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EVALUATION OF CONSISTENCY OF RATING BY CREDIT RATING AGENCIES AND CHECKING THE RELIABILTY OF CREDIT RATING MODEL: A LITERARTURE REVIEW

OJAL SAHU

Abstract We report on the current state and important older findings of empirical studies on corporate credit ratings and their relationship to ratings of other entities. Specially, we view the consistency of credit rating models and comparing the performance (ii) to check the reliability of credit score model on company And we consider the results of three lines of research: The correlation of credit ratings and corporate default, the influence of ratings on capital markets, and the determinants of credit ratings and rating changes. Results from each individual line are important and relevant for the construction and interpretation of studies in the other two fields, e.g. the choice of statistical methods. Moreover, design and construct of credit ratings and the credit rating scale are essential to understand empirical findings. Keywords: Rating agency; Credit Ratings; Through-the-cycle rating methodology; Corporate Governance INTRODUCTION CRAs have been in operation since the late 1890s, signifying an existence of over 100 years. Rating standards by Moody‟s and S&P were known to be stringent. From 1970 onwards, financial literature has been commenting on the superior information efficiency of the markets, in comparison to information disseminated by the CRAs. Lack of corporate governance standards and vigilance by accountants were identified as the root cause, while the CRAs were accused of abetting the intricate structures with high credit ratings. It is said that CRAs once again overestimated the credibility of the contracting parties to honour the structured obligations. The situation in India is different on account of conservative origin standards and lower complexity levels in securitized transactions with very little systemic implications. There is, however, the possibility of asymmetric information between the issuers and all others due to reasons mentioned in this study. CRAs have been operating in India since 1988. CRISIL, ICRA and Fitch India have collaborative arrangements with S&P, Moody‟s and Fitch respectively. CARE is promoted by IDBI & Canara Bank. Most of the ratings by CRAs relate to Bank Loans, on account of ascertaining the Credit-related capital adequacy. CRISIL:    It was incorporated in 1987 and was promoted by Industrial Credit and Investment Corporation of India Ltd. (ICICI) and Unit Trust of India (UTI). CRISIL has its association with internationally recognized rating agency Standard and Poor‟s (S&P) since 1996. CRISIL is a group of businesses which offers the following diversified services: Rating and Risk Assessment, Infrastructure Advisory, and Business Research.

INVESTMENT INFORMATION AND CREDIT RATING AGENCY OF INDIA LTD. (ICRA):  It was incorporated in 1991 and was jointly sponsored by Industrial Finance Corporation of India (IFCI) and other Financial Institutions and banks as an independent and professional investment information and credit rating agency. ICRA is an associate of the international rating agency Moody‟s Investors Services which is ICRA‟s largest shareholder. ICRA has been granted registration with SEBI under the Securities & Exchange Board of India (Credit Rating Agencies) Regulations, 1999. ICRA provides information products, ratings and solutions to different businesses and investors.

ICRA Online Limited (ICRON)  It is a wholly-owned subsidiary of ICRA Limited. ICRON was incorporated in January 1999 and is providing software and outsourcing solutions since then. ICRON has a wholly-owned subsidiary M-Serve Business Solutions Private Limited, a KPO services company which is headquartered in Kolkata, India. ICRON has two Strategic Business Units. CREDIT ANALYSIS & RESEARCH LTD. (CARE) Credit Analysis & Research Ltd. was incorporated in 1993 by consortium of Banks/financial institutions in India. The three largest shareholders of CARE are IDBI Bank, Canara Bank and State Bank of India. CARE‟s Ratings are recognized by Govt. of India and all regulatory authorities like RBI and SEBI. CARE has been granted registration with SEBI under the Securities & Exchange Board of India (Credit Rating Agencies) Regulations, 1999. CARE is a founder member of Association of Credit Rating Agencies in Asia (ACRAA). CARE is set up with two divisions: CARE Ratings CARE Ratings offers a wide range of rating and grading services across sectors. Types of debt instruments rated by CARE Ratings include commercial paper, fixed deposit, bonds, debentures, hybrid instruments, structured obligations, preference shares, loans, etc. CARE Ratings provide investors and risk managers with credit opinions based on detailed in-depth research, which encompasses detailed analysis of risks that affect credit quality of an issuer. CARE Research and Information Services CARE Research & Information Services is an independent division of CARE. The research division undertakes two activities, i.e., providing an in-house support to the ratings division and providing sectoral research to financial intermediaries, corporate, analysts, policy-makers, etc. as an aid to their decision-making process. CARE Research & Information Services offers both subscription based reports and also customised reports on request. Literature Review The study is a proactive initiative, with a view to assess the preparedness of the CRAs to communicate signals and reduce the informational asymmetries that generally exist between issuers and investors. CRAs have been rating instruments and subjecting them to periodic review, sometimes necessitating a transition to a lower or higher grade. Thus far, CRAs have obtained the approval of SEBI, giving them the status of approved rating agencies. The RBI also has put regulations in place with reference to credit rating agencies and credit information companies. There are four Credit Rating Agencies registered with SEBI, viz. CRISIL, ICRA, CARE. The study presents a timely opportunity for introspection by all concerned entities – policy makers, regulators, investors, rating

