Functions of a Credit Rating Agency

7/29/2019 Functions of a Credit Rating Agency

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Functions of a Credit Rating Agency

A credit rating agency serves following functions:

1. Provides unbiased opinion:An independent credit ratingagency 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 authenticate 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


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

assess the creditworthiness of the companies on their own.

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


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included in different kinds of institutional port-folio.

Functions ofCRISIL

CRISIL is acronym for Credit Rating Information Services of India

Limited. CRISIL is India's leading Ratings, Financial News, Risk

and Policy Advisory company. Since 1987 when CRISIL was

incorporated, CRISIL has played an integral role in India's

development milestones.

CRISIL's majority shareholder is Standard & Poor's, the world's


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foremost provider of independent credit ratings, indices, risk

evaluation, investment research and data. CRISIL's association

with Standard & Poor's, a division of The McGraw-Hill

Companies, dates back to 1996 when both companies started

working together on rating methodologies and joint projects.

CRISIL Ratings is the only ratings agency in India to operate on

the basis of sectoral specialisation. CRISIL Ratings plays a

leading role in the development of the debt markets in India.

CRISIL has also spearheaded the formation of the CariCRIS, the

world's first regional credit rating agency.

The main functions of CRISIL can be classified into following

subheads:

1. Ratings

CRISIL Ratings: It is the only ratings agency in India with

sectoral specialization It has played a critical role in the


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development of the debt markets in India. The agency has

developed new ratings methodologies for debt instruments and

innovative structures across sectors. CRISIL Ratings provides

technical know-how to clients all over the world and has helped

set up ratings agencies in Malaysia (RAM), Israel (MAALOT) and

in the Caribbean.

2. Research

CRISIL Research: It provides research, analysis and forecasts on

the Indian economy, industries and companies to over 500

Indian and international clients across financial, corporate,

consulting and public sectors.

CRISIL FundServices: It provides fund evaluation services and

risk solutions to the mutual fund industry.

The Centre for Economic Research: It applies economic

principles to live business applications and provide benchmarks


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and analyses for India's policy and business decision makers.

Investment Research Outsourcing: CRISIL added equity

research to its wide bouquet of services, by acquiring Irevna, a

leading global equity research and analytics company. Irevna

offers investment research services to the world's leading

investment banks and financial institutions.

3. Advisory

CRISIL Infrastructure Advisory: It provides policy, regulatory

and transaction level advice to governments and leading

organisations across sectors.

Investment and Risk Management Services: CRISIL Risk

Solutions offers integrated risk management solutions and

advice to Banks and Corporates by leveraging the experience

and skills of CRISIL in the areas of credit and market risk.


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ICRA:

ICRA was established in the year 1991 by the collaboration of

financial institutions, investment companies, and banks. The

company has formed the ICRA group together with its

subsidiaries. The company is headed by Mr. Piyush G. Mankad

and offers products like short-term debt schemes, Issue-specific

long-term rating and offers fund based as well as non-fund

based facilities to its clients.


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The most important criticism levied against public sector

undertakings has been that in relation to thecapital employed,

the level of profits has been too low. Even the government has

criticized the publicsector undertakings on this count. Of thevarious factors responsible for low profits in the public

sector Undertakings, the following are particularly important:-


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Price policy of public sector undertakings

Under utilization of capacity

Problem related to planning and construction of projects

Problems of labor, personnel and management

Lack of autonomy

REASONS FOR DISINVESTMENT

The public sector in India at present is at cross roads. The new

economic policy initiated in July 1991, clearly indicated that

the public sector undertakings have shown a very negative rate

of return oncapital employed. On account of this phenomenon

many public sector undertakings have become burden to the

government. They are in fact turning out to be liabilities to the

government rather than being assets.This is a sector which the

government clearly wants to get rid off. In this direction the

government hasadopted a new approach to reform and improve

the public sector undertakings performance i.e.Disinvestment

policy'. This has gained lot of importance especially in latter part


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of 90s. At present thegovernment seriously perceives the

disinvestment policy as inactive tool to reduce the burden to

financingthe public sectorOBJECTIVE OF THE DISINVESTMENT:

Privatization intended to achieve the following:

Releasing large amount of public resources

Reducing the public debt

Transfer of Commercial Risk

Releasing other tangible and intangible resources

Expose the privatized companies to market discipline

Wider distribution of wealth

Definition of 'Loan Syndication'


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The process of involving several different lenders in providing

various portions of a loan. Loan syndication most often occurs

in situations where a borrower requires a large sum of capitalthat may either be too much for a single lender to provide, or

may be outside the scope of a lender's risk exposure levels.

