S.S.

COLLEGE OF BUSINESS STUDIES

INTRODUCTION
Objective:
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

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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
disintermediation;

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

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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

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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
By Investors

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

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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.

By Issuers
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.

By Intermediaries
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.

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mandatory. 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.1956. The minimum to be eligible to raise fixed deposits from ICRA/BBB from CARE. public issue of debentures and convertible/redeemable beyond a period of 18 months rating. In India . Specific rules. credit rating has been made mandatory for issuance of the following instruments: a) as per the requirements of SEBI. 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. COLLEGE OF BUSINESS STUDIES By Regulators Regulatory authorities worldwide have promoted the use of Credit Rating by issuing mandatory requirements for issuers.S. CP in bonds need credit grade from c) as per the guidelines of RBI . b) as per the guidelines of RBI. NBFCs having net owned funds of than Rs. 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. by amendment of 6 . programmes of d) there is a proposal for making the rating of fixed deposit limited companies. other than NBFCs also the Companies Act. 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.

exercise due diligence. conflict of interest shall be disclosed to the client. 7) A credit rating agency shall always endeavour to ensure that all professional dealings ate effected in a prompt and efficient manner. possible sources of conflict of duties and interests. manner. come to its knowledge. any has to shall member Any potential assurance of higher 8) A credit rating agency shall not divulge to other clients. which of the rated company/client. while providing unbiased services. It shall service. press or other party any confidential information about its clients. COLLEGE OF BUSINESS STUDIES Code of Conduct for Credit Rating Agencies SEBI (Credit Rating Agencies) REGULATIONS.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. to the client about its qualification or its capability to render certain services or its achievements in regard services rendered to other clients. whether oral or written. without making disclosure to the concerned person 7 . high 3) A credit rating agency independent professional shall render at all times high standards of care and exercise wherever necessary. 5) A credit rating agency shall not indulge in unfair competition nor they wean away client of any other rating agency on rating. 4) A credit rating agency shall avoid any conflict of interest of any of its rating committee participating in the rating analysis. 6) A credit rating agency shall not make any exaggerated statement.S. judgment.S. ensure proper disclose to the clients.

Source: Notification No.O . members stock exchanges.S. 12) A credit rating agency shall abide by the provisions of the Act. 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. respect of (b) passing of price sensitive information to brokers. other players in the capital market other person or take any other action which is to the investors. COLLEGE OF BUSINESS STUDIES 9) A credit rating agency shall not make untrue statement furnished Board or to public or to stock exchange. S.547(E).issued by SEBI the 8 .S. regulations and circulars which may be applicable and relevant to activities carried on by the credit rating agency. dated 7-7-1999. 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.

com 9 .crisil. Research has been done from secondary sources of information.businessstandard.com www.S. 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. which matter in the rating process is also included in this study.com www. The nature of this study is such that it eradicates the necessary of doing primary research. Research Design: Descriptive Research is used in this study. The factors. COLLEGE OF BUSINESS STUDIES METHODOLOGY Objective: The main objective of this study is to find out how the Credit Rating Agencies function.S.icraindia. how they rate the instruments. Secondary sources of information:        Credit Rating manuals from ICRA ICRA Information brochures Chartered Financial Analyst magazines ICFAI Reader magazine www.

The rating services comprise rating of debt instruments and credit assessment. COLLEGE OF BUSINESS STUDIES CREDIT RATING AGENCIES IN INDIA The rating coverage in India is not too old. Established in 1991 . The Infrastructure and consultancy division provide assistance on specific sectors such as power. ICRA: It was promoted by IFCI and 21 other shareholders comprising nationalized and foreign banks and insurance companies. At present there are three main rating agencies – CRISIL(Credit Rating and Information Services of India Ltd. The fourth rating agency is a JV between Duff & Phelps.). it went public in 1992 and is the only listed credit rating agency in India. general assessment such as restructuring exercise and sector specific services such as for power. CRISIL: It was promoted by ICICI. CRISIL was established. nationalized and foreign banks and insurance companies in 1987. beginning 1987 when the first rating agency. Rating services cover rating of Debt instruments-long. The services offered can be broadly classified as Rating services . Information services .S. it is the second rating agency in India. The services offered are broadly classified as Rating. Infrastructure services and consulting. US and Alliance Capital Limited . securitised assets and builders. Calcutta. telecom. ports. (Investment Information and Credit Rating Agency of India Limited) and CARE(Credit Analysis and Research). Information services offer corporate research reports and the CRISIL 500 index. telecom and infrastructure financing. The Advisory services include strategic counseling. In 1996 it entered into a strategic alliance with Standard & Poor’s to extend its credit rating services to borrowers from the overseas market. Advisory services and Investment Information services.S. municipal 10 . medium and short term.ICRA Ltd.

Market share Marketshare of the different Credit Rating Agencies in India 2% 48% 39% 11% CRISIL ICRA CARE Duff& Phelps 11 . COLLEGE OF BUSINESS STUDIES ratings . a CARE: It was set up in 1992. of understanding to support these efforts. etc. viz. In 1996. promoted by IDBI jointly with other financial institutions. a Moody’s subsidiary to offer services on Risk Management Training and software: Moody’s and ICRA has entered into memorandum. The Information services also include equity related services. . sectors and corporates. ICRA entered into a strategic alliance with Financial Proforma Inc.S. The information or the research desk provides research reports on specific industries. nationalized and private sector finance companies.S. The services offered cover rating of Debt instruments and sector specific industry reports from the research desk and equity research. Equity Grading and Equity Assessment.

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.. dated the 19th Sept. United Bank of India. The major shareholders are:. The approval was granted subject to the following conditions viz . 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. UTI. Allahabad Bank.A Detailed Study Ministry of Finance. LIC. from 12 . COLLEGE OF BUSINESS STUDIES ICRA . SBI. Department of Economic Affairs . 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. Vysya Bank. Andhra Bank . 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. IFCI Ltd. PNB. Infrastructure Leasing and Financial Services Ltd. (2) The agency should be managerially independent. UCO Bank HDFC Ltd. professional and impartial assessment of such instruments/obligations.... (1) The Agency shall be self-supporting after a maximum period of 2 years and accordingly shall not require any subvention thereafter IFCI.S. Central Bank of India. GIC. Indian Bank.Moody’s Investment Company India private Ltd. Union Bank of India. 1(120) SE/89. vide its letter No. Export-Import Bank of India. Canara Bank.S.