agencies, issuers and intermediaries.

The relevance of credit ratings changes for capital markets, i.e. the efficient market hypothesis, can only be measured effectively if they are conditioned on the respective change in default probability. Moreover, market reactions around rating changes are asymmetrical. Specially, markets react

stronger to downgrades than to upgrades (even after incorporating the corresponding default probability). This discrepancy might have multiple reasons. It might be caused by the way rating agencies operate or specific features of the market for ratings. On the other hand it might be caused by the behavior of corporations and how they release relevant information. One important feature of the agencies' approach that might cause the asymmetrical information content of credit ratings is the so called through-the-cycle method. Rating agencies try to estimate the long term creditworthiness of a corporation independent of shortterm business cycle effects. Nevertheless, ratings do correlate with the business cycle. Therefore macroeconomic variables along with financial ratios and corporate governance characteristics are determinants of credit ratings.

Research objective The objective of this study is to gauge the robustness of the operations of the CRAs with a view to consistency of credit rating models and comparing the performance (ii) to check the reliability of credit score model on company X (iii) CRAs in India are more subjective in their assessment and (iv) the deterioration in ratings is not captured in time by CRAs, if compared with financial information in the public domain. The objective is to place a simple tool in the hands of the public that will enable a cross-verification of the reports by CRAs in a cost-effective manner and raise the quality standards bar of the CRAs. The study also suggests practical ways in which the CRAs can improve their rating processes and help reduce the information gap. Under study, a simple model, built around Net Worth, Leverage and Interest Cover, was used to detect deteriorations in creditworthiness. When compared with the actual ratings, it was found that the actual ratings did not always reflect the falling creditworthiness in a timely manner. A survey of CRAs and their Analysts revealed that there was a very low level of awareness among Indian accountants of International Financial Reporting Standards (IFRS) which Indian corporations need to comply with effective from financial year 2011. The outcome of such research could result in inputs to strengthen the financial markets and CRAs in particular The objective of the study is as follows.        Assessment of the performance of CRAs in India in terms of parameters like transition data. How far CRAs assessment helps financial regulation. Accountability, corporate governance issues of CRAs. Disclosures of methodologies of rating. Rating of complex products like structured obligation. Consistency of rating data with accounting data. Overall evaluation of what CRAs have done in terms of value addition or the Indian economy.  Place a simple tool in the hands of the public that will enable a cross-verification of the reports by CRAs in a cost-effective manner and raise the quality standards bar of the CRAs.  A comparative analysis of the operations carried out by the various credit rating agencies under study, viz. CRISIL, ICRA, CARE and FITCH has been presented and check the consistency.

