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COLLEGE OF BUSINESS STUDIES
The objective of this study is to find out (a) the need of credit rating (b) how the credit rating agencies function (c) the limitations of credit rating. An analysis of credit rating is also included in the study.
CREDIT RATING-An Introduction
The role of financial markets in a market economy is that of an efficient intermediator, mediating between savers and investors, mobilizing capital on hand and efficiently allocating them between competing uses on the other. Such an allocative role hinges crucially on the availability of reliable information. The doctrine of “efficient market allocation” in fact has as its bedrock, what economists label “ perfect information”. An investor in search of investment avenues has recourse to various sources of information- offer documents of the issuer(s), research reports of market intermediaries, media reports etc. In addition to these sources, Credit Rating Agencies have come to occupy a pivotal role as information providers, particularly for credit related opinions in respect of debt instruments; a role that has been strengthened by the perception that their opinions are independent, objective, well researched and credible. The impetus for the growth of Credit Rating came from the high levels of default in the US Capital markets after the Great Depression. Further impetus for growth came when regulatory agencies began to stipulate that institutions such as Government Pension Funds and Insurance Companies could not buy securities rated below a particular grade. Merchant bankers, underwriters and other intermediaries involved in the debt market also found rating useful for planning and pricing the placement of debt
S.S. COLLEGE OF BUSINESS STUDIES instruments. The other factors leading to the growing importance of the credit rating system in many parts of the world over the last two decades are 1. The increasing role of capital and money markets consequent to disintermediation;
2. Increasing securitization of borrowing and lending consequent to
3. Globalisation of the credit market; The continuing growth of information
technology; 4. The growth of confidence in the efficiency of the market mechanism: and 5. The withdrawal of Government safety nets and the trend towards privatization. It was this growing demand on rating services that enabled credit rating agencies to charge issuers for their services. This was much in variance with the mode of financing used hitherto-with no fees charged to the issuers, a credit rating agency used to provide rating information through the sale of their publication and other materials.
Historical perspective: The Origins The origins of credit rating can be traced to the 1840’s. Following the financial crisis of 1837, Louis Tappan established the first mercantile credit agency in New York in 1841. The agency rated the ability of merchants to pay their financial obligations. It was subsequently acquired by Robert Dun and its first rating guide was published in 1859. Another similar agency was set up by John Bradstreet in 1849, which published a ratings book in 1857. These two agencies were merged together to form Dun & Bradstreet in 1933, which became the owner of Moody’s Investors Service in 1962. The history of Moody’s Investors Service, and in 1909 published his ‘Manual of Railroad Securities’. This was followed by the rating of
S.S. COLLEGE OF BUSINESS STUDIES utility and industrial bonds in 1914, and the rating of bonds issued by U.S cities and other municipalities in the early 1920s. Further expansion of the credit rating industry took place in 1916, when the Poor’s Publishing Company published its first ratings, followed by the Standard Statistics Company in 1922, and Fitch Publishing Company in 1924. The Standard Statistics Company and the Poor’s Publishing company merged in 1941 to form Standard & Poor’s. Credit Rating: The Concept Ratings, usually expressed in alphabetical or alphanumeric symbols, are a simple and easily understood tool enabling the investor to differentiate between debt instruments on the basis of their underlying credit quality. The credit rating is thus 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 is focused on communicating to the investors , the relative ranking of the default loss probability for a given fixed income investment, in comparison with other rated instruments. A rating is specific to a debt instrument and is intended as a grade, an analysis of the credit risk associated with the particular instrument. It is based upon the relative capability and willingness of the issuer of the instrument to service the debt obligations( both principal and interest) as per the terms of the contract. Thus a rating is neither a general purpose evaluation of the issuer, nor an overall assessment of the credit risk likely to be involved in all the debts contracted or to be contracted by such entity.
The primary objective of rating is to provide guidance to investors/ creditors in determining a credit risk associated with a debt instrument/credit obligation. It does not amount to a recommendation to buy, hold or sell an instrument as at does not take into consideration factors such as market prices, personal risk preferences and other considerations which may influence an investment decision. The rating
S.S. COLLEGE OF BUSINESS STUDIES process is itself based on certain ‘givens.’ The agency, for instance, does not perform an audit . Instead It is required to rely on information provided by the issuer and collected by analysts from different sources, including interactions inperson with various entities. Consequently, the agency does not guarantee the completeness or accuracy of the information on which the rating is based.
The Use of Credit Rating
For the investor, the rating is an information service , communicating the relative ranking of the default loss probability for a given fixed income investment in comparison with other rated instruments. In the absence of a credit rating system , the risk perception of a common investor vis-à-vis debt instruments largely depends on his/her familiarity with the names of the promoters or the collaborators. Such “name recognition”, often used to evaluate credit quality in the underdeveloped markets can not be an effective surrogate for systematic risk evaluation ; it suffers from a number of avoidable limitations it is not true that every venture promoted by a well known name will be successful and free from default risk. Nor is it true that every venture promoted by a relatively lesser known entity is disproportionately risk prone. While on one hand , “name recognition “ restricts the options available to the investor, on the other it denies relatively lesser known entrepreneurs access to a wider investor base. What is therefore required for efficient allocation of resources is systematic risk evaluation. It is rarely, if ever, feasible for the corporate issuer of debt instrument to offer every prospective investor the opportunity to undertake a detailed risk evaluation. A professional credit rating agency is equipped with the required skills, the competence and the credibility, all of which eliminates, or at least minimizes, the role of ‘name recognition’ and replaces it with well researched and scientifically analysed opinions as to the relative ranking of different debt instruments in terms of their credit quality. A rating provided by a professional credit rating agency is of significance not just for the individual/small investor but also for an organized
S.S. COLLEGE OF BUSINESS STUDIES institutional investor. Rating for them provides a low cost supplement to their own in-house appraisal system. Large investors may use credit rating spectrum of investment options. Such investors could use the information provided by rating changes, by carefully watching upgrades and downgrades and altering their portfolio mix by operating in the secondary market. Banks in some developed countries use the ratings of other banks and financial intermediaries for their decisions regarding inter-bank lending, swap agreements and other counter-party risks.
The benefit of credit rating for issuers stems from the faith placed by the market on the opinions of the rating provided and the widespread use of ratings as a guide for investment decisions. The issuers of rated securities are likely to have access to a much wider investor base as compared to unrated securities , as a large section of investors not having the required resources an skills to analyse each and every investment opportunity would prefer to rely on the opinion of a rating agency. The opinion of a rating agency enjoying investor confidence could enable the issuers of highly rated instruments to access the market even under adverse market conditions. Credit rating provides a compensated for basis for determining the additional return( over and above a risk free return) which investors must get in order to be the additional risk that they bear. They could be a useful benchmark for issue pricing. The differential in pricing would lead to significant cost savings for highly rated instruments.
Rating is a useful tool for merchant bankers and other capital market
intermediaries in the process of planning, pricing, underwriting and placement of issues. The intermediaries, like brokers and dealers in securities, could use rating as an input for their monitoring of risk exposures. Regulators in some countries specify capital adequacy rules linked to credit rating of securities in a portfolio.
S. COLLEGE OF BUSINESS STUDIES By Regulators Regulatory authorities worldwide have promoted the use of Credit Rating by issuing mandatory requirements for issuers.1956. Specific rules. public issue of debentures and convertible/redeemable beyond a period of 18 months rating. by amendment of 6 . 2 crore must get their fixed deposit programmes March 1995 and the NBFCs having net owned 50 lacs(but less than 2 crore) must get their rated by 31st March 1996. other than NBFCs also the Companies Act. NBFCs having net owned funds of than Rs. credit rating has been made mandatory for issuance of the following instruments: a) as per the requirements of SEBI. Similar by National Housing Bank(NHB) more rated by 31st funds of more than Rs fixed deposit programme rating required by the NBFCs are FA(-) from CRISIL/ MA(-) regulations have been introduced for housing finance companies also. stipulate different margin requirements for mortgage of rated and unrated instrument and prohibit institutional investors from purchasing or holding of instruments rated below a particular level. for instance restrict entry to the market of new issues rated below a particular grade. one of the conditions for issuance of India is that the issue must have a rating not below the P2 CRISIL/A2 grade from ICRA/PR2 from CARE.S. The minimum to be eligible to raise fixed deposits from ICRA/BBB from CARE. CP in bonds need credit grade from c) as per the guidelines of RBI . programmes of d) there is a proposal for making the rating of fixed deposit limited companies. In India . b) as per the guidelines of RBI. mandatory.
manner. press or other party any confidential information about its clients. come to its knowledge. to the client about its qualification or its capability to render certain services or its achievements in regard services rendered to other clients. while providing unbiased services. 4) A credit rating agency shall avoid any conflict of interest of any of its rating committee participating in the rating analysis. high 3) A credit rating agency independent professional shall render at all times high standards of care and exercise wherever necessary. exercise due diligence. It shall service. which of the rated company/client. COLLEGE OF BUSINESS STUDIES Code of Conduct for Credit Rating Agencies SEBI (Credit Rating Agencies) REGULATIONS. without making disclosure to the concerned person 7 . 5) A credit rating agency shall not indulge in unfair competition nor they wean away client of any other rating agency on rating. 6) A credit rating agency shall not make any exaggerated statement.S. possible sources of conflict of duties and interests. 7) A credit rating agency shall always endeavour to ensure that all professional dealings ate effected in a prompt and efficient manner. any has to shall member Any potential assurance of higher 8) A credit rating agency shall not divulge to other clients. whether oral or written. ensure proper disclose to the clients.1999) 1) A credit rating agency in the conduct of its business shall observe standards of integrity and fairness in all its dealings with its 2) A credit rating agency shall fulfill its obligations in an ethical clients.S. conflict of interest shall be disclosed to the client. judgment.