2. claim paying ability of corporate governance. COLLEGE OF BUSINESS STUDIES RANGE OF SERVICES The services offered by Credit Rating Agencies are as follows:1. ICRA rates long-term. Grading services—includes grading of Construction Entities. The independence and professional approach of ICRA ensure reliable. 3. Commercial Paper(CP). Rating service—rating of bonds. Information service—provides sector/industry specific studies studies/publications. structured obligations. certificates of deposit(CD). as also other sources considered reliable by ICRA.S. 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. consistent and unbiased ratings. Real Developers & Projects and Mutual Fund schemes. services Management practice. medium-term and short-term debt instruments. The rating is based on an analysis of the information and clarifications obtained from the entity . insurance companies. Ratings facilitate investors to factor credit risk in their investment decisions. Advisory services—it offers wide ranging management advisory covering the areas of Strategy practice. ICRA offers its rating services to a wide range of issuers including:  Manufacturing companies 13 . Estate 4.S. corporate reports and mandate based customized research. debentures. Risk Regulatory practice and Transaction practice.

with the risk of loss being similar as in the case of a corporate credit rating of the same level. ICRA employs a specific methodology for each of its SFR products.ABS refers to the securitisation of a diversified pool of assets. The expected loss is defined as the product of probability of default and severity of loss.S. COLLEGE OF BUSINESS STUDIES      Banks and financial institutions Power companies Service companies Municipal and other local bodies Non-banking financial service companies. commercial vehicle loans. 14 . ICRA’s four major SFR products are listed below. which may include financial assets like automobile loans. under various possible scenarios.  Mortgage Backed Securitisation (MBS) An MBS has diversified housing loans as the underlying asset for the transaction. once the default has occurred. 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. 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.S. The methodology is based on ICRA’s understanding of that particular asset class and the structured and legal issues associated with the transaction involved. 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.  Asset Backed Securitization(ABS) .

FFTs are not completed de-linked from the credit risk of the issuer. improving capital adequacy. accessing new markets and investors on the strength of a higher rating vis-à-vis a stand-alone corporate credit rating. organizational structure/ownership and underwriting and investment strategies. Following deregulation. Some examples of such sources are property tax revenues of municipal corporations. bonds or any other debt security. its management. 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. 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. but the structure. The Benefits An issuer can derive multiple advantages from structured finance products like lowering the cost of funds.S. reducing asset-liability mismatches and increasing specialization. as the underlying asset. a paradigm shift is expected in the domestic insurance sector as newer players and products enter the market. 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.  Future Flow Transaction (FFT) FFTs involve devising a structure where specified sources of future cash flows are identified are earmarked for servicing investors. Besides.S. ICRA expects its CPRs to be an important input influencing the customer’s choice of insurance companies and products. through preferential tapping of cash flows of the issuer can achieve a rating that is higher than the issuer’s credit rating. the analysis includes an 15 . including structured debt. from a policy-holder’s perspective. Given this scenario. In other words a CPR is ICRA’s opinion on the financial strength of the insurer.

liquidity. dealings with third parties like creditors. and Board structure & process. bankers. the contractor. government and society at large. financial stakeholder relation. and bettering its corporate governance practices through benchmarking. the consultant. financial transparency & information disclosure. along with the Construction Development Industry Council(CIDC) encompasses all the entities in a construction project. the project owner and the project itself. operational and financial leverage. providing comfort to regulators. improving image/credibility. by providing an independent opinion on the quality of the entity graded . The aspects examined during a CGR exercise include: ownership structure. COLLEGE OF BUSINESS STUDIES assessment of an insurance company’s profitability. capital adequacy and asset / liability management method. creditors. The service of grading. helps the corporate entity concerned in raising funds. carrying the ICRA stamp. 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. improving its valuation.S. Grading of Mutual Fund Schemes 16 . employees. A CGR . listing on stock exchanges. is designed to enhance the lender’s confidence in financing construction sector participants. customers. 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.

reliable and independent opinion on the performance and risks associated with investing in individual Mutual Fund Schemes. Credit Risk  Regulatory compliance 17 . ICRA Advisory offers CPRA as an on-line plug and play model for emarketplaces/Virtual Private networks. venture capital firms.S. financial institutions. 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. and operational risks. 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 as an off-line facility for organizations desiring to assess counter party risks of buyers/dealers and suppliers. project financiers. For manufacturing and service companies.S. planning and control. COLLEGE OF BUSINESS STUDIES ICRA’s grading of Mutual Funds seeks to address the perceived need among investors and intermediaries for an informed. CPRA is a relative measure of counterparty’s ability to honour the terms of trade. insurance firms and manufacturing firms. non-banking finance companies. equity investors. ICRA Advisory offers consultancy in risk management. multi-lateral agencies. market risks. ICRA’s clients include commercial banks. Specifically the gradings are opinions on the relative past-performance of Mutual-Fund schemes and the various factors that can influence their future performance.

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.S.

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 . 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. Instances of the regulatory practice would be assisting in policy formulation with regard to pricing of public goods. Clients of regulatory practice are Governments. public sector. subsidies and public-private partnership structures. banking and urban infrastructure. regulatory authorities and municipalities who formulate economic and financial policies. efficient market making mechanisms. consumer protection and fair trade practices . ICRA also work with corporate entities in formulating their strategies in dealing with regulatory issues.S. competition.S. ICRA advisory Services has worked on several consulting projects concerning regulatory issues in the areas of power. water.

COLLEGE OF BUSINESS STUDIES 20 .S.S.