 To check the reliability of credit score model used. RATING PROCESS Rating is a multi-layered decision-making process which requires interactive dialogue with the issuer. The rating process is a fairly detailed exercise that starts with a rating request from the issuer, the signing of a rating agreement and continues up to the surveillance of rating. It involves among other things, analysis of published financial information, visits to issuer‟s offices and work places, and intensive discussions with issuer‟s auditors, bankers, creditors, etc. It also involves an in -depth study of the industry itself and a degree of environment scanning. The rating process is explained below: 1. Request for Rating: The rating process starts with the issuer‟s request for rating. Then the rating agreement is signed between the client and the rating agency. The rating agency assigns a rating team for the purpose, and the client provides the relevant information to the rating team along with the rating fees. 2. Analysis of Information: The rating team conducts the preliminary analysis of the information provided by the client. The team also conducts the site visits for the purpose of analysis. 3. Meeting: Then the meetings between the rating team and management of the issuer are conducted and the rating team does the final analysis of the information after clarification of any doubts in the management meeting. 4. Assignment of Rating: The rating team presents its analysis to the rating committee which assigns the rating to the given instrument and communicates the same to the issuer. The rating is then accepted by the issuer or the issuer may appeal the rating agency to further refine the rating. 5. Dissemination of Rating: In case the rating is accepted by the issuer it is disseminated to CRISIL's subscriber base, and to the local and international news media. Rating information is also updated on line on the website of rating agency. 6. Continuous Surveillance: All ratings are kept under continuous surveillance throughout its validity by the rating agency METHODOLOGY ADOPTED The financial credit score is calculated for company X in the following steps. 1. The first step is obtaining the ratio NW/ TL . This ratio usually ranges between 0 and 1. 2. In the next step, TD/ TA is calculated. A negative relationship is postulated between TD/ TA ratio and the FCS. This is because higher is the debt in relation to the assets, greater is the risk in lending to such a company, other things remaining the same. 3. The third step in calculating FCS is obtaining inverse of interest coverage ratio, i.e.,1/ PBDIT . This ratio ought to range between zero and one for a credit-worthy company. 4. The Financial Credit Score has been defined as stated in below equations for FCS. FCS = NW/ TL − TD/ TA – 1/ PBDIT, (if I/ PBDIT ≥ 0) FCS = NW/ TL – TD/ TA + 2∗ 1/ PBDIT, (if 1/ PBDIT < 0) For Company X, the FCS is calculated from 2007- 2012 Dec 2007 1,439.24 March 09 2,061.51 March 10 2,583.52 March 11 2,633.92 March 12 3,512.93

Net worth

Total Liabilities NW/TL Total Debt Total Assets TD/TA PBDIT 1/PBDIT FCS

1,527.77 0.9420 88.53 1,527.76 0.057 2,504.80 3.992 -3.107

2,483.46 0.8300 421.95 2,483.46 0.169 3,241.48 3.085 -2.424

2,583.52 1.00 0.00 2,583.52 0.00 2,997.43 3.336 -2.336

2,633.92 1.00 0.00 2,633.92 0.00 3,103.97 3.221 -2.221

3,512.93 1.00 0.00 3,512.93 0.00 3,688.52 2.711 -1.711

 Higher will be the NW/TL ratio, better is the FCS for company which can be seen in this case in 2012.  A negative relationship is postulated between TD/ TA ratio and the FCS. This is because higher is the debt in relation to the assets, greater is the risk in lending to such a company, other things remaining the same.  Due to the fact that this ratio can take values which are both positive and negative, an asymmetric treatment to this ratio is given.  For calculating credit score, following ratios are also taken into consideration. RATIOS Dec 07 March 09 March 10 March 11 March 12 Current 0.68 0.92 0.84 0.86 0.83 Ratio Debt 0.06 0.20 equity Ratio Inventory 7.20 9.26 8.99 7.91 9.93 Turnover Ratio Debtors 31.41 41.83 29.24 24.28 27.27 Turnover Ratio Net profit 12.58 12.09 12.29 11.56 12.07 margin The current ratio declined from 2011 to 2012, the current assets to current liabilities have declined. The debt equity ratio is zero which means that total debt is financed by equity only. The inventory turnover ratio increased from 2011 to 2012 which means that stock piling is not there and more inventory is converted into sales. The debtors turnover ratio has also increased which means that how quickly debtors are converted into cash. The net profit margin has also increased which means that net profit has increased from 2011 to 2012.

    

The instruments rated by different credit rating agencies and calculation of mean are as follows.

 The instruments rated by CRISIL.