to the 10) A credit rating agency shall not generally and particularly in issue of securities rated by it be party to— (a) creation of false market. regulations and circulars which may be applicable and relevant to activities carried on by the credit rating agency.S.547(E). members stock exchanges. S. respect of (b) passing of price sensitive information to brokers.issued by SEBI the 8 .S. other players in the capital market other person or take any other action which is to the investors. 12) A credit rating agency shall abide by the provisions of the Act. COLLEGE OF BUSINESS STUDIES 9) A credit rating agency shall not make untrue statement furnished Board or to public or to stock exchange.O . dated 7-7-1999. Source: Notification No. of the or to any unethical or unfair 11) A credit rating agency shall maintain an arm’s length relationship between its credit rating activity and any other activity.
businessstandard. Research has been done from secondary sources of information. which matter in the rating process is also included in this study.S. The factors. Research Design: Descriptive Research is used in this study.crisil.S.com www.com www. The secondary objective of this study is to find out the challenges being faced by the rating agencies and what is being done to face it.icraindia. COLLEGE OF BUSINESS STUDIES METHODOLOGY Objective: The main objective of this study is to find out how the Credit Rating Agencies function. how they rate the instruments.com 9 . The nature of this study is such that it eradicates the necessary of doing primary research. Secondary sources of information: Credit Rating manuals from ICRA ICRA Information brochures Chartered Financial Analyst magazines ICFAI Reader magazine www.
municipal 10 .). telecom and infrastructure financing. In 1996 it entered into a strategic alliance with Standard & Poor’s to extend its credit rating services to borrowers from the overseas market. The services offered are broadly classified as Rating. US and Alliance Capital Limited . The Advisory services include strategic counseling. Rating services cover rating of Debt instruments-long.S. (Investment Information and Credit Rating Agency of India Limited) and CARE(Credit Analysis and Research). Information services . ports. beginning 1987 when the first rating agency. The Infrastructure and consultancy division provide assistance on specific sectors such as power. Calcutta. it is the second rating agency in India. Information services offer corporate research reports and the CRISIL 500 index. CRISIL: It was promoted by ICICI. CRISIL was established. The services offered can be broadly classified as Rating services . general assessment such as restructuring exercise and sector specific services such as for power. Established in 1991 . securitised assets and builders.S. Advisory services and Investment Information services. ICRA: It was promoted by IFCI and 21 other shareholders comprising nationalized and foreign banks and insurance companies. Infrastructure services and consulting. nationalized and foreign banks and insurance companies in 1987. medium and short term. The fourth rating agency is a JV between Duff & Phelps.ICRA Ltd. COLLEGE OF BUSINESS STUDIES CREDIT RATING AGENCIES IN INDIA The rating coverage in India is not too old. The rating services comprise rating of debt instruments and credit assessment. it went public in 1992 and is the only listed credit rating agency in India. At present there are three main rating agencies – CRISIL(Credit Rating and Information Services of India Ltd. telecom.
. a CARE: It was set up in 1992. The information or the research desk provides research reports on specific industries. The Information services also include equity related services. promoted by IDBI jointly with other financial institutions. nationalized and private sector finance companies. viz. Equity Grading and Equity Assessment. a Moody’s subsidiary to offer services on Risk Management Training and software: Moody’s and ICRA has entered into memorandum. In 1996.S. of understanding to support these efforts. COLLEGE OF BUSINESS STUDIES ratings . sectors and corporates. etc.S. The services offered cover rating of Debt instruments and sector specific industry reports from the research desk and equity research. Market share Marketshare of the different Credit Rating Agencies in India 2% 48% 39% 11% CRISIL ICRA CARE Duff& Phelps 11 . ICRA entered into a strategic alliance with Financial Proforma Inc.
S. UTI. Andhra Bank . SBI. The major shareholders are:. United Bank of India. dated the 19th Sept. Indian Bank... Vysya Bank.. Export-Import Bank of India. Union Bank of India. The main objective of ICRA like any other Credit Rating Agency is to assess the credit instrument and award it a grade consonant to the risk associated with such instrument. Allahabad Bank. UCO Bank HDFC Ltd. IFCI Ltd. 1990 accorded approval for the establishment of a second Credit Rating and Information Agency in the country to meet the requirements of companies based in North. (2) The agency should be managerially independent.S. PNB. Canara Bank.. The approval was granted subject to the following conditions viz . Department of Economic Affairs . GIC.A Detailed Study Ministry of Finance. The ratings done by ICRA are not recommendations to buy or sell securities but culminate symbolic indicator of the current opinion of the relative capability of timely servicing of the debts and obligations. 1(120) SE/89. professional and impartial assessment of such instruments/obligations.Moody’s Investment Company India private Ltd. Central Bank of India. COLLEGE OF BUSINESS STUDIES ICRA . from 12 . ICRA’s main objectives include providing guidance to the investors/creditors in determining the credit risk associated with a particular debt instrument or credit obligation and reflecting independent. (1) The Agency shall be self-supporting after a maximum period of 2 years and accordingly shall not require any subvention thereafter IFCI. LIC. Infrastructure Leasing and Financial Services Ltd. vide its letter No.
RATING SERVICE Credit Rating The ICRA rating is a symbolic indicator of the current and prospective opinion on the relative capability of the corporate entity concerned to timely service debts and obligations with reference to the instrument rated.S. insurance companies. 2. ICRA offers its rating services to a wide range of issuers including: Manufacturing companies 13 . Information service—provides sector/industry specific studies studies/publications.S. medium-term and short-term debt instruments. The independence and professional approach of ICRA ensure reliable. corporate reports and mandate based customized research. Ratings facilitate investors to factor credit risk in their investment decisions. Real Developers & Projects and Mutual Fund schemes. services Management practice. Grading services—includes grading of Construction Entities. The rating is based on an analysis of the information and clarifications obtained from the entity . certificates of deposit(CD). Estate 4. Rating service—rating of bonds. ICRA rates long-term. 3. Advisory services—it offers wide ranging management advisory covering the areas of Strategy practice. Commercial Paper(CP). as also other sources considered reliable by ICRA. COLLEGE OF BUSINESS STUDIES RANGE OF SERVICES The services offered by Credit Rating Agencies are as follows:1. claim paying ability of corporate governance. consistent and unbiased ratings. structured obligations. Risk Regulatory practice and Transaction practice. debentures.
an SFR may be different from the credit rating of the issuer as in many cases the transaction is structured as an off-balance sheet item. consumer durable loans or any other nonfinancial class of assets that are identifiable and separable from the operations of the issuer and whose risk of loss is measurable. The methodology is based on ICRA’s understanding of that particular asset class and the structured and legal issues associated with the transaction involved. under various possible scenarios. Mortgage Backed Securitisation (MBS) An MBS has diversified housing loans as the underlying asset for the transaction.S. with the risk of loss being similar as in the case of a corporate credit rating of the same level. once the default has occurred.ABS refers to the securitisation of a diversified pool of assets. ICRA employs a specific methodology for each of its SFR products. ICRA’s four major SFR products are listed below. commercial vehicle loans. The expected loss is defined as the product of probability of default and severity of loss. 14 . COLLEGE OF BUSINESS STUDIES Banks and financial institutions Power companies Service companies Municipal and other local bodies Non-banking financial service companies.S. Asset Backed Securitization(ABS) . However. Structured Finance Rating Structured finance ratings (SFRs) are based on the estimation of the expected loss to the investor on the rated instrument. An SFR symbol indicates the relative level of expected loss for that instrument. which may include financial assets like automobile loans.
as the underlying asset. the analysis includes an 15 .S. Besides. FFTs are not completed de-linked from the credit risk of the issuer. its management. Future Flow Transaction (FFT) FFTs involve devising a structure where specified sources of future cash flows are identified are earmarked for servicing investors. including structured debt. The Benefits An issuer can derive multiple advantages from structured finance products like lowering the cost of funds. a paradigm shift is expected in the domestic insurance sector as newer players and products enter the market. Given this scenario. Following deregulation. Claims Paying Ability Rating (for Insurance companies) ICRA’s claims paying ability ratings (CPRs) for insurance companies are an opinion on the ability of the insurers concerned to honour policy-holder claims and obligations on time. Some examples of such sources are property tax revenues of municipal corporations. ICRA expects its CPRs to be an important input influencing the customer’s choice of insurance companies and products. ICRA’s rating process involves analysis of an insurer’s business fundamentals and its competitive position and focuses primarily on the insurer’s franchise value.S. bonds or any other debt security. from a policy-holder’s perspective. reducing asset-liability mismatches and increasing specialization. through preferential tapping of cash flows of the issuer can achieve a rating that is higher than the issuer’s credit rating. power receivables of bulk consumers and property lease rentals. COLLEGE OF BUSINESS STUDIES Collateralised Debt Obligation (CDO) A CDO transaction has a pool of corporate loans. organizational structure/ownership and underwriting and investment strategies. accessing new markets and investors on the strength of a higher rating vis-à-vis a stand-alone corporate credit rating. but the structure. improving capital adequacy. In other words a CPR is ICRA’s opinion on the financial strength of the insurer.
