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Sikkim-Manipal University Of Health, Medical and Technological Sciences

Manipal-576104. PROJECT REPORT Submitted in partial Fulfillment of Master of Business Administration (MBA-Finance) Entitled

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

SACHIN GANGADHAR INGALE Roll 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 Wing Syndicate House Manipal-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 Ingale Roll no:511136453 MBA Student

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Students Declaration
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

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Bonafide Certificate:

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 HEAD OF THE DEPARTMENT Department: MANAGEMENT Institution: EAPL

SIGNATURE FACULTY INCHARGE Department: MANAGEMENT Institution: EAPL

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Study center: Eduway Academy Pvt. Ltd.

Project Assessment

Examiner’s Certification

This MBA Project Report By

SACHIN GANGADHAR INGALE Roll no: 511136453
Of Sikkim-Manipal University Undertaken through Eduway Academy, CBD Belapur Entitled Is approved and Accepted in Quality and Form

Internal Examiner:

Signature:

Name: Mohammed Arshad Qualification: MBA Designation: DIRECTOR Department: MANAGEMENT Institution: EDUWAY ACADEMY PVT. LTD. External Examiner: Name: Mohammed Hanif Lakdawala Qualification:MPHIL Designation: HOD Department: Management Institution: AP COLLEGE

Signature:

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University Guide’ Certification
This is to certify that this MBA Project Entitled

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 INGALE Roll no: 511136453
Under Sikkim-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 : 6|Page

The HR Manager XYZ Pvt. Ltd. Date: Dear Sir/Madam, ___________ 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 Head Signature with Seal
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TABLE OF CONTENT
1.1 Introduction 1.2 Origin Part I 1.3 Meaning And Definition 1.4 Importance of Credit Rating 1.5 Factors Affecting Assigned Ratings 2.1 Nature Of Credit Rating 2.2 Instruments for Rating 2.3 Functions Of Credit Rating Agency 2.4 Advantages Of Credit Rating Part II A. Benefits to Investors B. Benefits of Rating to the Company C. Benefits to Intermediaries 2.5 Disadvantages of Credit Rating 3.1 Indian Credit Rating in INDIA- A case Part III for accountability Significance Of Credit Rating In India 4.1 Definition Part IV 4.2 Credit rating agencies 4.3 Rating Grades 5 Project Report On Significance Of Credit Rating In India 5.1 CRA Part V 5.2 AAA 5.3 CARE 5.4 Ratings use in structured finance

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CTEDIT RATING

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
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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 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.

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1.2 Origin –

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
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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 -

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.

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1.4 Importance of Credit Rating-

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
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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.

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, nonpayment 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.
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7. Market position of the company products is judged by the demand for the products, competitors market share, distribution channels etc.

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

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‗AA-‘ by another. It will indeed be unusual if one agency assigns a rating of AA while another gives a ‗BBB‘.

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.
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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 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 cooperation 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
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information, visits to the issuers offices and works, ‗intensive discussion with the senior executives of issuers, discussions with auditors, bankers, creditors etc. 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.

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2.2 Instruments for Rating –

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.
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Rating Other than Debt Instruments-

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

III. Chit Funds 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.

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A - A stands for asset quality. The loan is examined to determine nonperforming assets. An asset/loan is considered non-performing asset where 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
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tools like ratio analysis, trend analysis, fund flow analysis and cash flow analysis to comment upon company‘s liquidity, solvency, profitability and 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.

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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 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 AgencyA 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.

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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 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
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improvement in the financial position respectively.

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

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manufactured, shareholders are sure of high returns, investors feel secured of their investments and creditors are assured of timely payments of interest and principal.

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.

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2.5 Disadvantages of Credit Rating Credit rating suffers from the following limitations

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.
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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 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.

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 Indian Credit Rating in INDIA- A case for accountability

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
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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 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.

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 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 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 &
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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.

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),
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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 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
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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 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. There should be complete ‗Chinese walls‘ between the rating

8.

activity and non-rating activity handled by the agency and any nonrating business handled by the agency for a client should be clearly mentioned in the rating report on the said client.

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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 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.
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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.

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 cashfor-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

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to pre-empt any possibility of cash-for-rating scam, the government should initiate the steps suggested above early.

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

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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:

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
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The 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 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.

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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 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
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: medium grade borrowers, which are satisfactory at the moment

Non-Investment Grade

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
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: under regulatory supervision due to its financial situation

SD : has selectively defaulted on some obligations

D : 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".
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• 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".

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

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: Obligations rated C are the lowest rated class of bonds and are typically in default, and "potential recovery values are low".

Others • WR : 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.

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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.

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

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5 PROJECT REPORT ON SIGNIFICANCE OF CREDIT RATING IN INDIA 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
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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 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 reputationbased(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
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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." . 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
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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 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
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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- }

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 BBrated 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
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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 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
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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 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.

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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.

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
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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, 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
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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.] 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.

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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 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
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(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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