgaum, Karnataka

Credit rating• A credit rating estimates the credit worthiness of an individual,

corporation, or even a country. It is an evaluation made by credit bureaus of a borrower’s overall credit history.

• Credit ratings are based on financial history and current assets and liabilities.

• Typically, a credit rating tells a lender or investor the probability of the subject being able to pay back a loan.

• Commercial credit risk is the largest and most elementary risk faced by many banks and it is a major risk for many other kinds of financial institutions and corporations as well.

• Many uncertain elements are involved in determining both how likely it is that an event of default will happen and how costly default will turn out to be if it does occur.

There are four Credit Rating agencies in India

• CRISIL(Credit Rating Information Services of India Ltd)

• ICRA(Information and Credit Rating Services ltd)• CARE (Credit Analysis and Research Ltd)• FITCH India

Registration• Credit Rating agencies are regulated by SEBI.• Registration with SEBI is mandatory for carrying out

the rating Business.• A registration fee of Rs. 25000 should be paid to

SEBI

Promoter• A Credit rating agency can be promoted by:• Public Financial Institution• Scheduled Bank• Foreign Bank operating in India with RBI approval• Foreign Credit Rating agency having at least five

years experience in rating securities• Any company having a continuous net worth of

minimum 100 cores for the previous five years.

Eligibility Criteria• Is set up and registered as a company• Has specified rating activity as one of its main objects

in its Memorandum of Association.• Has a minimum Net worth of Rs 5 Crore.• Has adequate Infrastructure• Promoters have professional competence, financial

soundness and a general reputation of fairness and integrity in Business transactions , to the satisfaction of SEBI.

• Has employed persons with adequate professional and other relevant experience, as per SEBI directions.

Grant of Certificate of Registration

• SEBI will grant to eligible applicants a Certificate of Registration on the payment of a fee of Rs 5,00,000 subject to certain conditions.

Agreement with the client• The CRA should enter into a written agreement with

each client containing ,• Rights and liabilities of each party w.r.t rating of

securities.• Fee charged• A periodic review of the rating during the tenure• Clients agreement to cooperate and provide true,

adequate and timely information.• Disclosure by CRA to client regarding the rating

assigned.• Clients agreement to disclose the rating assigned in

the offer document for the last 3 years

Monitoring of rating

• The CRA should continuously monitor the rating of securities rated by it during their life time .

• It should disseminate information regarding newly assigned rating and its changes in the earlier ratings through press releases, websites and inform the same to stock exchanges.

Disclosure of rating definitions and Rational.

• The rating agency should make public the definitions of the concerned rating along with symbol

• They should also state that the ratings do not constitute recommendation to buy, sell or hold any securities.

• It should provide the public the rational of its rating which covers analysis of various factors justifying the assessment as well as the risk factors.

CRISIL• The first rating agency ‘Credit Rating Information Services

of India Ltd. , CRISIL, was promoted jointly in 1987 jointly by the ICICI and the UTI. Other shareholders included ADB, LIC, HDFC Ltd, General Insurance Corporation of India and several other foreign and Indian Banks.

• It pioneered the concept of credit rating in the country and since then has introduced new concepts in credit rating services and has diversified into related areas of information and advisory activities.

• It became public in 1993.• In 1996, it formed a strategic alliance with S&P rating group.

Services offered by CRISIL• Credit Rating Services• Advisory Services• Credibility first rating and evaluation Services• Training Services

Credit Rating Services(CRS)• The principle function of CRISIL is to rate mandated debt

obligations of Indian Companies chit fund, real estate developers, LPG Kerosene dealers, NBFC, Indian states and so on.

• Rating of debt obligations:– Debt obligation includes rupee denominated credit instruments

like debentures, preference shares, deposits, CD’s commercial papers and a structured obligations of manufacturing ,finance companies, banks, financial institutions etc.

– It ensures stable and healthy growth of capital market by offering credit rating which is widely acceptable. It provides increased disclosures, better accounting standards and improved financial information to the users.

– It reduces cost of issue by direct mobilization of resources.– It protects the interest of investors by constantly monitoring the

results of rated companies.

• Rating of structured obligations:– It reflects CRISIL opinion regarding the capacity

and willingness of the company to make timely payments of financial obligations on rated instruments.

• Rating of real estates developers:– CRISIL has developed framework for rating of

real estate projects. Such rating helps investors to identify their investment options

– The rating is expected to help developers mobilize funds for their projects.

– The methodology assesses a project in terms of project risk factors and developer’s risk factors.

• Bond Fund ratings:– The rating is an opinion of the quality of bond funds

underlying portfolio holdings. They mainly focus on fixed income securities.