creditors. providing comfort to regulators. improving image/credibility. customers. The service of grading. Grading of Mutual Fund Schemes 16 . COLLEGE OF BUSINESS STUDIES assessment of an insurance company’s profitability. carrying the ICRA stamp. bankers. helps the corporate entity concerned in raising funds. improving its valuation. listing on stock exchanges. financial transparency & information disclosure. operational and financial leverage. dealings with third parties like creditors. the project owner and the project itself. by providing an independent opinion on the quality of the entity graded . The aspects examined during a CGR exercise include: ownership structure. employees. Corporate Governance Rating ICRA’s Corporate Governance Rating(CGR) provides a current opinion on the level to which an organization accepts and agrees to codes and guidelines of corporate governance practices that serve the interests of stakeholders such as shareholders. is designed to enhance the lender’s confidence in financing construction sector participants. A CGR . GRADING SERVICES The grading services of ICRA include ---Grading of Construction Entities ---Grading of Mutual Fund Schemes Grading of Construction Entities The unique grading methodology developed by ICRA.S. liquidity. and Board structure & process. capital adequacy and asset / liability management method. the contractor.S. government and society at large. financial stakeholder relation. along with the Construction Development Industry Council(CIDC) encompasses all the entities in a construction project. and bettering its corporate governance practices through benchmarking. the consultant.
financial institutions. reliable and independent opinion on the performance and risks associated with investing in individual Mutual Fund Schemes.S. ICRA Advisory offers CPRA as an on-line plug and play model for emarketplaces/Virtual Private networks. market risks. Credit Risk Regulatory compliance 17 . ICRA Mutual Fund Grading services include: Performance Grading Credit Risk Grading Market Risk Grading ADVISORY SERVICES RISK MANAGEMENT PRACTICE The Risk Management Practice advises clients on efficient management of credit risks. and operational risks. ICRA’s clients include commercial banks. For manufacturing and service companies. insurance firms and manufacturing firms. CPRA is a relative measure of counterparty’s ability to honour the terms of trade. ICRA Advisory offers consultancy in risk management. venture capital firms. non-banking finance companies. equity investors. COLLEGE OF BUSINESS STUDIES ICRA’s grading of Mutual Funds seeks to address the perceived need among investors and intermediaries for an informed.S. multi-lateral agencies. and as an off-line facility for organizations desiring to assess counter party risks of buyers/dealers and suppliers. planning and control. project financiers. Specifically the gradings are opinions on the relative past-performance of Mutual-Fund schemes and the various factors that can influence their future performance. Counterparty risk assessment: ICRA Advisory has developed “Counterparty Risk Assessment”(CPRA) to assess risks that counterparties are exposed to in the course of buying and selling of goods and services in all kinds of marketplaces.
S. COLLEGE OF BUSINESS STUDIES Processes/systems for credit risk management Internal risk rating systems Credit monitoring systems(including MIS) Moody’s software for credit risk management Organization design for risk management Portfolio management Industry and corporate reports Credit risk culture assessment Market risk Regulatory compliance Asset-liability management Interest rate/liquidity/currency risks Hedging strategies Transfer pricing Software for ALM Integrating ALM with overall planning Training for Risk management Analyzing financial statements-basic/advanced Credit risk management-middle/senior executives Understanding ALM Customized training for bankers Operating Risk Diagnostic analysis of risk for a company 18 .S.
COLLEGE OF BUSINESS STUDIES Systems for risk measurement Risk mitigation strategies Internal control and corporate governance REGULATORY PRACTICE ICRA advisory Services focuses on issues concerned with economic aspects of regulation. efficient market making mechanisms. competition. Clients of regulatory practice are Governments.S. water. public sector. ICRA also work with corporate entities in formulating their strategies in dealing with regulatory issues.S. subsidies and public-private partnership structures. Instances of the regulatory practice would be assisting in policy formulation with regard to pricing of public goods. ICRA advisory Services has worked on several consulting projects concerning regulatory issues in the areas of power. regulatory authorities and municipalities who formulate economic and financial policies. banking and urban infrastructure. Functional Areas Tariff setting for public goods and services Economic development Development of regulations Fiscal management policies Privatization policies Institutional strengthening Determining of subsidies Evaluation of contracts & agreements 19 . consumer protection and fair trade practices .
S. COLLEGE OF BUSINESS STUDIES 20 .S.
The credit rating agency also has a panel of industry experts who provide data and trends including policies about the industry. The main points are described below: (a) Rating request: Ratings in India are initiated by a formal request (or mandate) from the prospective issuer. (e)Management meetings and plant visits: Rating involves assessment of provide guidance on specific issues to the rating team. The composition of the team is based on the expertise and skills required for evaluating the business of the issuer.S. The requirements are derived from the experience of the issuers business and broadly conform to all the aspects which have a bearing on the rating. Important issues that are covered include: binding the credit rating agency to maintain confidentiality. COLLEGE OF BUSINESS STUDIES RATING PROCESS Rating is an interactive process with a prospective approach. 21 . This mandate spells out the terms of the rating assignment. This requires intensive interactions with issuers’ management specifically relating to plans. (b) Rating team: The team usually comprises two members. competitive position and funding policies. the right to the issuer to accept or not to accept the rating and binds the issuer to provide information required by the credit rating agency for rating and subsequent surveillance. (d)Secondary information: The credit rating agency also draws on the secondary sources of information including its own research division. It involves series of steps. future outlook. (c )Information requirements: Issuers are provided a list of information requirements and the broad framework for discussions. The secondary sources generally number of qualitative factors with a view to estimate the future earnings of the issuer.S.
the issuer is bound by the mandate letter to provide information to the credit rating agency. he has a right to appeal for a review of the rating. unless the circumstances of the case warrant an early review. evaluate the quality of technical personnel and form and opinion on the key variables that influence level. (i)Rating reviews: If the rating is not accepted to the issuer . (h)Rating communication: The assigned rating along with the key issues is communicated to the issuer’s top management for acceptance. If the inputs are convincing. Finally a rating is assigned and all the issues. The ratings are generally reviewed every year.S. The ratings which are not accepted are either rejected or reviewed. These reviews are usually taken up only if the issuer provides fresh inputs on the issues that were considered for assigning the rating. the Committee can revise the initial rating decision. Issuers response is presented to the Rating Committee. (j)Surveillance: It is obligatory on the part of the credit rating agency to monitor the accepted ratings over the tenure of the rated instrument. COLLEGE OF BUSINESS STUDIES Plant visits facilitate understanding of the production process.S. The rating committee also considers the recommendations of the internal committee for the rating. (g)Rating committee meeting: This is the final authority for assigning ratings. These visits also help in assessing the progress of projects under implementations. which influence the rating. (f)Preview meeting: After completing the analysis. A brief presentation about the issuers business and the management is made by the rating team. All the issues identified during discussions in the internal committee are discussed. At this stage. the findings are discussed at length in the internal committee. comprising senior analysts of the credit rating agency. assess the state of equipment and main facilitates. As has been mentioned earlier. In a 22 . All the issues having a bearing on the rating are identified. are clearly spelt out. an opinion on the rating is also formed. The rejected ratings are not disclosed and complete confidentiality is maintained. quality and cost of production.
ICRA’s Rating Process An Overview Mandate Initial Stage Assign Rating Team Receive initial information Conduct basic research Fact findings and analysis Meetings and visits Analysis and Preparation of Report Purview Meeting Rating Finalisation Rating Meeting Fresh inputs/Clarifications Assign Rating Communicate the rating and rationale Request for Review Acceptance Non Acceptance Surveillance 23 . COLLEGE OF BUSINESS STUDIES surveillance review the initial rating could be retained or revised(upgrade or downgrade) .S.S. The various factors that are evaluated in assigning the ratings have been explained under rating framework.
while the long term ratings are generally entirely based on the adequacy of primary cash flows. This in a nutshell includes.S.S. an assessment is also made of the available marketable securities(secondary cash flows) which can be liquidated if require d. Business risk drivers • • • • • Industry characteristic Market position Operational efficiency New projects Management quality Financial risk drivers • • Funding policies Financial flexibility 24 . Additionally . These factors can be conceptually classified into business risk and financial risk drivers. COLLEGE OF BUSINESS STUDIES RATING FRAMEWORK The basic objective of rating is to provide an opinion on the relative credit risk (or default risk) associated with the instrument being rated. estimating the cash generation capacity of the issuer through operations (primary cash flows) vis-à-vis its requirements for servicing obligations over the tenure of the instrument. to supplement the primary cash flow may be noted that secondary cash flows have a greater bearing in the short term ratings . All the factors whish have a bearing on future cash generation and claims that require servicing are considered to assign ratings.
