UNIT-3

Merchant Banking:

“Merchant Banking refers to the financial intermediary services provided by specialised banks

called Merchant Bank (other than commercial banks) for business corporates and individual with
high net worth.”

Merchant banks act as an intermediary/ middleman between business corporates and investors.
In other words, merchant banking is financial intermediation between the business entities which
require funds and the investors who possess ready capital and seeking an opportunity for
investment so that they can make a return.  

Thus we can say that Merchant banking matches the gap between the issuer of capital
(Corporates) and purchaser of capital (Investors). Hence, it is the function that facilitates the flow
of capital in the financial system.

Role of Merchant Banking:

 Merchant Banking facilitates in channelising the financial surplus of the general public
into productive investment avenues.

 It coordinates the activities of various intermediaries to share issue.

 It ensures compliance with rules and regulations governing the securities market.

 Merchant banking is said to be the centre of capital market operations and their activities
are primarily non-fund based.

 Their basic requirement is a high professional with skills and worldwide contact.

Merchant Banking- Origin:

The concept of merchant banking is originated in the 13th century from Italy and the first-ever
merchant banks were Riccardi of Luca, Medici, Fugger etc. Initially, there was no distinction
between the functions of commercial banking and merchant banking until 1932.

The merchant banks are also known as “Accepting and Issuing Houses” in the United Kingdom
and they are known as Investment Banks in the United States as well.

Merchant Banking in India:

Merchant Banking Service in India was originated in 1969 when the merchant banking division
of Grindlays Bank was initiated for undertaking and management of the public issue and
financial consultancy. Further, State Bank of India stated merchant banking service in 1973 and

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ICICI Bank Ltd became the first development financial institution to initiate merchant banking
services in 1974.

During mid-seventies, India witnessed a boom in the growth of merchant banking organisations
which were sponsored by the banks, NBFCs, Brokers etc. This led to the diversification into the
scope of the following activities.

 Loan Syndication 

 Portfolio Management

 Corporate Counselling

 Project Counselling

 Debenture Trusteeship

 Mergers and Acquisitions

However, the scope of such services was neither defined nor any rules and regulation were set up
to govern such activities. Then in 1992, the formation of SEBI (Securities of Exchange Board of
India) was taken place. This became a landmark in the evolution of merchant banking as a
professional service in the country.

Evolution of Merchant Banking:

“Hundi” was the main instrument of credit used by indigenous bankers before the coming of
western merchants in India. It was in 1813 when merchants came from European countries to
trade with India. Agency houses were set up by merchant bankers based in London.

These agency houses raised deposits at cheaper rates of interest viz. 4% to 5% from their home
and made advances to native merchants at 10% to 12% and also, they charged high
commissions on every kind of service provided to the clients.

Easy availability of money at the spot from the agency houses had eliminated the role of
acceptance house or merchant banking in India. It was only with the entrance of East India
Company that restrictions were put on the operation of agency houses.

During the 19th century,

Foreign merchant bankers operated in India through “East India House”. East India House
members moved into real estate business viz. tea and rubber plantation, cotton mills, etc. They
faced tough competition from Persian finance houses who were willing to grant credit to the
trade with India.

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It was in 1860 when the merchant’s interest in joint-stock banking started growing and with their
investments, they floated joint-stock banks. Some new banks were founded which
included Orient Bank in 1845, Chartered Bank of India and Asia in 1853, Chartered
Mercantile Bank of India, London & China in 1857 and so on.

These banks financed trade transactions. The control and management of these banks lied with
managing agents. Also, the managing agency system enabled a single firm to look after several
firms in complementary industries.

With the result,

The banking industry flourished in India on the support of London based merchant bankers; and,
the merchants who had full control of the Board. Telegraphic transfers improved banking links
and the business.

The managing agents acted as merchants banks and performed functions of promoting financing
and marketing of securities. They developed strong roots in depth of India’s economic,
commercial and industrial structure. Also, they served the industry, trade, and commerce as the
merchant bankers were doing in the UK; and, European countries or the investment bankers were
doing in the USA.

With the advent of the industrial boom in India, there has been a growing need of Merchant
Bankers. Businesses often require specialised banking services which are concentrated in nature.
Hence, commercial bankers set up their merchant banking subsidiaries to cater  financial
services for the corporate sector.

The first Merchant Banker was set up in 1967 by Grindlay’s Bank, after that, there were a
number of merchant banks incorporated. There are multiple factors that have accelerated the
importance of Merchant Banking in the country. These could be enlisted in the following
pointers:

Globalization of Economy: Post the 1991 reforms, the Indian economy opened its gates to
overseas organizations. This encouraged fundings coming in from abroad and thereby pivoting
the importance of Merchant Bankers.

Increased Competition: With favorable business options and lucrative market scenarios, the
Indian corporates buckled up their games and were on an expansion spree. This encouraged the
Merchant Bankers to play substantial roles with their specialized services towards Corporates.

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Change in Consumer Trends: With multiple foreign players setting shop on Indian soil, there
has been a boost in the quality of products that were being offered to the Indian masses. This in
turn transformed the strategies of the Indian counterparts. Financial products and instruments
became more prominent in the prevailing environments.

Government Reforms: With a reduction in Government intervention and privatization, there

was a boost in the private corporate sector. Also, increasing the limits on investments and
reduction in direct interventions proved to be a lucrative proposition of foreign players. 

These factors, along with the enhancement of the ease of doing business has paved the way for
Merchant Bankers to gain a considerable position. In addition, SEBI has served to be an effective
watchdog for merchant banking activities. We, at Resurgent India, are a Category I Merchant
Banker, registered under SEBI. 