(b) Rating team: The team usually comprises two members. (e)Management meetings and plant visits: Rating involves assessment of provide guidance on specific issues to the rating team. (d)Secondary information: The credit rating agency also draws on the secondary sources of information including its own research division. The secondary sources generally number of qualitative factors with a view to estimate the future earnings of the issuer. 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. competitive position and funding policies. (c )Information requirements: Issuers are provided a list of information requirements and the broad framework for discussions. 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. This mandate spells out the terms of the rating assignment.S. The main points are described below: (a) Rating request: Ratings in India are initiated by a formal request (or mandate) from the prospective issuer. 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. It involves series of steps. 21 . The credit rating agency also has a panel of industry experts who provide data and trends including policies about the industry. The composition of the team is based on the expertise and skills required for evaluating the business of the issuer. This requires intensive interactions with issuers’ management specifically relating to plans.S. future outlook.

unless the circumstances of the case warrant an early review. Issuers response is presented to the Rating Committee. the issuer is bound by the mandate letter to provide information to the credit rating agency. an opinion on the rating is also formed. The rating committee also considers the recommendations of the internal committee for the rating. which influence the rating. (h)Rating communication: The assigned rating along with the key issues is communicated to the issuer’s top management for acceptance. assess the state of equipment and main facilitates.S. At this stage. All the issues having a bearing on the rating are identified. In a 22 . quality and cost of production. All the issues identified during discussions in the internal committee are discussed. The ratings are generally reviewed every year. These reviews are usually taken up only if the issuer provides fresh inputs on the issues that were considered for assigning the rating. COLLEGE OF BUSINESS STUDIES Plant visits facilitate understanding of the production process. (f)Preview meeting: After completing the analysis. the findings are discussed at length in the internal committee. he has a right to appeal for a review of the rating. If the inputs are convincing. (i)Rating reviews: If the rating is not accepted to the issuer . the Committee can revise the initial rating decision. are clearly spelt out. The rejected ratings are not disclosed and complete confidentiality is maintained. evaluate the quality of technical personnel and form and opinion on the key variables that influence level. comprising senior analysts of the credit rating agency. As has been mentioned earlier. (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. (g)Rating committee meeting: This is the final authority for assigning ratings.S. Finally a rating is assigned and all the issues. The ratings which are not accepted are either rejected or reviewed. These visits also help in assessing the progress of projects under implementations. A brief presentation about the issuers business and the management is made by the rating team.

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 .S. COLLEGE OF BUSINESS STUDIES surveillance review the initial rating could be retained or revised(upgrade or downgrade) . The various factors that are evaluated in assigning the ratings have been explained under rating framework.S.

All the factors whish have a bearing on future cash generation and claims that require servicing are considered to assign ratings.S. 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. Business risk drivers • • • • • Industry characteristic Market position Operational efficiency New projects Management quality Financial risk drivers • • Funding policies Financial flexibility 24 . an assessment is also made of the available marketable securities(secondary cash flows) which can be liquidated if require d. These factors can be conceptually classified into business risk and financial risk drivers.S. Additionally . 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. This in a nutshell includes. while the long term ratings are generally entirely based on the adequacy of primary cash flows. to supplement the primary cash flow may be noted that secondary cash flows have a greater bearing in the short term 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 . It is a key determinant of the level and volatility in earnings of any business.S.S. industry risk determines the cap for ratings. Other factors remaining the same . Some of the factors that are analyzed include: Demand factors • • • • Drivers & potential Nature of product Nature of demand-seasonal.

This assumes greater importance in commodity or “ me too” businesses. it is critical for any business unit to control its costs at all levels. proximity to the markets. COLLEGE OF BUSINESS STUDIES • • • Dependence on a particular supplier Threat of forward integration Switching costs For credit risk evaluation . In markets where competiveness is largely determined by costs.S. Some of these factors include positioning of the products . The result of these factors is reflected in the ability of the issuer to maintain/ improve its market share and command differential in pricing. where low cost producers almost always have an edge. 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 . Operational efficiency : In a competitive market . generally do not get favourable long term ratings. It may be mentioned that the issuers whose market share is declining. distribution network and relationship with the customers. Market position : All the factors influencing the relative competitive position of the issuer are examined in detail. It needs to be mentioned that with the opening up of the Indian economy. it is also critical to establish international competitiveness both at the industry and unit level. the market position is determined by the unit’s operational efficiency. perceived quality of products or brand equity.S. 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.

When the business conditions are adverse . Unrelated diversifications into new products are invariably assessed in greater detail. the protective factors that are assessed include: track record of the management in project implementation. project cost comparisons. plans & strategies. even non- completion in an extreme case. financing tie-up. Management quality : The importance of this factor can not be overemphasized. status of the project. experience and quality of the project implementation team. and market risk. composition of operations team and market outlook and plans. 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.S. operational risks. financing arrangements. New project risks : The scale and nature of new projects can significantly influence the risk profile of any issuer. implementation schedule.resource productivity. during construction phase. competitive position and views about the past performance and future outlook of the business.S. These discussions provide insights into the quality of the management. it is the strength of management that provides resilience. experience and track record of technology supplier. Collection efficiency and inventory levels are important indicators of both the market position and operational efficiency. Besides clearly establishing the rationale of new projects. material usage and energy consumption. A review of the organization 27 . It also helps in establishing management’s priorities. A detailed discussion is held with the management to understand its objectives. tie-up of raw material sources . The main risks from new projects are:-Time and cost overruns. Some of the indicators for measuring production efficiency are:.

S. COLLEGE OF BUSINESS STUDIES structure and information system is done to assess whether it aligns with the management’s plans and priorities. during periods of stress. These sources include: availability of liquid investments. market reputation. Issues like dependence on a particular individual and succession planning are also addressed. an assessment is also made of the ability of the issuer to draw on other sources. both internal(secondary cash flows) and external. Management’s views on its funding policies are discussed in detail. The interactions with key operating personnel help in determining the quality of the management. 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. relationship funds from different sources. 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. unutilized lines of credit. Funding policies :This determines the level of financial risk. with financial institutions and banks. Thus . financial strength of group companies. investor’s perceptions and experience of tapping 28 . a detailed review of the past financial statements is critical for better understanding of the influence of all the business and financial risk factors.