S. It is a key determinant of the level and volatility in earnings of any business. industry risk determines the cap for ratings. COLLEGE OF BUSINESS STUDIES Industry characteristics: This is the most important factor in credit risk assessment. cyclical Bargaining position of customers State of competition • • • • • Existing & expected capacities Intensity of competition Entry barriers for new entrants Exit barriers Threat of substitutes Environmental factors • • • Role of the industry in the economy Extent of government regulation Government policies-current and future direction Bargaining position of suppliers • Availability of raw material 25 . Some of the factors that are analyzed include: Demand factors • • • • Drivers & potential Nature of product Nature of demand-seasonal.S. Other factors remaining the same .
It may be mentioned that the issuers whose market share is declining. the market position is determined by the unit’s operational efficiency. Cost of production to a large extent is influenced by: • • • • • Location of the production units Access to raw materials Scale of operations Quality of technology Level of integration 26 . where low cost producers almost always have an edge. Operational efficiency : In a competitive market . it is critical for any business unit to control its costs at all levels. generally do not get favourable long term ratings. This assumes greater importance in commodity or “ me too” businesses. It needs to be mentioned that with the opening up of the Indian economy. stable businesses(low industry risk) with lower level of cash generation are viewed more favorably compared to business with higher cash generation potential but relatively higher degree of volatility. perceived quality of products or brand equity. In markets where competiveness is largely determined by costs. Market position : All the factors influencing the relative competitive position of the issuer are examined in detail. COLLEGE OF BUSINESS STUDIES • • • Dependence on a particular supplier Threat of forward integration Switching costs For credit risk evaluation . proximity to the markets. distribution network and relationship with the customers. The result of these factors is reflected in the ability of the issuer to maintain/ improve its market share and command differential in pricing. it is also critical to establish international competitiveness both at the industry and unit level.S.S. Some of these factors include positioning of the products .
financing tie-up. Some of the indicators for measuring production efficiency are:. material usage and energy consumption. A detailed discussion is held with the management to understand its objectives. It also helps in establishing management’s priorities. even non- completion in an extreme case. When the business conditions are adverse . project cost comparisons.S. financing arrangements. during construction phase. competitive position and views about the past performance and future outlook of the business. Collection efficiency and inventory levels are important indicators of both the market position and operational efficiency. New project risks : The scale and nature of new projects can significantly influence the risk profile of any issuer. tie-up of raw material sources . plans & strategies.S. Besides clearly establishing the rationale of new projects. Management quality : The importance of this factor can not be overemphasized. experience and quality of the project implementation team. Unrelated diversifications into new products are invariably assessed in greater detail. The main risks from new projects are:-Time and cost overruns. These discussions provide insights into the quality of the management. experience and track record of technology supplier. A review of the organization 27 . the protective factors that are assessed include: track record of the management in project implementation. composition of operations team and market outlook and plans. status of the project. operational risks. and market risk. it is the strength of management that provides resilience. COLLEGE OF BUSINESS STUDIES • • Experience Ability of the unit to efficiently use of its resources A comparison with the peers is done to determine the relative efficiency of the unit.resource productivity. implementation schedule.
These sources include: availability of liquid investments. both internal(secondary cash flows) and external. while the focus of rating exercise is to determine the future cash flow adequacy for servicing debt obligations. Past financial performance : The impact of the various drivers is reflected in the actual performance of the issuer.S. Management’s views on its funding policies are discussed in detail. market reputation. Issues like dependence on a particular individual and succession planning are also addressed. a detailed review of the past financial statements is critical for better understanding of the influence of all the business and financial risk factors. investor’s perceptions and experience of tapping 28 . unutilized lines of credit. with financial institutions and banks. during periods of stress. financial strength of group companies. an assessment is also made of the ability of the issuer to draw on other sources. These discussions are generally focused on the following issues: • • • • • • • Future funding requirements Level of leveraging Views on retaining shareholding control Target returns for shareholders Views on interest rates Currency exposures including policies to control the currency risk Asset-liability tenure matching Financial flexibility : While the primary source for servicing obligations is the cash generated from operations.S. Funding policies :This determines the level of financial risk. COLLEGE OF BUSINESS STUDIES structure and information system is done to assess whether it aligns with the management’s plans and priorities. The interactions with key operating personnel help in determining the quality of the management. Thus . relationship funds from different sources.
Some of the important indicators that are analyzed are presented below: Profitability : A traditional indicator of success or failure of any business endeavor has been its ability to add to its wealth or generate profits.S. COLLEGE OF BUSINESS STUDIES Evaluation of the existing financial position is also important for determining the sources of secondary cash flows and claims that may have to be serviced in future. notes to accounts and auditors comments in detail. Profitability also determines the market perception which has a bearing on the support of share holders and other lenders. Some important indicators are: • Total debt as a % of net worth 29 . A few important indicators are trends in: • • • Return on capital employed Return on net worth Gross operating margins Higher profitability implies greater cushion to debt holders. Accounting quality : Consistent and fair accounting policies are a pre-requisite for financial evaluation and peer group comparisons. Over a period of time the focus of financial analysis at the credit rating agency has shifted towards evaluation of cash flow statements as cash flows to a large extent offset the impact of “financial engineering”. Gearing or level of leveraging : This is an important determinant of the financial risk. This support can be an important factor during stress. Comparison with peers is important for better understanding of the industry trends and determining the relative position of the issuer. Rating analysts review the accounting policies.S. It may be mentioned that accounting quality is also an important indicator of the management quality. Indicators of financial performance: Financial indicators over the last few years are analyzed and performance of the issuer is compared with its peers. Wherever necessary. rating analysts adjust the financial statements to reflect the correct position.
30 . higher the level of coverage. Comparison with peers on these indicators helps to determine the relative position of the issuer in the industry. issuer’s market position & policies . Generally speaking. However as mentioned earlier . Cash flows reflect the sources from which cash is generated and it is deployed. while gearing has a secondary role in determining the overall rating. The important ratios are: • • • Interest coverage ratio(OPBIT/Interest) Debt service coverage ratio Net cash accruals as a % of total debt The level of these ratios reflects the result of business risk drivers and the funding policies.S. COLLEGE OF BUSINESS STUDIES • Long term debt as a % of net worth Total outside liabilities as a% of total assets • It needs to be emphasized that business risk is a prime driver. Liquidity position : The indicators of liquidity positions are . relationship with customers and suppliers arte the important factors that impact the above levels. higher is the rating. the levels of: • • • Inventory Receivables Payables The state of competition . any financial evaluation would be incomplete if cash flow analysis is not carried out. Thus. Coverage ratios : Considered to be of primary importance to the debt holders. The funding profile with respect to matching of asset – liability tenures also has an important bearing on the liquidity position.S. business with lower level of coverage can get higher ratings if the earnings are steady. Cash flow analysis : Cash is required to service obligations.
the financial projections are carried out for a number of scenarios incorporating a range of possibilities in the set of assumptions for the key cash flow drivers.S.S. COLLEGE OF BUSINESS STUDIES Cash flows offset the impact of diverse accounting policies and hence facilitate peer comparison. Future cash flow adequacy : The ultimate objective of the rating is to determine the adequacy of cash generation to service obligations. Invariably. value of currencies. 31 . Number of assumptions based on the future outlook of the business is made to draw projections of financial statements. input costs. working capital requirements. A few important drivers are expectations of growth . selling prices.
Adequate safety. the protective factors are strong and the prospect of timely Payment of principal and interest as per terms under adverse circumstances. The protective factors are average and any adverse change in circumstances. as may be visualized. The timely payment of interest and principal is more likely to be affected by present or prospective changes in business/economic 32 . LAA+ LAA LAA LA+ LA LAHigh safety. Risk factors are more variable and greater in periods of economic stress. as may be visualized. Risk factors are negligible. The protective factors are below average. There may be circumstances adversely affecting the degree of safety but such circumstances. may alter the fundamental strength and affect the timely payment of principal and interest as per terms LBBB+ LBBB LBBBLBB+ LBB : Moderate safety. Risk factors are modest and may vary slightly. Adverse changes in business /economic circumstances are likely to affect the timely payment of principal and interest as per terms Inadequate safety.S. Indicates fundamentally strong position. differs from LAAA only marginally. COLLEGE OF BUSINESS STUDIES Rating Scale by ICRA Long-Term –including Debentures LAAA : Highest safety. Considerable variability in risk factors.S. as may be visualized are not likely to affect the timely payment of principal and interest as per terms.
Default. COLLEGE OF BUSINESS STUDIES LBBcircumstances. Inadequate safety. The prospect of timely servicing of the interest and principal as per terms is adequate. Recovery is likely only on liquidation or re-organisation. The prospect of timely servicing of the interest and principal as per terms is high. debt servicing may be affected by adverse changes in the business/economic conditions. 33 . Adverse changes in business/ economic conditions could result in inability/unwillingness to service debts on time as per terms. Substantial risk. The prospect of timely servicing of the Interest and principal as per terms is the best. LB+ LB LBLC+ LC LCLD : : : Risk-prone. but not as high as in ‘MAAA’ rating. Risk factors indicate that obligations may not be met when due. The protective Factors are narrow. Either already in default in Payment of interest and/or principal as per terms or expected to default. Extremely speculative. Medium-Term –including Fixed Deposit Programmes MAAA : Highest Safety. MAA+ MAA MAAMA+ MA MAMB+ : : Adequate safety.S. There are inherent elements of risk and timely servicing of debts/obligations could be possible only in case of continued existence of favourable Circumstances. The timely payment of interest : High safety. The protective factors fluctuate in case of changes in economy/business conditions.S. However.