– The rating methodology takes into account the following factors i.e., credit associated with the securities, the systems and procedures followed by the funds and management quality and expertise.

• Bank loan rating: – The creditworthiness of bank’s borrower is assessed

offering comments on the likelihood of repayment of loans.– The methodology considers the borrowers underlying

assets liquidity and risk management initiative and for NBFC quality of assets , loans and investment.

• Collective investment schemes: This covers rating of collective investment schemes offering

opinion on the degree of certainty of the scheme to deliver the assured returns in terms of cash as mentioned in the offer document

• Grating of health care institutions: The grading for healthcare institutions is an opinion on the

relative quality of health care delivered by the institutions to the patients. Grading is done taking into account facilities, quality , consistency in delivering the service etc. Flowing are the grades given Grade A( Very good quality), Grade B (Good Quality) , Grade C (Average Quality) and Grade D( Poor Quality)

CRICIL Advisory Services (CAS)• The CAS offers consulting services that aim at identifying and

mitigating risk. The main focus of these services is transaction and policy level assignments in the area of energy, transport, banking and finance disinvestment, privatization and valuation.– Energy group services: it offers advisory services to

companies engaged in energy sector like power, coal, oil and gas. The policy level assignments Include aspects like sector reforms and structuring, regulatory framework privatization, corporate plan fuel related services.

– Transaction level assignment include project scoping and structuring, bid process management, financial viability analysis of projects, risk identification and analysis and structuring of project contacts, security package, structuring and analysis.

• Transport and urban infrastructure group services: It provides financial advisory services to transport and infrastructure service provider. – Policy level assignments include advice on transport sector

privatization policy of state ports, development of risk identification allocation, long term sector plans and state role.

– Transaction level assignments include financial viability analysis, project structuring, bid process management, negotiation of terms with successful bidders

– Privatization and disinvestment group: this group renders advisory services to central state governments, public sector enterprises and private sector entities interested in participating in privatization program, these services cover 3 aspects policy level, enterprise level and reforms and restructuring.

• Banking and finance group:CRISIL offers a wide range of services covering restructuring and business reengineering, credit management, investment management and portfolio insurance, equity valuation, resource mobilization studies and financial feasibility studies

• Capital Market Group:This group provides customized research and advisory assistance to meet specific transactional and strategic requirements of clients. It offers services like diagnostic evaluation for valuation of Indian partner of a foreign asset management company, technical assistance to AMFI, portfolio evaluation and portfolio analysis for leading mutual funds, composite performance ranking of domestic mutual funds, assistance to government for the development of India’s financial sector.

ICRA Ltd• Information and Credit Rating Services (ICRA) has been promoted

by IFCI Ltd as the main promoter and started operations in 1991.• Other shareholders are UTI, Banks, LIC, GIC, Exim Bank, HDFC

and ILFS.• It provides Rating, Information and Advisory services ranging from

strategic consulting to risk management and regulatory practice.• The main objectives of ICRA are to assist investors both individual

and institutional in making well informed decisions• To assist issuers in raising funds from a wider investor base.• To enable banks, investment bankers, Brokers in placing debt with

investors.• To provide regulators with market driven systems to encourage the

healthy growth of capital markets.• It provides rating services, information services and advisory

services.

Rating services• ICRA rates debt instruments issued by manufacturing

companies, commercial banks, NBFCs, financial institutions, PSUs and municipalities.

• The instruments rated by it include bonds/ debentures, fixed deposits commercial papers and certificate of deposit. It also rates structured obligations in accordance with the terms of the structure based on risk assessment of the instrument . It rates sector specific debt obligations issued by power, telecom and infrastructure companies.

• It also provides corporate governance rating , rating of claims paying ability of insurance companies, credit assessment of large medium and small scale companies to obtain assistance from banks, FIs. It also provides services of general assessment of companies.

Information services• The information services division of ICRA focuses

on providing authentic data and value added products used by intermediaries, financial institutions, banks, asset managers, institutions and investors.

• Value added services include equity grading providing a critical input on a company's earning prospects and inherent risks in decision making process of equity investors and equity assessment.

• Other services include corporate reports, equity assessment, mandate based studies (customized research) and sector/industry specific publication.

Advisory services• The advisory services division of ICRA offers wide ranging

management advisory services. Under advisory services ICRA provides its understanding on the business processes and relevant organizational issues to different players of financial markets such as investors, issuers, regulators, intermediaries and media.

• The advisory services include 1.strategic consulting/ strategic practice 2. risk management (credit risk, market risk and operations risk) 3. regulatory practice 4 transaction practice 5. information( content services).