Year

Long Debentu res

term Prefere nce shares 89(11.1 7) 79(9.55 ) 92(10.5 9) 107(7.2 0) 123(6.4 9) 117(5.6 5) 138(5.8 5) 1039(6. 20) 58.85 115.44

instrume nts Loan

Mediu m FD

term CD

Short term CP STL Others Total

2006 2007 2008 2009 2010 2011 2012 Total Over all % Mea n

197(24.7 2) 205(24.7 9) 213(24.5 1) 420(28.2 6) 429(22.6 3) 436(21.0 6) 487(20.6 6) 2231(13. 31)

153(19.2 0) 169(20.4 4) 161(18.5 3) 496(33.3 8) 705(37.1 8) 728(35.1 7) 855(36.2 7) 6595(39. 34)

42(5.2 7) 47(5.6 8) 55(6.3 3) 63(4.2 4) 69(3.6 4) 88(4.2 5) 97(4.1 2) 675(4. 03) 6.80 75.00

22(2.7 6) 22(2.6 6) 35(4.0 3) 48(3.2 3) 50(2.6 4) 59(2.8 5) 69(2.9 3) 465(2. 77)

131(16. 44) 145(17. 53) 137(15. 77) 149(10. 03) 175(9.2 3) 192(9.2 8) 177(7.5 1) 465(2.7 7) 12.97 165.78

60(7.53 ) 53(6.41 ) 66(7.59 ) 79(5.32 ) 67(3.53 ) 80(3.86 ) 89(3.78 ) 1492(8. 90)

103(12. 92) 107(12. 94) 110(12. 66) 79(5.32 ) 278(14. 6) 370(17. 87) 445(18. 88) 682(4.0 7) 21.38 398.11

797(100 ) 827(100 ) 869(100 ) 1486(10 0) 1896(10 0) 2070(10 0) 2357(10 0) 16672(1 00)

381.22

599.44

51.67

75.78

 The instruments rated by ICRA Year Long Debentu res 2006 2007 2008 2009 2010 2011 2012 Total Over all % 42(22.2 2) 38(19.5 9) 53(22.7 5) 59(24.6 9) 67(23.6 7) 68(21.7 9) 98(21.1 2) 630(21. 51) 50.84 term Prefere nce shares 24(12.7 0) 26(13.4 0) 28(11.7 2) 28(11.7 2) 34(12.0 1) 41(13.1 4) 58(12.5 0) 379(12. 94) instrume nts Loan Mediu m FD Term CD Short CP term STL Others Total

33(17.4 6) 35(18.0 4) 38(16.3 1) 38(15.9 0) 45(15.9 0) 50(16.0 3) 78(16.8 1) 480(16. 39)

14(7.4 1) 15(7.7 3) 17(7.3 0) 17(7.1 1) 22(7.7 7) 23(7.3 7) 35(7.5 4) 229(7. 82) 11.78

4(2.12) 5(2.58) 8(3.43) 8(3.35) 10(3.5 3) 12(3.8 5) 19(4.0 9) 116(3. 96)

27(14.2 9) 29(14.9 5) 35(15.0 2) 35(14.6 4) 42(14.8 4) 47(15.0 6) 74(15.9 5) 433(14. 78) 21.54

13(6.8 8) 14(7.2 2) 15(6.4 4) 15(6.2 8) 19(6.7 1) 21(6.7 3) 33(7.1 1) 198(6. 76)

32(16.9 3) 32(16.4 9) 39(16.7 4) 39(16.3 2) 44(15.5 5) 50(16.0 3) 69(14.8 7) 464(15. 84) 15.84

189(100.0 0) 194(100.0 0) 233(100.0 0) 239(100.0 0) 283(100.0 0) 312(100.0 0) 464(100.0 0) 2929(100. 00)

Mea n

70.00

42.11

53.33

25.54

12.89

48.11

21.00

51.56

 The instruments rated by CARE Year Long Debentu res 2006 2007 2008 2009 2010 2011 2012 Total Over all % Mea n 40(21.5 1) 45(21.1 3) 50(19.8 4) 61(21.0 3) 73(21.1 0) 82(21.5 2) 93(21.6 8) 653(21. 24) 52.78 72.56 term Prefere nce shares 24(12.9 0) 29(13.6 2) 35(13.8 9) 37(12.7 6) 45(13.0 1) 49(12.8 6) 56(13.0 5) 400(13. 01) instrume nts Loan Mediu m FD Term CD Short CP term STL Others Total