Adequate safety. likely to default in case of adverse changes in business/economic conditions.S. The relative safety is marginally lower than in A1 rating. Default. 34 . Susceptibility to default is high. Short-Term –Commercial Paper A1+ A1 A2+ A2 A3+ A3 : : : Highest safety. Default.S. The degree of safety is low . but any adverse change in business/economic conditions may affect the fundamental strength. Either already in default or expected to default. Either already in default or expected to default. COLLEGE OF BUSINESS STUDIES MB MBMC+ MC MCMD : : and principal is more likely to be affected by future uncertainties. Adverse changes in business/economic conditions could result in inability/unwillingness to service debts on time and as per terms. Risk prone. The prospect of timely payment of interest and installment is adequate. High safety. A4+ A4 A5 : : Risk prone. The prospect of timely payment of debt/ obligation is the best.
etc.) into tradable securities is generally referred to as ‘securitization’ and the securities thus created are referred to as ‘asset backed securities’(AIS).S. Advantages of securitisation The main advantages of securitisation for companies holding financial assets are listed below: (a) Increased Liquidity: relatively illiquid assets are converted into tradable securities. receivables. a repayment mechanism is devised in such a way that the debt servicing is taken over by a specific pool of assets or by a third party which acts as a credit support provider. in the case of structured obligations. In conventional debt instruments the income/profits made by the company remain the primary source of debt servicing. cash reserve account.S. A structured obligation can be considered as variation of conventional secured debt instrument wherein the credit quality of debt obligation is backed by a lien on identified assets or credit support from third party. Examples include-letter of credit. Credit Enhancement’ is a form of protection against collateral losses. 35 . over collateralization. However. COLLEGE OF BUSINESS STUDIES RATING OF STRUCTURED OBLIGATION Structured Obligation (SO) or Structured Finance is a term that is applied to a wider variety of debt instruments wherein the repayment of principal and interest is backed by: • Cash flows from sense • Credit enhancement from a third party. etc. guarantee. The cash flows to the investors are secured primarily by cash flows from the specific pool of assets. A cash flow structure is the one in which some or all of the cash flows generated by the identified assets are dedicated for the payment of principal and interest. financial assets and/or The process of converting financial assets (loans.
(e) Funding Sources: securitisation allows the issuer to find alternate sources of funding and also raise funds at low costs with improved credit rating. (c) Higher Credit Quality: the structure of the instrument can be tailored in such a manner that a desired credit rating. which is higher than company holding the assets is achieved.S. COLLEGE OF BUSINESS STUDIES (b) Risk Diversification: securitisation allows the issuer to manage its credit exposure to a particular borrower/sectors and thus helps in risk diversification of asset portfolios. CASH FLOW STRUCTURE Borrower of assets loan repayments Transfer of assets Company holding financial assets LENDER Payment for assets Servicer repayments loan Issuer Spl Purpose Vehicle Principal & Interest payments Payment for Securities Credit Support Issues Securities Investors 36 . the rating of (d) Asset Liability Management: securitisation offers an efficient way of tenure matching of assets and liabilities.S.
S.) Step2: Pooling-Large number of homogenous loans are aggregated or packaged into a pool. a positive interest rate spread which is defined as the difference between interest earned on the assets and the interest plus servicing costs of security. etc. relatively predictable stream of cash flows from the identified assets. An SPV may be a trust. NBFCs. cash collateral or over-collateralisation. a special purpose bankruptcy remote company or a public sector entity.S. The maturities and interest rates of pooled loans generally the same. Step5: Issue of ABS –SPV issues securities to investors and the proceeds from the issuance are used to pay the originator for the pool of loans.) makes a loan to a borrower for purchase of an asset(car. etc. Examples include letter of credit. Step4: Credit Enhancement-Protection against the failure of borrower to make interest and principal payments on the loans. The conditions under which a securitisation transaction is highly suited for issuers are: • • • the availability of clearly identifiable and homogenous pool of assets. Some Conditions for Securitisation A structured obligation is highly beneficial for issuers who are in a position to ’structure’ appropriate levels of credit protection so that they achieve the desired credit rating. • the presence of full credit support in the structure. property. financial guarantee from a third party. COLLEGE OF BUSINESS STUDIES The Steps in Securitisation Transaction Step1: Origination-Lender (Banks. are 37 . Step3: Sales/Transfer –Sale (or transfer ) of assets from originator to an entity that is generically referred to as a ‘Special Purpose Vehicle” or SPV.
It refers to the uncertainty regarding the extent to which the borrowers of underlying assets backing the security will pay as per terms of contract. The factors considered in assessment of credit risk are: • • credit risk characteristics of the underlying pool of assets. evaluation of the size of enhancement and the change in size over time. Credit ratings provide a simple and objective assessment of default risk in the form of a symbolic indicator which is easy to comprehend. Assessment of structural risk includes the following factors: • • analysis of credit support provider.S. a) Credit Risk: It is the risk of default by the borrower. COLLEGE OF BUSINESS STUDIES Rating Methodology Credit ratings plays a very important role in the issuance of structured debt instruments.S. trigger events. b) Structured Risk: It refers to the manner in which the transaction is structured to direct the payment stream from the collateral or support provides to the investors. The framework used for assessing the risk of default involves assessment of three types of risk-credit risk. • • pool selection process. structured risk and legal risk. The structure of the instruments is generally quite complex which makes the task of assigning the credit risk extremely difficult for lay investors. future performance of the selected pool. key factors that influence the incentive and ability of borrowing to pay off their loans. 38 .
c) Legal Risk: It refers to the risk of potential insolvency of the issuer or other parties involved in securitisation transaction. • third party risk which is the risk of non-performance of the various parties such as receiving and paying agent. trustees. etc who are involved in the transaction.S. • Legal enforceability of cash flows structure under various Scenarios • Compliance with various laws and regulations Thus credit rating of a structured obligation is a forward-looking measure of relative safety level of the structural transaction against credit loss that may occur over the life of the instrument. 39 . COLLEGE OF BUSINESS STUDIES • analysis of liquidity facilitates in structures wherein cash inflows do not match the payments to the investors.S. Assessment of legal risk includes: • Evaluation of the manner in which the rights of the assets are transferred to investors.
COLLEGE OF BUSINESS STUDIES RATING INADEQUACIES Rating agencies by making information widely available at a low cost have increased market efficiency radically over the last few decades. If the companies buy the services of the 40 . However. The potential for conflict of interest facing rating agencies is thus inherent. Diversification: Traditionally. financial intermediaries and other end –users use the results of the rating agencies. Market based ratings provided by market analysts outside the purview of the rating agencies. they were not the only source of information.S. As the sale of these products generates revenues the rating agencies will not be willing to lose them. this is the basic source of revenue of the rating agencies. This again accentuates the possibility of the rating agencies to exploit the regulation. The issuer of the financial instruments whose information is disclosed by the rating agency actually pays it . the companies will always try to oblige the rating agencies by buying them. Rating agencies sell information and survive. It is so because though investors. unlike any other business. Then they used to utilize it to provide a rating of the intrinsic value or quality of a security.S. This aspect makes the rating business a different animal. However . they actually do not pay for it. There lies the potential conflict of interest. in the credit rating business. This was considered as a convenient way for investors to judge quality and make investment decisions. However. also performed about as well as the agency ratings. rating agencies begin to sell not only information but also valuable property rights associated with compliance of regulation. once regulation is passed that makes it mandatory for a company to incorporate ratings. the agencies used to gather and analyse all sorts of pertinent financial and non-financial information. Though the rating agencies will never force any company to buy their information. based on their ability to accumulate and retain reputation capital. the issuers of information do not pay for it. This eventually posed challenges to the rating agencies and emerged as a potential threat.