Thus, multiple lenders will work together to provide the

borrower with the capital needed, at an appropriate rate agreed

upon by all the lenders.

The Process

The process of bond valuation takes into consideration the cash

flow, or interest payments, connected with the bond issue.

Typically, the cash flow is realized from the interest paymentsthat are made on the bond at regularly scheduled intervals. This

in turn is related to the par value of the bond, or the face value

that the bond holds at the time it reaches maturity. By

approaching the overall worth of the investment from both these

angles, it is easier for an investor to evaluate the issue anddecide if it is worth his or her time, or if another investment

option should be selected.
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There are multiple, in-depth calculations that may be used to

figure bond valuation. Under the relative pricing approach, the

face value of a bond is often determined by comparing the bondto a standard bond, usually one issued by the government; the

credit rating of a bond with comparable maturity dates and cash

flow can be used to determine a bond's fair market value.

Arbitrage-free pricing involves subtracting each cash flow

payment separately; the amount is determined by the rate of azero-coupon bond on the same date the interest payment is

made. Another option, the stochastic calculus approach,

recognizes the possibility of fluctuating interest rates and uses a

partial differential math equation to determine a bond's fair

market value. The equations for each of these processes can be

found online, or calculated on the Internet by use of a free

financial calculator; a financial advisor is often very helpful

when trying to determine the most accurate value of a bond.

Raising Foreign Currency Finance:

The major sources available to an Indian firm for raising foreign

currency finance are:
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(1) Foreign currency term loans from financial institutions

(2) Export credit schemes

(3) External commercial borrowing(4) Euro issues

(5) issues in foreign domestic markets

Foreign Currency Term loans Financial Institutions:

Financial institutions provide foreign currency term loans formeeting the foreign currency expenditures towards import of

plant, machinery, and equipment and also towards payment of

foreign technical know how fees. The periodical liability for

interest and principal remains in the currency/currencies of the

loans and is translated into rupees at the then prevailing rate ofexchange for making payments to the financial institution.

Export Credit Schemes:

Export credit agencies have been established by the

governments of major industrialized countries for financingexports of capital goods and related technical services. These

agencies follow certain consensus guidelines for supporting

exports under a convention known as the Berne Union. As per


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these guidelines, the interest ate applicable for export credits to

Indian companies for various maturities are regulated. Two

kinds of export credit are provided: buyers credit and supplierscredit.

Buyers credit: Under this arrangement, credit is provided

directly to the Indian buyer for purchase of capital goods and/or

technical services from the overseas exporter. The buyers credit

facility operates as follows:

(1) The overseas exporter and the Indian buyer negotiate a

contract.

(2) An application of the buyers credit facility is made to the

export agency of the exporters country along with relevantdetails like the types of goods/services to be exported

approximate value of the contract, terms of payments schedule

of protected shipment of goods or provision of services,

percentage of financing required etc.

(3) The buyers credit facility is approved by the export creditagency of the exporters country.

(4) A loan agreement delineating the terms and conditions of the

buyers credit is negotiated between the overseas exporters


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bank, the Indian borrowers, and where applicable, the Indian

guarantor.

Suppliers Credit: This is a credit provided to the overseas

exporters so that they can make available medium-term finance

to Indian importers. The suppliers credit facility operates as

follows:

(1) The overseas exporter notifies his bank and the export credit

agency of a potential export order of an Indian buyer who

requires medium-term finance.

(2) The export credit agency communicates to the bank its

willingness to provide the facility.

(3) The terms of the facility are incorporated in the contract

between the overseas exporter and the Indian buyer.

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Below mentioned are disadvantages/ demerits of Derivatives:

1. Raises Volatility: As a large no. of market participants can

take part in derivatives with a small initial capital due to

leveraging derivatives provide, it leads to speculation and raises

volatility in the markets.

2. Higher no. of Bankruptcies: Due to leveraged nature of

derivatives, participants assume positions which do not matchtheir financial capabilities and eventually lead to bankruptcies.

3. Increased need of regulation: Large no. of participants take

positions in derivatives and take speculative positions. It is

necessary to stop these activities and prevent people from

getting bankrupt and to stop the chain of defaults.

the major types of financial derivatives:

1. Forwards: A forward contract is a contract between two

parties obligating each to exchange a particular good or

instruments at a set price on a future date. It is an over the

counter agreement and has standardized market features.