35(18.8 2) 40(18.7 8) 46(18.2 5) 58(20.0 0) 64(18.5 0) 70(18.3 7) 76(17.7 2) 570(18. 54)

7(3.76) 9(4.23) 9(3.57) 11(3.7 9) 13(3.7 6) 15(3.9 4) 18(4.2 0) 122(3. 97) 8.89 13.56

7(3.76) 8(3.76) 10(3.9 7) 13(4.4 8) 15(4.3 4) 17(4.4 6) 19(4.4 3) 136(4. 42)

30(16.1 3) 34(15.9 6) 48(19.0 5) 50(17.2 4) 56(16.1 8) 61(16.0 1) 70(16.3 2) 505(16. 42) 25.92 56.11

18(9.6 8) 19(8.9 2) 22(8.7 3) 27(9.3 1) 34(9.8 3) 37(9.7 1) 41(9.5 6) 292(9. 50)

25(13.4 4) 29(13.6 2) 32(12.7 0) 33(11.3 8) 46(13.2 9) 50(13.1 2) 56(13.0 5) 397(12. 91) 12.91 44.11

186(100.0 0) 213(100.0 0) 252(100.0 0) 290(100.0 0) 346(100.0 0) 381(100.0 0) 429(100.0 0) 3075(100. 00)

44.44

63.33

15.11

32.44

These are different ratings given by different credit rating agencies. Through SPSS, data is analyzed to know whether there is significant difference between rating agencies evaluation or not. Thus, our null hypothesis is that there is no significant difference in evaluation process of credit rating agencies and our alternate hypothesis is that there is significant difference in evaluation process.

ANALYSIS  Ho: there is no significant difference between evaluation processes of CRISIL, ICRA and CARE.  Ha: there is significant difference between evaluation processes of CRISIL, ICRA and CARE.

 As we can see in annexure, output sheet the probability i.e. 2 tailed test between CRISIL and ICRA is 0.023 which is less than 0.05, thus the null hypothesis is rejected and there is significant difference between evaluation process of CRISIL and ICRA.

 Another test for CRISIL and ICRA is also done which is Wilcoxon test according to which the probability is 0.012 which is also less than 0.05, thus according to this test also our null hypothesis is rejected.

 Similar tests are done for CRISIL and CARE which gives probability value of 0.023 with paired sample t- test and 0.012 with Wilcoxon test which rejects our null hypothesis.  When the same tests was performed for ICRA and CARE, it was found that the probability value is greater than 0.05 i.e. 0.486 for t test and 0.401 for Wilcoxon test which tells that the null hypothesis is retained and there is no significant difference between evaluation process of ICRA and CARE.

 The financial credit score for company X is calculated using the model which is negative. Higher will be the NW/ TL , better will be the financial credit score of company which can be seen in 2012.According to the research done , the model could be taken as somewhat reliable.

CONCLUSION According to analysis done, it could be concluded that there is no significant difference between evaluation process of CARE and ICRA. It could also be concluded that there is significant difference between ICRA and CRISIL. The financial credit score model used could be considered as somewhat reliable. CRAs have assigned very poor ratings to Collective Investment Schemes and some IPOs, hence driving poor quality issuers out of the market. The basic accounting figures: Total Income and PBDIT are contaminated due to the influx of „other income‟ being merged into the Total Income. There are several instances where the Interest Coverage ratio has deteriorated but the ratings have remained the same, without any downgrade, despite adverse business prospects, mergers & acquisitions and forays into diversified areas. All CRAs reveal the processes flows. But they do not disclose the actual methodologies. Unaccepted ratings are not published; hence information is asymmetric to that extent. CRAs generally give information based on Credit risk. Markets factor in other risks also.