And that took time to downgrade the company. it is possible that they thought it better to think twice before having the courage to say that the emperor is not wearing any clothes. The risk –consultancy services of Moody’s has become a leading provider to investors. Presently both the rating giants provide a well – diversified portfolio of risk-consultancy services. 41 .S. many investors would have saved themselves from burning their hands. after perceiving the potential threat and partly foreseeing the saturation of the market for new rating business. The international practice is being replicated in India on an increasing basis by ICRA and CRISIL given the fact that Moody’s and S&P hold stakes in each of them respectively. Over the past two decades. say that their job is to portray the true picture of the riskiness associated with a bond and its likelihood of default in the long run. In the aftermath of the Enron debacle . With Enron . to price credit risk. irrespective of the quality aspect. ICRA have diversified into the consultancy business. then the reward they expect is definitely a better rating. The possibility of the rating agencies being jittery of revealing shoddy financial statements hiding actual transaction cannot be ruled out. It allows credit risk professionals to employ Moody’s ratings and credit history experience to better measure and manage credit risk. financial analysts and other end-users in managing the risk in portfolios of credit exposures to both private and public companies.S. to identify industry and geographic concentrations . and to measure the impact of the prospective purchases or sale of debt within a portfolio context. It has been opined by various people that had the rating agencies been quick in envisaging the company’s bankruptcy. allegations have been raised against the rating agencies for not being prompt in identifying the Enron debacle. Holier than thou approach The rating agencies defending themselves. Both CRISIL. COLLEGE OF BUSINESS STUDIES rating agencies .
the forward looking commentary will enable the investor to identify “ credit cliff situations” and the change in the credit worthiness of companies over a period of time. high volatility among investment grade credits and securities price behavior has fueled the demand for a more complete and rigorous surveillance and commentary from rating agencies.S. the flipside of prompt down(or up) gradation by the rating agencies henceforth . Clifford Griep. to a grate extent. As the credit rating agencies have to maintain their own reputation for their survival. will increase the volatility in the stock prices. credit rating services will continue to occupy a place of significance in our growing economy. The success of the system will ultimately hinge on the presentation of credibility and integrity by the concerned agencies. Chief Credit Officer. It may also lead to a loss of long-term focus of credit rating. Mr.S.” According to him . increased global competition. However . COLLEGE OF BUSINESS STUDIES CONCLUSION Credit Rating in India is a concept with not too long a history. 42 . Allegations have already been raised against the rating agencies for not doing their job. The rating agencies faces a lot of challenges specially after the Enron debacle. The fast changing economic scenario. it becomes imperative to them to remain extremely alert to the developments both in the market and within companies. S&P says “ Many changes are underway. Given its significance as an information provider and facilitator for the efficient allocation of resources by the financial market. including publishing commentary more frequently so that the markets hear from us after routine events such as earning calls and management changes.
lesser the transparency in financial disclosure. 43 .S. COLLEGE OF BUSINESS STUDIES Another issue that asks for introspection is how the credit rating agencies account for off-balance sheet deals and the degree of financial disclosure of the company they rate. The rating agencies must put more focus on the information related to the offbalance sheet transactions. The rating agencies should more promptly identify companies trying to suppress financial information. Clearly.S. more is the possibility of surprises to investors.
SEBI Manual. 2. Taxmann 3. 4.businessstandard. Bharat Publishing House. 6.S.C/ Credit Rating(Practice & Procedure).com 7. ICRA . 5. “Risky Conflicts. icraindia.” Chartered Financial Analyst. www. www. www. Credit Rating.com 8.com 44 .S. Verma J. “Rating-Knotty issues.crisil.” Chartered Financial Analyst. COLLEGE OF BUSINESS STUDIES BIBLIOGRAPHY 1. New Delhi.
NBFC’s. Credit Rating agencies . Credit Rating is a boon for the common investors in terms of information which are not always accessible to them and also for the issuers as it helps them to build a credibility and helps them to raise funds from the market at a cheaper rate. FI’s.S. PSU’s and municipalities. commercial banks. 45 . Real Estate Developers & Projects. COLLEGE OF BUSINESS STUDIES PREFACE This study was undertaken to understand the functioning of credit rating agencies.S. Corporate Governance. worldwide has evolved over the years. structured obligation. Claim paying ability of Insurance Companies. and Mutual Fund Schemes. Construction Entities. their role and impact in the capital market in India. Nowadays the items that are rated include debt. It was started by rating the ability of merchants to pay their financial obligations and that of Railroad Securities. instruments issued by manufacturing companies.
S. COLLEGE OF BUSINESS STUDIES CONTENTS Introduction --Objective --Historical Origin --Concept of Credit Rating --Use --SEBI Regulations Methodology Credit Rating Agencies in India ICRA -Range of services Rating Process Rating Framework Rating of Structured obligations Rating Inadequacies Conclusion Annexure Bibliography 46 .S.
S. In the United States. which pioneered the credit rating concept in the late 1950s. credit worthiness is usually determined through a statistical analysis of the available credit data. Personal credit ratings In countries such as the United States. The factors which may influence a person's credit rating are: * ability to pay a loan * interest * amount of credit used * saving patterns Corporate credit rating or 47 . R1 refers to on-time payments. COLLEGE OF BUSINESS STUDIES ANNEXURE Source: Internet Credit Ratings and Analysis A credit rating is an assessment by a third party of the creditworthiness of an issuer of financial securities. comes from Fair Isaac Corporation. the most common ratings are the North American Standard Account Ratings. and establish the amount of a utility or leasing deposit. A poor credit rating indicates a high risk of defaulting on a loan. affects his or her ability to borrow money through financial institutions such as banks. R9 refers to bad debt. corporation. determine employment eligibility. an individual's credit history is compiled and maintained by companies called credit bureaus. However. or the refusal of a loan by the creditor. which have a range between R0 and R9. A common form of this analysis is a 3-digit credit score provided by independent financial service companies such as the FICO credit score. (The term. credit ratings have also been used to adjust insurance premiums.) An individual's credit score. It tells investors the likelihood of default. Typically. in recent years. by the issuer of its financial obligations. or nonpayment. also known as the "R" ratings. and thus leads to high interest rates. Credit ratings are calculated from financial history and current assets and liabilities. R0 refers to a new account. a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. ____________________________________________ What is credit rating??? How is it generally done? A credit rating assesses the credit worthiness of an individual. In Canada. along with his or her credit report. a registered trademark.S. or even a country.
or national governments issuing debt-like securities that can be traded on a secondary market. For investors.S.S.) * Moody's (U. COLLEGE OF BUSINESS STUDIES Bond credit rating The credit rating of a corporation is a financial indicator to potential investors of debt securities such as bonds. Credit rating is done by a credit rating agency.) * Pacific Credit Rating (Peru) Uses of ratings by credit rating agencies Credit ratings are used by investors. (A company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency.) * Baycorp Advantage (Australia) * Dominion Bond Rating Service (Canada) * Fitch Ratings (U. startup companies. cities. This in turn increases the total supply of risk capital in the economy. easy-to-use measurements of relative credit risk. this generally increases the efficiency of the market. and affects the interest rate applied to loans. these issuers are companies. issuers.S.S.) * Standard & Poor's (U. leading to stronger growth. the ability to pay back a loan. In most cases. Ratings use by bond issuers Issuers rely on credit ratings as an independent verification of their own creditworthiness. the issuance may be undersubscribed or the price offered by investors too low for the issuer's purposes). These are assigned by credit rating agencies such as Standard & Poor's or Fitch Ratings and have letter designations such as AAA.check out info about that also A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations.. broker-dealers. hospitals and universities.S. a form of price discrimination based on the different expected costs of different borrowers.) Interest rates are not the same for everyone. Best (U. as set out in their credit rating. and by governments. In most cases. B. It also opens the capital markets to categories of borrower who might otherwise be shut out altogether: small governments. CC. a significant bond issuance must have at least one rating from a respected CRA for the issuance to be successful (without such a rating. There exist more than 100 rating agencies worldwide. A credit rating measures credit worthiness. lowering costs for both borrowers and lenders. Recent studies by the Bond Market Association note that many 48 . investment banks. non-profit organizations.S. credit rating agencies increase the range of investment alternatives and provide independent. Credit rating agencies for corporations * A. but instead are based on risk-based pricing. M.
49 . Issuers also use credit ratings in certain structured finance transactions. Conversely. COLLEGE OF BUSINESS STUDIES institutional investors now prefer that a debt issuance have at least three ratings. a company with a low credit rating might be able to borrow on better terms if it were to form an SPE and transfer significant assets to that subsidiary and issue secured debt securities. the Securities and Exchange Commission (SEC) permits investment banks and broker-dealers to use credit ratings from "Nationally Recognized Statistical Rating Organizations" (or "NRSROs") for similar purposes. government bonds or short-term commercial paper from very stable companies). Ratings use by investment banks and broker-dealers Investment banks and broker-dealers also use credit ratings in calculating their own risk portfolios (i. if the financial institution is heavily invested in highly liquid and very "safe" securities (such as U. if the venture were to fail. Some CRAs avoid this conflict by refusing to rate debt offerings for which its advisory services were sought.S. or permit these ratings to be used for regulatory purposes.. This "special purpose entity" would then assume all of the research risk and issue its own debt securities to finance the research. The idea is that banks and other financial institutions should not need to keep in reserve the same amount of capital to protect the institution against (for example) a run on the bank. This creates a potential conflict of interest. The same issuer also may have different credit ratings for different bonds. the collective risk of all of their investments).S. This difference results from the bond's structure. This would lower the interest rate the SPE would need to pay as part of the debt offering. banking regulators can allow banks to use credit ratings from certain approved CRAs (called "ECAIs" or "External Credit Assessment Institutions") when calculating their net capital reserve requirements. as the CRA may feel obligated to provide the issuer with that given rating if the issuer followed its advice on structuring the offering. Larger banks and broker-dealers conduct their own risk calculations. this risk would not lower the parent company's overall credit rating because the SPE would be a legally separate entity. and the degree to which the bond is subordinated to other debt.e. under the Basel II agreement of the Basel Committee on Banking Supervision. However. That way. the lenders would have recourse to the assets owned by the SPE. how it is secured. In the United States. For example. but rely on CRA ratings as a "check" (and double-check or triple-check) against their own analyses. Many larger CRAs offer "credit rating advisory services" that essentially advise an issuer on how to structure its bond offerings and SPEs so as to achieve a given credit rating for a certain debt tranche. Ratings use by government regulators Regulators use credit ratings as well.S. For example. of course. The SPE's credit rating likely would be very low and the issuer would have to pay a high rate of return on the bonds issued. a company with a very high credit rating wishing to undertake a particularly risky research project could create a legally separate entity with certain assets that would own and conduct the research work.