• It focuses on sectors like banking and financial services, infrastructure sector, manufacturing and service sector, government and regulatory authorities.

CARE Ltd.• Credit Analysis and Research Ltd or CARE is promoted by

IDBI jointly with Financial Institutions, Public/Private Sector Banks and Private Finance Companies.

• It commenced its credit rating operations in October, 1993 and offers a wide range of products and Services in the field of Credit Information and Equity Research.

• It also provides advisory services in the areas of securitisation of transactions and structuring Financial Instruments.

• It offers services like 1. Credit rating of debt instruments 2. Advisory services like securitization transactions, structuring financial instruments, financing infrastructure projects and municipal finances 3. Information services like providing information to companies, industry and businesses. 4. Equity research

Fitch Ratings India Ltd.

• It is the latest entrant in the credit rating Business in the country as a joint venture between the international credit Rating agency Duff and Phelps and JM Financial and Alliance Group.

• In addition to debt instruments, it also rates companies and countries on request.

Rating Process• The process begins with issue of rating request letter

by the issuer of the instrument and signing of the rating agreement.

• CRA assigns an analytical team consisting of two or more analysts one of whom would be the lead analyst and serve as the primary contact.

• Meeting with Management- The analytical team obtains and analyses information relating to its financial statements, cash flow projections and other relevant information.

• Discussion with management on management philosophy, competitive position, financial policies and future plans.

Rating Process cont-• Discussions on financial projections based on

objectives and growth plan , risks and opportunities.• Rating committee- after meeting with the

management the analysts present their report to a rating committee which then decides on the rating.

• After the committee has assigned the rating, the rating decision is communicated to the issuer, with reasons or rationale supporting the rating.

• Dissemination to the Public: Once the issuer accepts the rating, the CRAs disseminate it, along with the rationale, to the print media.

Rating Review for a possible change• The rated company is on the surveillance system of

the CRA, and from time to time, the earlier rating is reviewed. The CRA constantly monitors all rating with respect to new political ,economic, financial development and industry trends.

• Analysts review new information or data available on the company. On preliminary analysis of the new information if the analyst feel that there is a possibility for change in the rating then they meet with the management and proceed with comprehensive rating analysis.

Credit Rating Watch• During the review monitoring or surveillance

exercise, rating analysts might become aware of imminent events like mergers and so on, which effect the rating and warrants a rating change.

• In such a possibility, the issuer’s rating is put on ‘credit watch’ indicating the direction of a possible change and supporting reasons for review.

• Once a decision to either change or present the rating had been made, the issue will be removed from credit watch.

Rating Methodology

• The rating methodology involves an analysis of industry risk, issuer’s business and financial risk. A rating is assigned after assessing all factors that could affect the credit worthiness of the entity. The industry analysis is done first followed by the company analysis.

Credit rating for manufacturing companies

• The main elements of rating methodology are as below• Business risk Analysis : It begins with an assessment

of the company’s environment focusing on the strength of the industry prospects, business cycle as well as competitive factors affecting the industry. The vulnerability of the industry to political factors is also assessed. If a company is involved in more than one business, each segment is analyzed separately. The main factors include Industry Risk, Market position, operating efficiency and legal position.

• Financial risk analysis: Financial risk is analyzed mainly through financial ratios. Emphasis is placed on the ability of the company to maintain /improve its future financial performance.

• The profitability of a company is an important determinant of its ability to withstand business adversity. The main measures of profitability include operating and net margins and returns on capital. The absolute levels of these ratios, trends and comparison of these ratios with other competitors is analyzed. Emphasis is also laid on cash flow patterns.

• The area analyzed are accounting quality, earnings prospects, adequacy of cash flows financial flexibility and interest and tax sensitivity.

• Management Risk: A proper assessment od debt protection levels requires an evaluation of management philosophies and its strategies. The analyst compares the company’s business strategies and financial plans to provide insights into a management’s ability to forecast and implement plans. The areas analyzed include track record of the management, planning and control systems, evaluation of capacity to overcome adverse situations, goals, philosophy and strategies.

Credit rating for financial service sector

• When rating debt instruments of financial institutions, banks, NBFCs in addition to the financial analysis and management evaluation the following factors are considered

• Regulatory and competitive environment• Fundamental analysis• Capital adequacy • Asset quality• Liquidity management• Profitability and financial position• Interest and tax sensitivity

Rating symbols/Grades• Rating symbols are a symbolic expression of the

opinion/assessment of the credit rating agency regarding the investment, credit quality, grade of the debt, obligation instrument.