This support can be an important factor during stress.S.S. It may be mentioned that accounting quality is also an important indicator of the management quality. 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. Profitability also determines the market perception which has a bearing on the support of share holders and other lenders. Comparison with peers is important for better understanding of the industry trends and determining the relative position of the issuer. Wherever necessary. Indicators of financial performance: Financial indicators over the last few years are analyzed and performance of the issuer is compared with its peers. Gearing or level of leveraging : This is an important determinant of the financial risk. rating analysts adjust the financial statements to reflect the correct position. Some important indicators are: • Total debt as a % of net worth 29 . 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”. 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. notes to accounts and auditors comments in detail. Rating analysts review the accounting policies. 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.

any financial evaluation would be incomplete if cash flow analysis is not carried out. The funding profile with respect to matching of asset – liability tenures also has an important bearing on the liquidity position. Comparison with peers on these indicators helps to determine the relative position of the issuer in the industry. issuer’s market position & policies . Cash flows reflect the sources from which cash is generated and it is deployed.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. Thus. higher is the rating. Coverage ratios : Considered to be of primary importance to the debt holders. Generally speaking. Liquidity position : The indicators of liquidity positions are . higher the level of coverage. 30 . 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. However as mentioned earlier . 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. while gearing has a secondary role in determining the overall rating. relationship with customers and suppliers arte the important factors that impact the above levels.S. the levels of: • • • Inventory Receivables Payables The state of competition .

Future cash flow adequacy : The ultimate objective of the rating is to determine the adequacy of cash generation to service obligations. value of currencies. A few important drivers are expectations of growth . working capital requirements. selling prices. 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. Number of assumptions based on the future outlook of the business is made to draw projections of financial statements.S. input costs. 31 .S. Invariably. COLLEGE OF BUSINESS STUDIES Cash flows offset the impact of diverse accounting policies and hence facilitate peer comparison.

as may be visualized are not likely to affect the timely payment of principal and interest as per terms. Risk factors are modest and may vary slightly. Risk factors are more variable and greater in periods of economic stress. differs from LAAA only marginally. Adverse changes in business /economic circumstances are likely to affect the timely payment of principal and interest as per terms Inadequate safety. The protective factors are below average.S. as may be visualized. Indicates fundamentally strong position. Risk factors are negligible. Adequate safety. the protective factors are strong and the prospect of timely Payment of principal and interest as per terms under adverse circumstances. 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. LAA+ LAA LAA LA+ LA LAHigh safety. COLLEGE OF BUSINESS STUDIES Rating Scale by ICRA Long-Term –including Debentures LAAA : Highest safety.S. The timely payment of interest and principal is more likely to be affected by present or prospective changes in business/economic 32 . Considerable variability in risk factors. The protective factors are average and any adverse change in circumstances. as may be visualized.

The prospect of timely servicing of the interest and principal as per terms is adequate. The protective Factors are narrow. Substantial risk. Default. There are inherent elements of risk and timely servicing of debts/obligations could be possible only in case of continued existence of favourable Circumstances. debt servicing may be affected by adverse changes in the business/economic conditions. The prospect of timely servicing of the Interest and principal as per terms is the best. LB+ LB LBLC+ LC LCLD : : : Risk-prone. The protective factors fluctuate in case of changes in economy/business conditions. However. Either already in default in Payment of interest and/or principal as per terms or expected to default.S. Adverse changes in business/ economic conditions could result in inability/unwillingness to service debts on time as per terms. 33 . Recovery is likely only on liquidation or re-organisation. MAA+ MAA MAAMA+ MA MAMB+ : : Adequate safety. The timely payment of interest : High safety. COLLEGE OF BUSINESS STUDIES LBBcircumstances. Extremely speculative. Medium-Term –including Fixed Deposit Programmes MAAA : Highest Safety. Inadequate safety. Risk factors indicate that obligations may not be met when due. but not as high as in ‘MAAA’ rating.S. The prospect of timely servicing of the interest and principal as per terms is high.

Susceptibility to default is high. likely to default in case of adverse changes in business/economic conditions. Default.S. Short-Term –Commercial Paper A1+ A1 A2+ A2 A3+ A3 : : : Highest safety. The relative safety is marginally lower than in A1 rating.S. Risk prone. The degree of safety is low . High safety. 34 . The prospect of timely payment of debt/ obligation is the best. Adverse changes in business/economic conditions could result in inability/unwillingness to service debts on time and as per terms. but any adverse change in business/economic conditions may affect the fundamental strength. A4+ A4 A5 : : Risk prone. COLLEGE OF BUSINESS STUDIES MB MBMC+ MC MCMD : : and principal is more likely to be affected by future uncertainties. Either already in default or expected to default. Default. Either already in default or expected to default. Adequate safety. The prospect of timely payment of interest and installment is adequate.

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. 35 . 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. In conventional debt instruments the income/profits made by the company remain the primary source of debt servicing.S. Examples include-letter of credit. etc. The cash flows to the investors are secured primarily by cash flows from the specific pool of assets. cash reserve account. Credit Enhancement’ is a form of protection against collateral losses.S. receivables.) into tradable securities is generally referred to as ‘securitization’ and the securities thus created are referred to as ‘asset backed securities’(AIS). over collateralization. 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. 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. guarantee. However. 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. in the case of structured obligations.

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. the rating of (d) Asset Liability Management: securitisation offers an efficient way of tenure matching of assets and liabilities.S. 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 .S. which is higher than company holding the assets is achieved. (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.

) Step2: Pooling-Large number of homogenous loans are aggregated or packaged into a pool.S. 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. 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.S. etc. a special purpose bankruptcy remote company or a public sector entity. 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. An SPV may be a trust. etc. are 37 . 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.) makes a loan to a borrower for purchase of an asset(car. The conditions under which a securitisation transaction is highly suited for issuers are: • • • the availability of clearly identifiable and homogenous pool of assets. property. • the presence of full credit support in the structure. cash collateral or over-collateralisation. financial guarantee from a third party. relatively predictable stream of cash flows from the identified assets. The maturities and interest rates of pooled loans generally the same. Step4: Credit Enhancement-Protection against the failure of borrower to make interest and principal payments on the loans. COLLEGE OF BUSINESS STUDIES The Steps in Securitisation Transaction Step1: Origination-Lender (Banks. Examples include letter of credit. NBFCs.

structured risk and legal risk. 38 . a) Credit Risk: It is the risk of default by the borrower. 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. COLLEGE OF BUSINESS STUDIES Rating Methodology Credit ratings plays a very important role in the issuance of structured debt instruments. The structure of the instruments is generally quite complex which makes the task of assigning the credit risk extremely difficult for lay investors. evaluation of the size of enhancement and the change in size over time.S. The framework used for assessing the risk of default involves assessment of three types of risk-credit risk. The factors considered in assessment of credit risk are: • • credit risk characteristics of the underlying pool of assets. key factors that influence the incentive and ability of borrowing to pay off their loans. Credit ratings provide a simple and objective assessment of default risk in the form of a symbolic indicator which is easy to comprehend. 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. Assessment of structural risk includes the following factors: • • analysis of credit support provider. future performance of the selected pool. • • pool selection process.S. trigger events.

