Credit Rating Agencies

What Is the Role of Rating Agencies? How Did Rating Agencies Start? How Did They Get Government-Sanctioned Roles? Why Are There Only Three? Do the Agencies Have Insider Information? How Do the Agencies Make Ratings?

Role of Credit Rating Agencies

Facilitate investment decisions through credit ratings based on
Superior and low cost Information

Increases investor confidence and guide them

Trade off between risk and return

Enhance the ability of the borrower/issuer to access the money and capital markets for tapping larger volumes of resources from a wider range of investing public Healthy discipline imposed on corporate borrowers
Encourages financial discipline

Benefits the industry as a whole

Firms can access markets at low cost

Helps to allocate capital efficiency across sectors

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Benefits of Credit Rating Agencies

Investor Perspective

Safeguard their interest Monitor the performance of the company Provides signals to the investors Channelizes savings into the capital market
Access to investors Helps establish credibility among investors Provides early warning signals to the company
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Issuer Perspective

Benefits of Credit Rating Agencies

Banks

Banks to save on capital if loans are rated

Based on Basel II norms

Incentive to have portfolio rated

Regulator

Bank regulator can use these ratings for assessing capital requirements of system Capital market regulator can use them for regulatory purposes
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Products offered: Evolution from debt to.

Debt
Sub-sovereign

Others
Equity: Equi Grading/IPO

Debt: Shortterm/Long term

Corporate Governance

Securitization

Mutual funds/ Insurance etc.

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How Did Rating Agencies Start?

Moody, John. Manual of Railroad Securities, 1909. Provided operating statistics for 200 railroads and their securities. 1916Standard Co. began grading bonds. 1920sPoor and Fitch began bond rating. 1941Poors and Standard merged. Customers were investors who wanted unbiased, arms-length financial analysis

Changes Occurred!
1970sBegan charging issuers for ratings, because of ease of photocopy! 1990sBegan lucrative side business in rating impact studies to predict effect of M/A activity on credit ratings 2000sBegan moving into Euro market ratings in a big way

How Did They Acquire GovernmentSanctioned Roles?

1936Comptroller of the Currency: Banks can hold only investment grade securities! 2002Basle Accord changes are likely to require use of ratings for capital adequacy measures (if adopted, will go into effect 2006)

Why Are There Only Three?

1975SEC designated the companies whose ratings were acceptableNRSROs The SEC has enveloped the webbing that keeps anyone There they are, a 2 firm agencies in a very protective else from challenging them. industry, sitting pretty.

(Lawrence White, Economics, NYU)

S&P Moodys Fitch

Do the Agencies Have Insider Information?

Usually! Selective disclosure
SEC allows sensitive financial information to be released to bond raters, without requiring it to be revealed to the public. No on-going disclosure requirement.

Lack of competition keeps it Market mover status keeps

insider status it as insider information

Credit Rating
CRISILS RATING SYMBOLS
AAA : HIGHEST SAFETY AA A : HIGH SAFETY : ADEQUATE SAFETY

BBB
BB B C D

: LOW SAFETY
: INADEQUATE SAFETY : HIGH RISK : SUBSTANTIAL RISK : IN DEFAULT

KEY FACTORS CONSIDERED IN CREDIT RATING

INDUSTRY & BUSINESS ANALYSIS FINANCIAL ANALYSIS EARNING POWER

GROWTH RATE & RELN WITH THE ECONOMY

INDUSTRY RISK CHARACTERISTICS

STRUCTURE OF INDUSTRY & NATURE OF COMPETITION COMPETITIVE POSITION OF THE ISSUER MANAGERIAL CAPABILITY OF THE ISSUER

BUSINESS & FINANCIAL RISKS

ASSET PROTECTION CASH FLOW ADEQUACY FINANCIAL FLEXIBILITY

QUALITY OF ACCOUNTING

How Do the Agencies Make Ratings of Countries?

Trends within a country: economic condition, reforms, % of government debt held by domestic investors Consistency among countries: stability, inflation

How Do the Agencies Make Ratings of Companies

80/20 rulefor debt, 80% based on the past, 20% based on projections. Reversed for equity Issuers market position and size

How Do the Agencies Make Ratings of Specific Securities?