2. Futures: Futures are standardized contracts between the


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buyers and sellers, which fix the terms of the exchange that will

take place between them at some fixed future date. A futures

contract is a legally binding agreement. Futures are special typesof forward contracts which are exchange traded, that is traded on

an organized exchange. The major types of futures are stock

index futures, interest rate futures, and currency futures.

3. Options: Options are contracts between the option writers ad

buyers which obligate the former and entitles (withoutobligation) the latter to sell/buy stated assets as per the

provisions of contracts. The major types of options are stock

options, bond options, currency options, stock index options,

futures options, and options on swaps. Options are of two types:

calls and Puts. A call option gives a buyer/holder a right but not

an obligation to buy the underlying on or before specified time

at a specified price (usually called strike/exercise price) and

quantity. A put option gives a holder of that option a right but

not an obligation to sell the underlying on or before specified

time at a specified price and quantity.

4. Warrants: Warrants are long term options with three to seven

years of expiration. In contrast, stock options have a maximum

life of nine months. Warrants are issued by companies as a


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means of raising finance with no initial servicing costs, such as

divided or interest. They are like a call option on the stock of the

issuing firm. A warrant is a security with a market price of itsown that can be converted into a specific share which leads at a

predetermined price and date. If warrants are exercised, the

issuing firm has to create a new share which leads to a dilution

of ownership. Warrants are sweeteners attached to bonds to

make these bonds more attractive to the investor. Most of thewarrants are detachable and can be traded in their own right or

separately. Warrants are also available on stock indices and

currencies.

5. Swaps: Swaps are generally customized arrangements

between counterparties to exchange one set of financial

obligations for another as per the terms of agreement. The major

types of swaps are currency swaps, and interest rate swaps, bond

swaps, coupon swaps, debt equity swaps.

6. Swaptions: Swaptions are options on swaps. It is an option

that entitles the holder the right to enter into having calls and

puts, swaptions have receiver swaption (an option to receive

fixed and pay floating) and a payer swaption (an option to pay

fixed and receive floating).


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Problems associated with Disinvestment

A number of problems and issues have bedevilled the

disinvestment process. The number of bidders for equity has

been small not only in the case of financially weak PSUs, but

also in that of better-performing PSUs. Besides, the

government has often compelled financial institutions, UTI and

other mutual funds to purchase the equity which was being

unloaded through disinvestment. These organizations have not

been very enthusiastic in listing and trading of shares

purchased by them as it would reduce their control over PSUs.

Instances of insider trading of shares by them have also come
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to light. All this has led to low valuation or under pricing of

equity.

Further, in many cases, disinvestment has not really

changed the ownership of PSUs, as the government has

retained a majority stake in them. There has been some

apprehension that disinvestment of PSUs might result in the

crowding out of private corporates (through lowered

subscription to their shares) from the primary capital market...

An important fact that needs to be remembered in the context

of divestment is that the equity in PSUs essentially belongs to

the people. Thus, several independent commentators have

maintained that in the absence of wider national consensus, a

mere government decision to disinvest is not enough to carry

out the sale of peoples assets. Inadequate information about

PSUs has impeded free, competitive and efficient bidding of

shares, and a free trading of those shares. Also, since the PSUs

do not benefit monetarily from disinvestment, they have been

reluctant to prepare and distribute prospectuses. This has in


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turn prevented the disinvestment process from being

completely open and transparent.

It is not clear if the rationale for divestment process is well-

founded. The assumption of higher efficiency, better / ethical

management practices and better monitoring by the private

shareholders in the case of the private sector all of which

supposedly underlie the disinvestment rationale is not

always borne out by business trends and facts.

Total disinvestment of PSUs would naturally concentrate

economic and political power in the hands of the private

corporate sector. The US economist Kenneth Galbraith had

visualized a role ofcountervailing power for the PSUs.While the creation of PSUs originally had economic, social

welfare and political objectives, their current restructuring

through disinvestment is being undertaken primarily out of

need of government finances and economic efficiency.

Lastly, to the extent that the sale of government equity in

PSUs is to the Indian private sector, there is no decline in

national wealth. But the sale of such equity to foreign


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companies has far more serious implications relating to

national wealth, control and power, particularly if the equity is

sold below thecorrect price!

If the disinvestment policy is to be in wider public interests,

it is necessary to examine systematically, issues such as - the

correct valuation of shares, the crowding out

possibility, the appropriate use of disinvestment proceeds and

the institutional and other prerequisites.

Functions of a Credit Rating Agency

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