ANNEXURE

T-Test

Paired Samples Statistics Mean N Std. Deviation CRISIL Pair 1 CARE 42.7075 8 21.43987 7.58014 232.8050 8 201.56886 Std. Error Mean 71.26535

Paired Samples Correlations N Pair 1 CRISIL & CARE 8 Correlation .738 Sig. .036

Paired Samples Test Paired Differences Mean Std. Deviation Std. Error Mean 95% Confidence Interval of the Difference Lower Pair 1 CRISIL - CARE 190.09750 186.30345 65.86822 34.34392 Upper 345.85108 2.886 7 .023 t df Sig. (2tailed)

Wilcoxon Signed Ranks Test

Ranks N Mean Rank Sum of Ranks Negative Ranks Positive Ranks CARE - CRISIL Ties Total a. CARE < CRISIL b. CARE > CRISIL c. CARE = CRISIL 0 8 0
a b c

4.50 .00

36.00 .00

8

Test Statistics

a

CARE CRISIL Z Asymp. Sig. (2-tailed) a. Wilcoxon Signed Ranks Test b. Based on positive ranks. -2.521
b

.012

T-Test

Paired Samples Statistics Mean N Std. Deviation CRISIL Pair 1 CARE ICRA Pair 2 CARE 42.7075 8 21.43987 7.58014 42.7075 40.5675 8 8 21.43987 19.21314 7.58014 6.79287 232.8050 8 201.56886 Std. Error Mean 71.26535

Paired Samples Correlations N Pair 1 Pair 2 CRISIL & CARE ICRA & CARE 8 8 Correlation .738 .924 Sig. .036 .001

Paired Samples Test Paired Differences Mean Std. Deviation Std. Error Mean 95% Confidence Interval of the Difference Lower Pair 1 Pair 2 CRISIL - CARE ICRA - CARE 190.09750 -2.14000 186.30345 8.23035 65.86822 2.90987 34.34392 -9.02074 Upper 345.85108 4.74074 2.886 -.735 7 7 .023 .486 t df Sig. (2tailed)

Wilcoxon Signed Ranks Test

Ranks N Mean Rank Sum of Ranks Negative Ranks Positive Ranks CARE - CRISIL Ties Total Negative Ranks Positive Ranks CARE - ICRA Ties Total a. CARE < CRISIL b. CARE > CRISIL c. CARE = CRISIL d. CARE < ICRA e. CARE > ICRA f. CARE = ICRA 0 0 8 0
a b c

4.50 .00

36.00 .00

8 2 6
d e f

6.00 4.00

12.00 24.00

8

Test Statistics

a

CARE CRISIL Z Asymp. Sig. (2-tailed) a. Wilcoxon Signed Ranks Test b. Based on positive ranks. c. Based on negative ranks. -2.521
b

CARE ICRA -.840
c

.012

.401

T-Test

Paired Samples Statistics Mean N Std. Deviation CRISIL Pair 1 ICRA 40.5675 8 19.21314 6.79287 232.8050 8 201.56886 Std. Error Mean 71.26535

Paired Samples Correlations

N Pair 1 CRISIL & ICRA 8

Correlation .761

Sig. .028

Paired Samples Test Paired Differences Mean Std. Deviation Std. Error Mean 95% Confidence Interval of the Difference Lower Pair 1 CRISIL - ICRA 192.23750 187.35887 66.24136 35.60157 Upper 348.87343 2.902 7 .023 t df Sig. (2tailed)

Descriptive Statistics N Mean Std. Deviation CRISIL ICRA 8 8 232.8050 40.5675 201.56886 19.21314 51.67 12.89 599.44 70.00 Minimum Maximum

Wilcoxon Signed Ranks Test

Ranks N Mean Rank Sum of Ranks Negative Ranks Positive Ranks ICRA - CRISIL Ties Total a. ICRA < CRISIL b. ICRA > CRISIL c. ICRA = CRISIL 0 8 0
a b c

4.50 .00

36.00 .00

8

Test Statistics

a

ICRA CRISIL Z Asymp. Sig. (2-tailed) -2.521
b

.012

a. Wilcoxon Signed Ranks Test b. Based on positive ranks.

REFERENCES
1)Alexander B. Matthies, 2013-2003 ,Empirical Research on Corporate Credit- Ratings: A Literature Review, “Discussion paper” 2) Altman E.I., (1968), Financial Ratios, Discriminate Analysis and the Prediction of Corporate Bankruptcy, Journal of Finance, Sept., pp. 589-609. 3) Financial Times, (1996), Emerging Markets - Credit Ratings, Financial Times Publishing, Pearson Professional Ltd.