investing instrument or market. Likewise. a security or a country . credit ratings are essential tools for helping you make some investment decisions. loans.S. Standard and Poor's (S&P's) and Fitch IBCA. Ratings can be assigned to short-term and long-term debt obligations as well as securities. for example. SEC. _________________________________________________________ What Is A Corporate Credit Rating? by Reem Heakal Before you decide whether to invest into a debt security from a company or foreign country. Measuring the ability and willingness of an entity . A ratings company can help you do this. insurance regulators use credit ratings to ascertain the strength of the reserves held by insurance companies. It is important to gain insight into different investment environments but also to understand the risks and advantages these environments pose. A lack of foreign reserves. These are: Moody's. sell or hold 50 .S. has issued bonds before. The Raters There are three top agencies that deal in credit ratings for the investment world. for example. a credit ratings company helps investors decide how risky it is to invest money in a certain country and/or security. but without FDIC insurance) comprise only securities with a very high rating from an NRSRO. There are advantages to investing in foreign markets.to keep its financial commitments or its debt. and has a credit rating above a certain level. it is difficult to decide not only which companies but also which countries are good investment opportunities. permits certain bond issuers to use a shorten prospectus form when issuing bonds if the issuer is older. Each of these agencies aim to provide a rating system to help investors determine the risk associated with investing in a specific company. The U.S. you must determine whether the prospective entity will be able to meet its obligations. For a government or company it is sometimes easier to pay back local-currency obligations than it is to pay foreign-currency obligations. preferred stock and insurance companies. may warrant a lower rating for those obligations a country made in foreign currency. SEC regulations also require that money market funds (mutual funds that mimic the safety and liquidity of a bank savings deposit. a corporation. Credit in the Investment World As investment opportunities become more global and diverse. Providing independent objective assessments of the credit worthiness of companies and countries. The ratings therefore assess an entity's ability to pay debts in both foreign and local currencies. COLLEGE OF BUSINESS STUDIES CRA ratings are also used for other regulatory purposes as well. Long-term credit ratings tend to be more indicative of a country's investment surroundings and/or a company's ability to honor its debt responsibilities.which could be a person. It is important to note that ratings are not equal to or the same as buy. but the risks associated with sending money abroad are considerably higher than those associated with investing in your own domestic market.
"AA" represents very high credit quality. This rating gives the investor an immediate understanding of the level of risk associated with investing in the country. Ratings are rather a measure of an entity's ability and willingness to repay debt. A sovereign credit rating provides the latter as it signifies a country's overall ability to provide a secure investment environment. and "BBB" is good credit quality. In most circumstances. political stability. These ratings are considered to be investment grade. a rating can refer to an entity's specific financial obligation or to its general creditworthiness. Ratings that fall under "BBB" are considered to be speculative or junk. or the ability for a country's economy to remain stable despite political change. "A" means high credit quality. foreign direct investment. B Junk High Risk Caa/Ca/C CCC/CC/C Junk Highest Risk C D Junk In Default Sovereign Credit Ratings As previously mentioned. Thus. which are. foreign currency reserves. and C or D (depending on the agency issuing the rating) is the lowest or junk quality. levels of public and private investment flows. Thus for Moody's a Ba2 would be a speculative grade rating while for S&P's. Within this spectrum there are different degrees of each rating. the sovereign rating is the first thing most institutional investors will look at when making a decision to invest money abroad. a "AAA" rating signifies the highest investment grade and means that there is very low credit risk.S. transparency in the capital market. depending on the agency. a country's sovereign credit rating will be its upper limit of credit ratings. The Ratings Are In The ratings lie on a spectrum ranging between highest credit quality on one end and default or "junk" on the other. So to attract foreign money. Here is a chart that gives an overview of the different ratings symbols that Moody's and Standard and Poor's issue: Bond Rating Grade Risk Moody's Standard & Poor's Aaa AAA Investment Lowest Risk Aa AA Investment Low Risk A A Investment Low Risk Baa BBB Investment Medium Risk Ba. which means that the security or the entity being rated carries a level of quality that many institutions require when considering overseas investments.S. most countries will strive to obtain a sovereign rating and they will strive even more so to reach investment grade. sometimes denoted by a plus or negative sign or a number. 51 . a "D" denotes default of junk bond status. Long–term credit ratings are denoted with a letter: a triple A (AAA) is the highest credit quality. B BB. This rating reflects factors such as a country's economic status. COLLEGE OF BUSINESS STUDIES recommendations. A country with a sovereign rating will therefore get more attention than one without. for Fitch IBCA. Because it is the doorway into a country's investment atmosphere.
Credit Rating is also a valuable input in establishing business relationships of various types. many countries and companies will strive to maintain and improve their ratings. hence ensuring a stable political environment and a more transparent capital market.S. The reason is that some factors. by Reem Heakal Some FAQs about Credit Rating What is credit rating? Credit rating is. Why is credit rating necessary at all? Credit rating is an opinion expressed by an independent professional organisation. different investors have different views regarding the level of risk to be taken and rating agencies can only express their views on the relative credit risk. are not taken into account by rating agencies. Does credit rating constitute an advice to the investors to buy? It does not. And because the credit rating acts to facilitate investments. For example. a more meaningful relationship between the quality of debt and the yield from it. for emerging market economies. attracting foreign money and boosting a nation's economy. In general. rather than give marks or descriptive credit opinion? The great advantage of rating symbols is their simplicity. the opinion of the rating agency on the relative ability and willingness of the issuer of a debt instrument to meet the debt service obligations as and when they arise. which are of significance to an investor in arriving at an investment decision. Further. to facilitate deeper understanding. 52 . but also for the entities looking for investors. credit rating is expected to improve quality consciousness in the market and establish. which facilitates universal understanding. An investment grade rating can put a security. COLLEGE OF BUSINESS STUDIES Conclusion A credit rating is a useful tool not only for the investor. after making a detailed study of all relevant factors. It also helps the issuers of debt instruments to price their issues correctly and to reach out to new investors. the credit rating is key to showing their worthiness of money from foreign investors. Indeed. Such an opinion will be of great assistance to investors in making investment decisions. secondary market liquidity and pre-payment risk. over a period of time. Why do rating agencies use symbols like AAA. Rating companies also publish explanations for their symbols used as well as the rationale for the ratings assigned by them.S. essentially. company or country on the global radar. Regulators like Reserve Bank of India (RBI) and Securities & Exchange Board of India (SEBI) often use credit rating to determine eligibility criteria for some instruments. AA. These include reasonableness of the issue price or the coupon rate. the RBI has stipulated a minimum credit rating by an approved agency for issue of Commercial Paper.
Further.S. the rating agencies often put issues under credit watch and upgrade or downgrade the ratings as and when necessary. It will indeed be unusual if one agency assigns a rating of DOUBLE A while another gives a TRIPLE B.S. to totally eliminate the subjective element. incurs a loss on the investment? A credit rating is a professional opinion given after studying all available information at a particular point of time. rating is essentially an investor service and a rating agency is expected to maintain the highest possible level of analytical competence and integrity. such opinions may prove wrong in the context of subsequent events. Nevertheless. who makes his investment decision on the basis of its rating. It is. affecting the debt servicing capabilities of the issuer. In the context of emerging developments. Co-operation from the issuers as well as their willingness to share even confidential information are important prerequisites. How reliable and consistent is the rating process? How do rating agencies eliminate the subjective element in rating? To answer the second question first. a number of qualified professionals are involved in the rating process. a debt issue may be rated DOUBLE A PLUS by one agency and DOUBLE A or DOUBLE A MINUS by another. Rating does not come out of a pre-determined mathematical formula. consists of professionals with impeccable credentials. Rating agencies do a great amount of number crunching. in some cases. On its part. And. Do rating companies undertake unsolicited ratings? Not in India. The Rating Committee. the rating agency has a great responsibility to ensure confidentiality of the sensitive information that comes into its possession during the rating process. It will be relevant to mention here that any rating based entirely on published information has serious limitations and the success of a rating agency will depend. To ensure consistency and reliability. one way or the other. it is neither possible nor even desirable. there is no privity of contract between an investor and a rating agency and the investor is free to accept or reject the opinion of the agency. rated by more than one agency. Normally. debt issues are. There is however. Rating agencies also ensure that the rating process is insulated from any possible conflicts of interest. at least not yet. on its ability to access privileged information. corporate strategy. a good case for undertaking unsolicited ratings. but the final outcome also takes into account factors like quality of management. it is only natural that the opinions given by two or more agencies will vary. brick by brick. Nevertheless. For example. In the well-developed capital markets. more often than not. But it will be very unusual if such differences are very wide. to a great extent. In the long run. COLLEGE OF BUSINESS STUDIES What kind of responsibility or accountability will attach to a rating agency if an investor. therefore. Is it customary to have the same issue rated by more than one rating agency? Do the ratings for the same instrument vary from agency to agency? The answer to both the questions is yes. such action is taken after intensive interaction with the issuers. which assigns the final rating. many things change. economic outlook and international environment. on the quality of its services. which fixes the relevant variables as well as the weights attached to each one of them. 53 . As time goes by. Why do rating agencies monitor the issues already rated? A rating is an opinion given on the basis of information available at a particular point of time. the credibility of a rating agency has to be built. rating agencies monitor all outstanding debt issues rated by them. essential that as a part of their investor service.