Assessment of legal risk includes: • Evaluation of the manner in which the rights of the assets are transferred to investors. trustees.S. • third party risk which is the risk of non-performance of the various parties such as receiving and paying agent.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. COLLEGE OF BUSINESS STUDIES • analysis of liquidity facilitates in structures wherein cash inflows do not match the payments to the investors. c) Legal Risk: It refers to the risk of potential insolvency of the issuer or other parties involved in securitisation transaction. etc who are involved in the transaction. 39 .

However . they were not the only source of information. However. As the sale of these products generates revenues the rating agencies will not be willing to lose them. However. This again accentuates the possibility of the rating agencies to exploit the regulation. unlike any other business. the companies will always try to oblige the rating agencies by buying them. This eventually posed challenges to the rating agencies and emerged as a potential threat. This was considered as a convenient way for investors to judge quality and make investment decisions. This aspect makes the rating business a different animal. Then they used to utilize it to provide a rating of the intrinsic value or quality of a security. There lies the potential conflict of interest. once regulation is passed that makes it mandatory for a company to incorporate ratings. The potential for conflict of interest facing rating agencies is thus inherent. 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. financial intermediaries and other end –users use the results of the rating agencies. the issuers of information do not pay for it. Rating agencies sell information and survive. Market based ratings provided by market analysts outside the purview of the rating agencies. Though the rating agencies will never force any company to buy their information. also performed about as well as the agency ratings. the agencies used to gather and analyse all sorts of pertinent financial and non-financial information.S. The issuer of the financial instruments whose information is disclosed by the rating agency actually pays it . they actually do not pay for it. If the companies buy the services of the 40 . this is the basic source of revenue of the rating agencies. in the credit rating business. based on their ability to accumulate and retain reputation capital. It is so because though investors.S. rating agencies begin to sell not only information but also valuable property rights associated with compliance of regulation. Diversification: Traditionally.

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. 41 . 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. It allows credit risk professionals to employ Moody’s ratings and credit history experience to better measure and manage credit risk. COLLEGE OF BUSINESS STUDIES rating agencies . then the reward they expect is definitely a better rating. Over the past two decades. With Enron . many investors would have saved themselves from burning their hands. It has been opined by various people that had the rating agencies been quick in envisaging the company’s bankruptcy. The risk –consultancy services of Moody’s has become a leading provider to investors. 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. to identify industry and geographic concentrations .S. allegations have been raised against the rating agencies for not being prompt in identifying the Enron debacle. and to measure the impact of the prospective purchases or sale of debt within a portfolio context. to price credit risk. Presently both the rating giants provide a well – diversified portfolio of risk-consultancy services.S. The possibility of the rating agencies being jittery of revealing shoddy financial statements hiding actual transaction cannot be ruled out. after perceiving the potential threat and partly foreseeing the saturation of the market for new rating business. irrespective of the quality aspect. financial analysts and other end-users in managing the risk in portfolios of credit exposures to both private and public companies. Holier than thou approach The rating agencies defending themselves. ICRA have diversified into the consultancy business. Both CRISIL. In the aftermath of the Enron debacle .

As the credit rating agencies have to maintain their own reputation for their survival. to a grate extent.” According to him . Given its significance as an information provider and facilitator for the efficient allocation of resources by the financial market.S. 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. including publishing commentary more frequently so that the markets hear from us after routine events such as earning calls and management changes. the flipside of prompt down(or up) gradation by the rating agencies henceforth . Allegations have already been raised against the rating agencies for not doing their job. it becomes imperative to them to remain extremely alert to the developments both in the market and within companies. The fast changing economic scenario. credit rating services will continue to occupy a place of significance in our growing economy. However . S&P says “ Many changes are underway. The success of the system will ultimately hinge on the presentation of credibility and integrity by the concerned agencies. will increase the volatility in the stock prices. COLLEGE OF BUSINESS STUDIES CONCLUSION Credit Rating in India is a concept with not too long a history. Clifford Griep. increased global competition. 42 .S. The rating agencies faces a lot of challenges specially after the Enron debacle. Mr. 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. It may also lead to a loss of long-term focus of credit rating. Chief Credit Officer.

43 . The rating agencies should more promptly identify companies trying to suppress financial information. The rating agencies must put more focus on the information related to the offbalance sheet transactions. more is the possibility of surprises to investors.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. lesser the transparency in financial disclosure. Clearly.S.

2.com 44 . “Rating-Knotty issues.com 7.C/ Credit Rating(Practice & Procedure).” Chartered Financial Analyst. 4.com 8.S. Verma J. Credit Rating. 6.businessstandard.crisil. icraindia. Bharat Publishing House. Taxmann 3. “Risky Conflicts.” Chartered Financial Analyst. COLLEGE OF BUSINESS STUDIES BIBLIOGRAPHY 1. www. New Delhi. 5. www. SEBI Manual. ICRA . www.S.

NBFC’s. instruments issued by manufacturing companies. FI’s. structured obligation.S. Real Estate Developers & Projects. Corporate Governance. 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. 45 . 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. their role and impact in the capital market in India. PSU’s and municipalities. Claim paying ability of Insurance Companies. worldwide has evolved over the years. COLLEGE OF BUSINESS STUDIES PREFACE This study was undertaken to understand the functioning of credit rating agencies. commercial banks. Construction Entities.S. and Mutual Fund Schemes. Credit Rating agencies .