• CRISIL rating symbols: The rating symbols of CRISIL with respect debentures, fixed deposits, short term instruments(CPs), credit assessment, structured obligations, bond funds, bank loans, collective investment schemes, Indian states, real estate developers are as follows.

Rating symbols for Debentures• High Investment Grade:• AAA-(Triple A ) Highest security- Offer the highest

safety against payment of interest and principal• AA(Double A) High Safety - Offer high safety

against payment of interest and principal.• A- Adequate safety- Offer adequate safety against

payment of interest and principal. In adverse conditions might affect such issues.

• BBB(Triple B)- Moderate safety- Offer sufficient safety against payment of interest and principal. Circumstances may lead to weakened capacity to pay interest and principal.

• Speculative grades • BB(Double B)- Inadequate safety- These

instruments carry inadequate safety of timely payment of interest and principal.

• B (High risk)- Instruments rated B have greater risk of default.

• C (Substantial risk)- Risk of default. Repayment can only be expected in favorable conditions.

• D (Default) Such instruments are extremely speculative and default risk is highest.

Rating symbols for Fixed deposits.• FAAA( F triple A)- Highest safety• FAA( F- double A)- High safety• FA- Adequate safety• FB- Inadequate safety• FC- High Risk• FD- Default

Rating symbols for Short term instruments

• P-1 (highest safety)• P-2 (High Safety)• P-3( Adequate safety)• P-4(Inadequate safety)• P_5 (default)

Rating for credit assessment• It indicates the capability of entity to repay the

interest and principal as per the terms of the contract. The rating symbols are as below-

• 1-Very strong capability• 2,3,4- Strong capability• 5,6,7- Adequate capability• 8,9,10- Inadequate capability• 11,12,13 –Poor capability• 14- Default

Ratings for structured obligations• High investment grades:• AAA(SO)- Highest safety• AA(SO)- high safety• Investment grades:• A(SO) –Adequate safety• BBB(SO)- Moderate safety• Speculative grades:• BB(SO)- Inadequate safety• B(SO) – High Risk• C (SO)- Substantial risk)• D (SO)- Default

Ratings for bond funds

• AAAf – Very Strong Protection against losses• AAf - Strong Protection against losses• Af- Adequate Protection against losses• BBBf- Moderate Protection against losses• BBf - Inadequate Protection against losses• Cf – vulnerable to credit defaults.

Bank Loan Ratings• BLR-1: strong likelihood of repayment of interest and

principal on bank loan • BLR-2: good likelihood of repayment of interest and

principal on bank loan • BLR-3: satisfactory likelihood of repayment of

interest and principal on bank loan • BLR-4: moderate likelihood of repayment of interest

and principal on bank loan • BLR-5: sub standard , vulnerable to loss• BLR-6: High likelihood of loss

Rating of collective investment schemes.

• GRADE I (high certainty of assured returns)• GRADE II (adequate certainty of assured returns)• GRADE III (moderate certainty of assured returns)• GRADE IV ( Inadequate certainty of assured returns)• GRADE V (high uncertainty of assured returns)

Credit Rating of Indian States

• Rating of the states by the CRISIL represents a landmark in the diversification of the rating Business in the country.

• It has already rated several states.• While assessing a state, CRISIL considers two

basic factors:• The Economic Risk and• The Political Risk

Economic Risk• Economic structure of the state and its finances• Macroeconomic performance• Infrastructure• Sector studies• Whether revenue and expenditure patterns are

sustainable.• Deficit Management• Degree of dependence on Central support• Tax policy of the state• Performance of Public sector undertakings and their

effect on the state’s finances.

Political Risk

• Relations between the state and the Centre and its impact on transfer of resources as well as centre’s influence on political stability in the state.

• Various political parties in the state, their economic policies and their effect on the state’s policies.

• Quality of the current leadership and administration• Ability of the Government to take decisions that are

politically difficult.

Rating of real estate developers• Rating pertains to particular project and not to the company as

a whole. It assigns ratings after assessing the factors that could affect the ability of the developer to meet agreed specifications in terms of quality and time as well as the ability to transfer clear titles to customers. Ratings are based on project risk analysis and developer risk analysis

• Project risk analysis : The quality of legal title in respect of the property constructed, quality of construction and timeliness of delivery of the completed unit is assessed.

• Developer risk analysis: The track record of the developer, existing financial statements, financial flexibility and management evaluation are considered with rating the position of developer.

Rating symbols for developers

• PA1- Highest Ability to build the project• PA2- High Ability to build the project• PA3- Adequate Ability to build the project• PA1- Inadequate Ability to build the project• PA1- Inability to build the project