furnishing additional information. intensive discussion with the senior executives of issuer. arrive at different conclusions on the same issue. credit rating agencies offer grading of IPOs which take into account the fundamentals of the issuer. It may. If a rating is downgraded. consistency and integrity. So. COLLEGE OF BUSINESS STUDIES Do issuers have a right of appeal against a rating assigned? Yes. It is of paramount importance to rating companies to ensure that they do not. credit reinforcements specific to the issue etc. an issuer approaches another. Is the rating assigned for an instrument or for the Issuer Company? Both. be pointed out here that two rating companies may. subject to availability of all the solicited information. Is it possible that not satisfied with the rating assigned by one rating agency. then. How much time does rating take? The rating process is a fairly detailed exercise. While issuer ratings are more often than not. discussions with auditors. as equity is in the nature of venture capital. undertake a review and thereafter indicate its final decision. but rating companies do not and should not indulge in competitive generosity. In a situation where an issuer is unhappy with the rating assigned. analysis of published financial information. etc. Issuer ratings consider the overall debt management capability of an issuer on a medium term perspective. It involves. Unless the rating agency had overlooked critical information at the first stage. typically three to five years. All this takes time and a rating agency may take three to four weeks or more to arrive at a decision. considered relevant. one time assessments of credit quality. he may request for a review. However. visits to the issuer’s office and works. chances of the rating being changed on appeal are rare. compromise on the quality of their analysis. however. in the hope of getting a better result? It is possible. there is no pre-determined servicing obligation. how would it "benefit" (or compensate ) the investor? A credit rating is a professional opinion on the ability and willingness of an issuer to meet debt-servicing obligations. credit rating is an opinion on the issuers capacity to service debt. Why are equity shares not rated? By definition. The rating agency will. as perceptions differ. of late. under pressure from issuers for quick results. It also involves an in-depth study of the industry itself and a degree of environment scanning. credit rating in the conventional sense does not apply to equity shares. instrument ratings are monitored over the life of the instrument.S. among other things. in any way. Any attempt by issuers to play one agency against another will have to be discouraged by all the rating companies. It is an opinion on future debt servicing capabilities given on the 54 . Rating of instruments would consider instruments’ specific characteristics like maturity. and often do. bankers. Issuers would also be well advised to approach the rating agencies sufficiently in advance so that issue schedules can be adhered to.S. if any. This is only natural. (which is unlikely). Who rates the rating companies? Informed public opinion will be the touchstone on which the rating companies have to be assessed and the success of a rating agency should be measured by the quality of the services offered. In the case of equity.
evaluate the reasonableness of the issue price. On the occurrence of such an event. Such changes are reported widely through the media. statutory auditors. it must be noted that there is no privity of contract between an investor or a lender and a rating agency and the investor is free to accept or reject the opinion of the agency. for example. Hence. industry trends and management capabilities. In other words. inter-alia. or interest or exchange risks. the rating essentially is an opinion on the relative quality of the credit risk. interaction with company management. A credit rating is not an advice to buy. a rating agency can only review and make appropriate changes in the rating. possibilities for capital gains or take into account the liquidity in the secondary market. While rating agencies make all possible efforts to project corporate business prospects.S. Further.) at a particular time. companies in such segments or with large exposures to such segments are adversely affected and their credit ratings get downgraded. They do not. of past performance and all available information (from audited financial statements. credit quality (and credit rating) is dynamic. banks and financial institutions. Moreover. such opinions may prove wrong in the context of subsequent events. GLOSSSARY 55 . It is the experience of all rating agencies that some instruments initially rated as investment grade fall below investment grade or go into default. over a period of time. sell or hold securities or investments and investors are expected to take their investment decisions after considering all relevant factors and their own policies and priorities. not static and all rating agencies review their ratings periodically and make changes. wherever considered appropriate. when there are recessionary trends in certain segments of the economy. many events are unpredictable. A credit rating is not a guarantee against future losses. Such downgradations are a natural consequence of the recessionary trends. Although these are often related to the credit risk. Please also note that credit ratings do not take into account many aspects which influence investment decisions.S. COLLEGE OF BUSINESS STUDIES basis. etc. Ratings also do not take into account the risk of prepayment by issuer. based on the information available at a given point of time.
under which the agency assigns a grade to an equity issue. as to guarantee the issuer of securities a specified price by entering into a purchase and sale agreement. CARE: Credit Analysis and Research Ltd. Standard & Poorʼs: a division of McGraw-Hill that publishes financial research and analysis on stocks and bonds. at the request of the prospective is § § § § § § § § § § § § 56 .S. Calcutta. It is one of the top three companies in this business Audit : An examination of a company's accounting records and books conducted by an outside professional in order to determine whether the company is maintaining records according to generally accepted accounting principles Underwriting: To guarantee.S. The company has a 40% share in the world credit rating market. To bring securities to market RBI: Reserve bank of India SEBI: Securities and exchange board of India CRISIL: Credit Rating and Information Services of India Ltd. ICRA Limited. US and Alliance Capital Limited . ICRA Ltd: Investment Information and Credit Rating Agency of India Limited. Equity Grading : A service offered by the credit rating agency. The company also ranks the credit-worthiness of borrowers using a standardized ratings scale. COLLEGE OF BUSINESS STUDIES § Intermediator:institution that provide the market function of matching borrowers and lenders or traders Disintermediation: Withdrawal of funds from a financial_institution in order to invest them directly Moodyʼs investor service:performs financial research and analysis on commercial and government entities. FITCH: JV between Duff & Phelps.
UTI: Unit trust of India PNB: Punjab National Bank GIC: General insurance corp. Currency hedges reduce (direct) currency exposure Gross operating margin What remains from sales after a company pays out the cost of goods sold. Currency risk arises from a combination of currency exposure and currency volatility. the biggest life insurer in India and under control of govt of India. Gross operating margin is expressed as a percentage. a psu and biggest insurer in india. This ratio measures a firm's ability to pay interest § § § § § § § § § § § 57 .: The Industrial Finance Corporation of India. of India. COLLEGE OF BUSINESS STUDIES § IFCI Ltd.the biggest PSU bank in India. Financial leverage is measured by the ratio of debt to debt plus equity. SBI: State bank of India. Interest coverage ratio(OPBIT/Interest) :The ratio of earnings before interest and taxes to annual interest expense. the first Development Financial Institution in the country to cater to the long-term finance needs of the industrial sector.S. Switching costs: cost of Liquidating a position and simultaneously reinstating a position in another futures contract of the same type Leveraging :Use of debt to increase the expected return on equity. To obtain this margin.S. Currency exposures: The part of a portfolio that is denominated in a currency (or currencies) other than the base currency and is not hedged.formed for the purpose of superintending.controlling and carrying on the business of general insurance Forward integration: The expansion of a business' products and/or services to related areas in order to more directly fulfill the customer's needs. divide gross profit by sales. LIC: Life Insurance corp.
Lien :A security interest in one or more assets that lenders hold in exchange for secured debt financing Collateral : In the context of project financing. In addition. Enron stood on the verge of undergoing the largest bankruptcy in history by mid-November 2001. where it denotes the volatility of the underlying asset return from now to the expiration of the option Financial disclosure: A company's release of all information pertaining to the company's business § § § § § § § § § § § 58 . worldwide economic downturn beginning in some countries as early as 1928. Enron debacle: After a series of revelations involving irregular accounting procedures bordering on fraud perpetrated throughout the 1990s involving Enron and its accounting firm Arthur Andersen. divided by interest expense plus the quantity of principal repayments divided by one minus the tax rate Net cash accruals:??? Equity assessment:??? Great depression: The Great Depression (also known in the U. 2001. Franchise value: franchise value refers to the popularity of a particular brand or product with consumers. which at the time was one of the world's top accounting firms.K. COLLEGE OF BUSINESS STUDIES § Debt service coverage ratio: Earnings before interest and income taxes. Volatility is a variable that appears in option pricing formulas. Capital adequacy : A measure of the financial strength of a bank or securities firm. usually expressed as a ratio of its capital to its assets. as the Great Slump) was a dramatic. additional security pledged to support the project financing Securitization: the process of conversion of financial assets into tradable securities.S. the scandal caused the dissolution of Arthur Andersen. Volatility: A measure of risk based on the standard deviation of the asset return.S. Enron filed for bankruptcy on December 2.
S.S. regardless of how that information may influence investors § § Differential: A small charge added to the purchase price and subtracted from the selling pr Liquidation Occurs when a firm's business is terminated. proceeds are used to pay creditors. COLLEGE OF BUSINESS STUDIES activity. Any transaction that offsets or closes out a long or short position Financial engineering: Combining or carving up existing instruments to create new financial products § 59 . Assets are sold. and any leftovers are distributed to shareholders.
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