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.

and establish the amount of a utility or leasing deposit. and thus leads to high interest rates. or the refusal of a loan by the creditor. which have a range between R0 and R9. Personal credit ratings In countries such as the United States. R0 refers to a new account.S. (The term. R1 refers to on-time payments. corporation. affects his or her ability to borrow money through financial institutions such as banks. 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. a credit rating tells a lender or investor the probability of the subject being able to pay back a loan. which pioneered the credit rating concept in the late 1950s. 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 . ____________________________________________ What is credit rating??? How is it generally done? A credit rating assesses the credit worthiness of an individual. It tells investors the likelihood of default. A common form of this analysis is a 3-digit credit score provided by independent financial service companies such as the FICO credit score. a registered trademark. In the United States. Typically. the most common ratings are the North American Standard Account Ratings. Credit ratings are calculated from financial history and current assets and liabilities.) An individual's credit score. also known as the "R" ratings.S. along with his or her credit report. However. or even a country. by the issuer of its financial obligations. comes from Fair Isaac Corporation. credit worthiness is usually determined through a statistical analysis of the available credit data. an individual's credit history is compiled and maintained by companies called credit bureaus. determine employment eligibility. A poor credit rating indicates a high risk of defaulting on a loan. or nonpayment. In Canada. R9 refers to bad debt. in recent years. credit ratings have also been used to adjust insurance premiums.

Ratings use by bond issuers Issuers rely on credit ratings as an independent verification of their own creditworthiness. M. This in turn increases the total supply of risk capital in the economy.. Recent studies by the Bond Market Association note that many 48 . broker-dealers. A credit rating measures credit worthiness. It also opens the capital markets to categories of borrower who might otherwise be shut out altogether: small governments. startup companies. cities. or national governments issuing debt-like securities that can be traded on a secondary market. B. In most cases.) * Baycorp Advantage (Australia) * Dominion Bond Rating Service (Canada) * Fitch Ratings (U. but instead are based on risk-based pricing. CC. as set out in their credit rating.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. For investors. Best (U. and by governments. (A company that issues credit scores for individual credit-worthiness is generally called a credit bureau or consumer credit reporting agency. these issuers are companies. a significant bond issuance must have at least one rating from a respected CRA for the issuance to be successful (without such a rating. easy-to-use measurements of relative credit risk. There exist more than 100 rating agencies worldwide.S.S. and affects the interest rate applied to loans.S. credit rating agencies increase the range of investment alternatives and provide independent.) Interest rates are not the same for everyone. investment banks. Credit rating agencies for corporations * A. the ability to pay back a loan.) * Standard & Poor's (U. leading to stronger growth.) * Pacific Credit Rating (Peru) Uses of ratings by credit rating agencies Credit ratings are used by investors.S. a form of price discrimination based on the different expected costs of different borrowers. 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. this generally increases the efficiency of the market. non-profit organizations.S.) * Moody's (U. lowering costs for both borrowers and lenders. hospitals and universities. the issuance may be undersubscribed or the price offered by investors too low for the issuer's purposes). issuers. These are assigned by credit rating agencies such as Standard & Poor's or Fitch Ratings and have letter designations such as AAA. Credit rating is done by a credit rating agency. In most cases.S.

However.e. Ratings use by investment banks and broker-dealers Investment banks and broker-dealers also use credit ratings in calculating their own risk portfolios (i. and the degree to which the bond is subordinated to other debt. For example. 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. if the venture were to fail. 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. or permit these ratings to be used for regulatory purposes. The same issuer also may have different credit ratings for different bonds. of course. government bonds or short-term commercial paper from very stable companies). 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. the lenders would have recourse to the assets owned by the SPE. That way. This difference results from the bond's structure. if the financial institution is heavily invested in highly liquid and very "safe" securities (such as U. 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. 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. This "special purpose entity" would then assume all of the research risk and issue its own debt securities to finance the research. 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. 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. Issuers also use credit ratings in certain structured finance transactions. under the Basel II agreement of the Basel Committee on Banking Supervision. as the CRA may feel obligated to provide the issuer with that given rating if the issuer followed its advice on structuring the offering. This creates a potential conflict of interest. Conversely. COLLEGE OF BUSINESS STUDIES institutional investors now prefer that a debt issuance have at least three ratings. but rely on CRA ratings as a "check" (and double-check or triple-check) against their own analyses. In the United States. the collective risk of all of their investments). For example. Ratings use by government regulators Regulators use credit ratings as well. this risk would not lower the parent company's overall credit rating because the SPE would be a legally separate entity.S. Larger banks and broker-dealers conduct their own risk calculations..S. 49 . how it is secured. This would lower the interest rate the SPE would need to pay as part of the debt offering. Some CRAs avoid this conflict by refusing to rate debt offerings for which its advisory services were sought.S.

may warrant a lower rating for those obligations a country made in foreign currency.which could be a person. For a government or company it is sometimes easier to pay back local-currency obligations than it is to pay foreign-currency obligations. permits certain bond issuers to use a shorten prospectus form when issuing bonds if the issuer is older.S. A lack of foreign reserves. Standard and Poor's (S&P's) and Fitch IBCA.S. The ratings therefore assess an entity's ability to pay debts in both foreign and local currencies. The Raters There are three top agencies that deal in credit ratings for the investment world. Likewise. SEC regulations also require that money market funds (mutual funds that mimic the safety and liquidity of a bank savings deposit. but without FDIC insurance) comprise only securities with a very high rating from an NRSRO. sell or hold 50 .to keep its financial commitments or its debt. A ratings company can help you do this. credit ratings are essential tools for helping you make some investment decisions. The U. but the risks associated with sending money abroad are considerably higher than those associated with investing in your own domestic market.S. There are advantages to investing in foreign markets. Ratings can be assigned to short-term and long-term debt obligations as well as securities. and has a credit rating above a certain level. insurance regulators use credit ratings to ascertain the strength of the reserves held by insurance companies. Credit in the Investment World As investment opportunities become more global and diverse. investing instrument or market. 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. Each of these agencies aim to provide a rating system to help investors determine the risk associated with investing in a specific company. a security or a country . a corporation. has issued bonds before. loans. you must determine whether the prospective entity will be able to meet its obligations. Measuring the ability and willingness of an entity . Providing independent objective assessments of the credit worthiness of companies and countries. COLLEGE OF BUSINESS STUDIES CRA ratings are also used for other regulatory purposes as well. SEC. It is important to gain insight into different investment environments but also to understand the risks and advantages these environments pose. These are: Moody's. It is important to note that ratings are not equal to or the same as buy. for example. a credit ratings company helps investors decide how risky it is to invest money in a certain country and/or security. it is difficult to decide not only which companies but also which countries are good investment opportunities. for example. _________________________________________________________ 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. preferred stock and insurance companies.