Rating agency picks a sample of loans to inspect and underwrite
50-70% of the package, including largest 10 Loan-to-value ratios, debt service coverage, individual cash flow component analysis

Results are extrapolated to the non-sampled portion of the portfolio of underlying assets Often more than one agency rates a deal In the financial services business, there would be no commerce without credibility (Bergsman)

Scope of the Business Today

LucrativeMoodys as the example
$4.2 billion assets $158 million (2000) revenues85% paid by security issuers $770 million (2001) revenues $382 million operating income 36% of revenues come from relationship pricing; 64% from transactional pricing 1/3 of revenues from structured financing Rates $30 trillion, from 100 countries, 4,200 corporations, and 68,000 public finance obligations

Scope of the Business Today

Accurate predictions
Less than 1% of A- or better rated bonds default over 5 years 85% of A rated securities retain the rating for more than 1 year

Growth outside the US

Europe: 1500 unrated companies with revenues greater than 1 billion

Major CRA
CRISIL, Credit Rating Information services of India LTD. From a pioneering step taken in 1987, to playing an integral role in India's development milestones, CRISIL has emerged as India's leading Ratings, Research, Risk and Policy Advisory company. CARE Credit Analysis & Research Ltd. (CARE), incorporated in April 1993, is a credit rating, information and advisory services company promoted by Industrial Development Bank of India (IDBI), Canara Bank, Unit Trust of India (UTI) and other leading banks and financial services companies. In all CARE has 14 shareholders ICRA , Investment Credit Rating Agency of India Ltd (an Associate of Moody's Investors Service) was incorporated in 1991 as an independent and professional company. ICRA is a leading provider of investment information and credit rating services in India. ICRAs major shareholders include Moody's Investors Service and leading Indian financial institutions and banks.

 Onicra SSI and SME rating approved by the Govt of India and Indian banks association. NSCI is its nodal agency Rating 1A, 1B, 1C 5A, 5B ,5C( high to Poor) SME rating agency of India (SMERA) (1995) is a joint initiative by SIDBI, Dun & Bradstreet Information Services India Private Limited (D&B), and several leading banks in the country. -- Objective is to enhance credit flow to credit-constrained SME sector. It was first of its kind in the world. --The agency would rate any individual or company engaged in any field like manufacturing, trading, business and commerce but not the non banking finance corporations (NBFCs), chit funds and nidhis.

Importance
To increase investor confidence and guide them Facilitate decision making Measures probability of default to meet obligations Strengths and weaknesses of the company Rated instrument enjoys higher confidence

 Provide information and guidance to institutional and individual investors/creditors. Enhance the ability of borrowers/issuers to access the money market and the capital market for tapping a larger volume of resources from a wider range of the investing public. Assist the regulators in promoting transparency in the financial markets. Provide intermediaries with a tool to improve efficiency in the funds raising process.

Issues
CRA are not auditors

Credit rating changes with time

Judgment in India is a mix of quantitative and qualitative factors Is it necessary to regulate CRA Solicited or Unsolicited ratings Regulating the Raters

Factors contributing to success of rating system

Credibility arises from objectivity of resource allocation Rating agencies are not and should not assume the role of regulators Continued growth and evolution of the credit rating business would depend on the size and the growth of the debt market.

Are Indian Credit Ratings Credible

CR involves subjective judgment with objective analysis Rating shopping is a cause of concern Lack of transparency on the part of CRA In most countrys CRA are not regulated Credibility arises from objectivity of resource allocation

Difference in Rating
Fuzziness of data Readiness/ Reluctance of the company in disclosing information Proper control systems are not in place Credibility of the agencies carrying out the rating Industry is still young Fuzziness of data

 Conclusions Still Young Foreign CRA entering India, quality will improve No credit rating association Attempt to develop core competencies

Global scene: CRAs and financial crisis

During this period global credit rating agencies came under microscope
Were Unable to predict the crisis General belief that they were liberal with ratings in return for high fees

Did not sufficiently understand the products they were rating such as CDOs and CDS

better regulation has been the solution advocated for smooth operations of the market

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Concern 1: Business model

Based on issuer pays rule
Alternative models such as investor pays or government or exchange pays not feasible

In this model the rating agency is receiving fees form the issuer they rate Entity issuing the debt instrument pays for the rating The only check is reputation This rating model adopted by most rating agencies in various countries An External Rating Committee is the solution here A committee that comprises members
Experts in the field Have no relation with the company being rated

Have no responsibility for CRAs commercials

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Concern 2: Conflict of interest

Few rating agencies mix ratings with consultancy business
Giving rise to conflict of interest The two businesses need to be separated So-called Chinese walls may not really exist

Models need to be transparent

Disclosures need to be made on methodology and approach to ratings

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Need to strengthen the System

Making the rating process more robust Need to have External Rating Committee Separation of analyst compensation and revenue from issuer Analysts not allowed to trade in shares of rated entities Separation of analytical and business development teams Transparency Default studies to be published Movements in ratings to be disclosed

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Need to strengthen the Systemcontd.

Integrity of Ratings Accounting practices viewed more closely Due Diligence by agency and regulator Overall process Timely and rigorous surveillance Increasing in-house research capabilities Stress testing

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Regulatory changes
Rating structures and procedures to be strengthened
SEBI has prescribed certain guidelines Attempts to address issue of multiple regulators

Internal code of conduct More discussions

Internal assessment needs to be more rigorous

Stability of ratings to be ensured

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