the sovereign rating is the first thing most institutional investors will look at when making a decision to invest money abroad. Long–term credit ratings are denoted with a letter: a triple A (AAA) is the highest credit quality. In most circumstances. foreign direct investment. 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. and "BBB" is good credit quality. levels of public and private investment flows. foreign currency reserves. and C or D (depending on the agency issuing the rating) is the lowest or junk quality. Thus. Ratings that fall under "BBB" are considered to be speculative or junk. transparency in the capital market.S. This rating gives the investor an immediate understanding of the level of risk associated with investing in the country. a "AAA" rating signifies the highest investment grade and means that there is very low credit risk. Thus for Moody's a Ba2 would be a speculative grade rating while for S&P's. which means that the security or the entity being rated carries a level of quality that many institutions require when considering overseas investments. B Junk High Risk Caa/Ca/C CCC/CC/C Junk Highest Risk C D Junk In Default Sovereign Credit Ratings As previously mentioned. sometimes denoted by a plus or negative sign or a number. Ratings are rather a measure of an entity's ability and willingness to repay debt. political stability. most countries will strive to obtain a sovereign rating and they will strive even more so to reach investment grade. These ratings are considered to be investment grade. 51 . a "D" denotes default of junk bond status. Because it is the doorway into a country's investment atmosphere. 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. So to attract foreign money. or the ability for a country's economy to remain stable despite political change. This rating reflects factors such as a country's economic status. "A" means high credit quality. Within this spectrum there are different degrees of each rating. B BB.S. A sovereign credit rating provides the latter as it signifies a country's overall ability to provide a secure investment environment. a country's sovereign credit rating will be its upper limit of credit ratings. for Fitch IBCA. "AA" represents very high credit quality. a rating can refer to an entity's specific financial obligation or to its general creditworthiness. A country with a sovereign rating will therefore get more attention than one without. which are. depending on the agency. COLLEGE OF BUSINESS STUDIES recommendations.

52 . a more meaningful relationship between the quality of debt and the yield from it.S. but also for the entities looking for investors. Credit Rating is also a valuable input in establishing business relationships of various types. An investment grade rating can put a security. the credit rating is key to showing their worthiness of money from foreign investors. which are of significance to an investor in arriving at an investment decision. credit rating is expected to improve quality consciousness in the market and establish. to facilitate deeper understanding. many countries and companies will strive to maintain and improve their ratings. And because the credit rating acts to facilitate investments. Rating companies also publish explanations for their symbols used as well as the rationale for the ratings assigned by them. 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. Indeed. AA. Does credit rating constitute an advice to the investors to buy? It does not. after making a detailed study of all relevant factors. The reason is that some factors. For example. 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. company or country on the global radar. for emerging market economies. over a period of time. which facilitates universal understanding. essentially. by Reem Heakal Some FAQs about Credit Rating What is credit rating? Credit rating is. Further. hence ensuring a stable political environment and a more transparent capital market. are not taken into account by rating agencies. Why do rating agencies use symbols like AAA. 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. 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. rather than give marks or descriptive credit opinion? The great advantage of rating symbols is their simplicity. attracting foreign money and boosting a nation's economy. Why is credit rating necessary at all? Credit rating is an opinion expressed by an independent professional organisation. secondary market liquidity and pre-payment risk.S. In general. Such an opinion will be of great assistance to investors in making investment decisions. It also helps the issuers of debt instruments to price their issues correctly and to reach out to new investors. COLLEGE OF BUSINESS STUDIES Conclusion A credit rating is a useful tool not only for the investor.

On its part. In the well-developed capital markets. 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. There is however. Nevertheless. who makes his investment decision on the basis of its rating. the rating agency has a great responsibility to ensure confidentiality of the sensitive information that comes into its possession during the rating process. on the quality of its services. It is. For example. to totally eliminate the subjective element. brick by brick. Do rating companies undertake unsolicited ratings? Not in India. a good case for undertaking unsolicited ratings. therefore. Nevertheless. 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. 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. which fixes the relevant variables as well as the weights attached to each one of them. Rating does not come out of a pre-determined mathematical formula. rating is essentially an investor service and a rating agency is expected to maintain the highest possible level of analytical competence and integrity. COLLEGE OF BUSINESS STUDIES What kind of responsibility or accountability will attach to a rating agency if an investor. But it will be very unusual if such differences are very wide. to a great extent. consists of professionals with impeccable credentials. the rating agencies often put issues under credit watch and upgrade or downgrade the ratings as and when necessary. Rating agencies do a great amount of number crunching. 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. Rating agencies also ensure that the rating process is insulated from any possible conflicts of interest. It will indeed be unusual if one agency assigns a rating of DOUBLE A while another gives a TRIPLE B. it is neither possible nor even desirable. In the long run. such action is taken after intensive interaction with the issuers. essential that as a part of their investor service. How reliable and consistent is the rating process? How do rating agencies eliminate the subjective element in rating? To answer the second question first. such opinions may prove wrong in the context of subsequent events. 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. As time goes by. Co-operation from the issuers as well as their willingness to share even confidential information are important prerequisites. corporate strategy. 53 . 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. debt issues are. but the final outcome also takes into account factors like quality of management. Normally. economic outlook and international environment.S. which assigns the final rating. the credibility of a rating agency has to be built. many things change.S. it is only natural that the opinions given by two or more agencies will vary. on its ability to access privileged information. one way or the other. at least not yet. more often than not. affecting the debt servicing capabilities of the issuer. The Rating Committee. rating agencies monitor all outstanding debt issues rated by them. In the context of emerging developments. To ensure consistency and reliability. rated by more than one agency. in some cases. Further. And.

subject to availability of all the solicited information. This is only natural. 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. Is the rating assigned for an instrument or for the Issuer Company? Both. then. if any. visits to the issuer’s office and works. All this takes time and a rating agency may take three to four weeks or more to arrive at a decision. Why are equity shares not rated? By definition. How much time does rating take? The rating process is a fairly detailed exercise. credit rating agencies offer grading of IPOs which take into account the fundamentals of the issuer. bankers. instrument ratings are monitored over the life of the instrument. compromise on the quality of their analysis. there is no pre-determined servicing obligation. he may request for a review. Rating of instruments would consider instruments’ specific characteristics like maturity. undertake a review and thereafter indicate its final decision.S. It may. In the case of equity. as perceptions differ. It is an opinion on future debt servicing capabilities given on the 54 . credit rating is an opinion on the issuers capacity to service debt. COLLEGE OF BUSINESS STUDIES Do issuers have a right of appeal against a rating assigned? Yes. So. Issuers would also be well advised to approach the rating agencies sufficiently in advance so that issue schedules can be adhered to. (which is unlikely). discussions with auditors. an issuer approaches another. Any attempt by issuers to play one agency against another will have to be discouraged by all the rating companies. It involves. in the hope of getting a better result? It is possible. intensive discussion with the senior executives of issuer. be pointed out here that two rating companies may. chances of the rating being changed on appeal are rare. analysis of published financial information. considered relevant. While issuer ratings are more often than not. in any way. consistency and integrity. typically three to five years. arrive at different conclusions on the same issue. among other things. credit reinforcements specific to the issue etc. However. The rating agency will. of late. credit rating in the conventional sense does not apply to equity shares. It is of paramount importance to rating companies to ensure that they do not. and often do. In a situation where an issuer is unhappy with the rating assigned. It also involves an in-depth study of the industry itself and a degree of environment scanning. however. under pressure from issuers for quick results.S. Unless the rating agency had overlooked critical information at the first stage. If a rating is downgraded. furnishing additional information. 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. but rating companies do not and should not indulge in competitive generosity. as equity is in the nature of venture capital. one time assessments of credit quality. Issuer ratings consider the overall debt management capability of an issuer on a medium term perspective. etc. Is it possible that not satisfied with the rating assigned by one rating agency.

It is the experience of all rating agencies that some instruments initially rated as investment grade fall below investment grade or go into default. They do not. industry trends and management capabilities. statutory auditors. Further. companies in such segments or with large exposures to such segments are adversely affected and their credit ratings get downgraded. not static and all rating agencies review their ratings periodically and make changes. or interest or exchange risks. Such changes are reported widely through the media. In other words. 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. Ratings also do not take into account the risk of prepayment by issuer. many events are unpredictable. based on the information available at a given point of time. A credit rating is not an advice to buy. wherever considered appropriate. On the occurrence of such an event. for example.S. A credit rating is not a guarantee against future losses. possibilities for capital gains or take into account the liquidity in the secondary market. the rating essentially is an opinion on the relative quality of the credit risk. of past performance and all available information (from audited financial statements.S. Hence. Please also note that credit ratings do not take into account many aspects which influence investment decisions. While rating agencies make all possible efforts to project corporate business prospects. interaction with company management. Moreover. etc. banks and financial institutions. evaluate the reasonableness of the issue price. GLOSSSARY 55 . such opinions may prove wrong in the context of subsequent events. COLLEGE OF BUSINESS STUDIES basis. when there are recessionary trends in certain segments of the economy. 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. inter-alia.) at a particular time. Such downgradations are a natural consequence of the recessionary trends. over a period of time. Although these are often related to the credit risk. a rating agency can only review and make appropriate changes in the rating. credit quality (and credit rating) is dynamic.

ICRA Ltd: Investment Information and Credit Rating Agency of India Limited. under which the agency assigns a grade to an equity issue. FITCH: JV between Duff & Phelps. at the request of the prospective is § § § § § § § § § § § § 56 .S.S. 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. CARE: Credit Analysis and Research Ltd. 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. Calcutta. ICRA Limited. The company has a 40% share in the world credit rating market. Standard & Poorʼs: a division of McGraw-Hill that publishes financial research and analysis on stocks and bonds. as to guarantee the issuer of securities a specified price by entering into a purchase and sale agreement. The company also ranks the credit-worthiness of borrowers using a standardized ratings scale. US and Alliance Capital Limited . 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. Equity Grading : A service offered by the credit rating agency.

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. Currency risk arises from a combination of currency exposure and currency volatility. of India. SBI: State bank of India. This ratio measures a firm's ability to pay interest § § § § § § § § § § § 57 .: The Industrial Finance Corporation of India. Financial leverage is measured by the ratio of debt to debt plus equity. LIC: Life Insurance corp. the biggest life insurer in India and under control of govt of India.formed for the purpose of superintending. Interest coverage ratio(OPBIT/Interest) :The ratio of earnings before interest and taxes to annual interest expense. COLLEGE OF BUSINESS STUDIES § IFCI Ltd.S. divide gross profit by sales. UTI: Unit trust of India PNB: Punjab National Bank GIC: General insurance corp.the biggest PSU bank in India. Currency hedges reduce (direct) currency exposure Gross operating margin What remains from sales after a company pays out the cost of goods sold.S. the first Development Financial Institution in the country to cater to the long-term finance needs of the industrial sector. To obtain this margin. a psu and biggest insurer in india. Currency exposures: The part of a portfolio that is denominated in a currency (or currencies) other than the base currency and is not hedged. Gross operating margin is expressed as a percentage.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.

Enron filed for bankruptcy on December 2. Enron stood on the verge of undergoing the largest bankruptcy in history by mid-November 2001. Volatility: A measure of risk based on the standard deviation of the asset return.K. 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 . which at the time was one of the world's top accounting firms.S. additional security pledged to support the project financing Securitization: the process of conversion of financial assets into tradable securities.S. as the Great Slump) was a dramatic. Franchise value: franchise value refers to the popularity of a particular brand or product with consumers. Volatility is a variable that appears in option pricing formulas. 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. 2001. 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. the scandal caused the dissolution of Arthur Andersen. 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. usually expressed as a ratio of its capital to its assets. worldwide economic downturn beginning in some countries as early as 1928. In addition. COLLEGE OF BUSINESS STUDIES § Debt service coverage ratio: Earnings before interest and income taxes. Capital adequacy : A measure of the financial strength of a bank or securities firm.

COLLEGE OF BUSINESS STUDIES activity. Assets are sold. 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 . 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. and any leftovers are distributed to shareholders. proceeds are used to pay creditors.S.S.

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