Merchant banking scope

fund Raising

Acquisition of required funds timely for their clients is one of the major role played by Merchant
bankers. They provide access to various sources of finances at both domestic and international
level to their customers. These professional analyses the needs of people and accordingly suggest
them better source of finance. Various source of finance available are taking loans, issuing equity
share and debentures etc. Timely availability of funds facilitates in establishing a new business
project, modernizing and expanding their areas of activities.

Portfolio Management

It does the work of managing the portfolio of their customer. Merchant banker direct their clients
with regard to their investment decisions by suggesting them the securities in which they should
invest. They ensure safety of their clients’ money by analyzing the securities in terms of risk,
return and rate of votality.

Manages Project
Merchant banker perform the responsibility of managing the project of their clients. They guide
them in various events related to project such as choosing the project location, preparing project
report, performing feasible studies, deciding financing plan, choosing financial source and
informing them about government incentives.

Revive Sick Industrial Units

Revival of sick industrial units is an important function rendered by merchant banks. They help
small industries by arranging the finance facilities for them by doing negotiations with lending
institutions, banks and Board for Industrial and Financial reconstruction. These professionals
support the expansion of these industries by apprising them of new technologies and guiding in
legal matters.

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Manage Public Issues Of Companies
Merchant banks handles all activities of companies related to public issue of their securities.
These highly-skilled individuals forecast the market conditions and accordingly direct
organization when to issue securities, at what price and in what amount. All process related to
such issue like accepting application forms from public, allotting shares, appointment of broker
and underwriter etc. are all performed by merchant bankers.

Decides Interest And Dividend Decisions

A merchant banks assist its clients in taking decisions regarding declaration of dividend on its
securities and interest on loans/debentures. They conduct an analysis of overall market
conditions and availability of business profit before deciding the rate and timing of such
declaration. 

Broker In Stock Exchange

Merchant bankers act as stock exchange broker by dealing in activities such as purchasing and
selling of securities. They perform all these activities on part of their customers. These
individuals conduct a detailed analysis of market performance for choosing the most suitable
securities. They give advice regarding which security to purchase, when to purchase, in what
amount and when it should be sell.

Leasing Services
These banks also offers leasing service to their clients. Lease is a formal agreement entered into
between two individuals for renting a particular equipment whereby owner allows the usage of
its asset by another person on rent basis. Merchant banks facilitate the access to these services by
acting as an intermediary of leasing companies. 

Merchant Banker Functions:

Although merchant banks provide numerous services to their client these days, some of the most
significant functions of merchant banks are explained below.

1) Underwriting of Debt and Equity:

Underwriting/ management of debt securities such as debentures and share capital is one of the
most important functions of a merchant banker. The merchant banks act as middlemen between
the issuer of debt securities and individual or institutional investor and assists the companies in
raising funds from the market. Merchant banks evaluate the value of the business and the number
of shares or debentures is to be issued.

2) Placement and Distribution:

The merchant bankers facilitate in distributing various securities like equity shares, debt
instruments, mutual funds, fixed deposits, insurance policies, commercial papers and distribution
network of the merchant banker can be classified as institutional and retail.

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3) Corporate Advisory Services:

Merchant bankers offer customised solutions to their clients’ financial problems and financial
structuring includes determining the right debt-equity ratio and gearing ratio for the client and
appropriate capital structure theory is framed as well.

Merchant banker explores the refinancing alternatives for the client and evaluates cheaper
sources of funds. It also provides Rehabilitation, Turnaround and Risk management services
such as designing a revival package in coordination with banks and financial institutions for sick
industrial units, appropriate hedging strategies to reduce the risk associated.

4) Project Advisory Services:

Merchant bankers help their clients in various stages of the project undertaken by the clients:

1. They assist them in conceptualising the project idea in the initial stage

2. Once the idea is formed, they conduct feasibility studies to examine the viability of the
proposed project

3. They also assist the client in preparing different documents like a detailed project report

5) Loan/ Credit Syndication:

Merchant bankers arrange tie-up loans for their clients. This takes place in a series of steps.
Firstly they analyse the pattern of the client’s cash flows, based on which the terms of
borrowings can be defined. Then the merchant banker prepares a detailed loan memorandum,
which is circulated to various banks and financial institutions and they are invited to participate
in the syndicate. The banks then negotiate the terms of lending based on which the final
allocation is done.

6) Provide Venture Capital and Mezzanine Financing:

Merchant bankers help companies in obtaining venture capital financing for financing their new
and innovative strategies. They also help small organisations and entrepreneurs to obtain initial
funding, other business ideas and opportunities, Government policies and incentives.

In addition, merchant bankers also provide various other services as well.

7) Portfolio Management Services:

Merchant banks offer portfolio management service to their clients. They guide their clients
regarding profitable, easy liquid and less risky investment avenue. They also update their clients
with important and crucial news and updates regarding investment opportunities and market
fluctuations.

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8) Interest/ Dividend Management:

Merchant bankers also facilitate their client on computing, declaration and allocation of interest
on debt securities such as debentures and dividend of shares/stocks. 

9) Brokerage Services:

Merchant banks also act as a broker in the stock exchange. They purchase or sell the shares on
behalf of their clients and also provide guidance on which or when to buy or sell shares. 

10) Manage Money Market Instruments:

Merchant bankers also manage money market instruments like Government bonds, Treasury
bills, commercial papers, certificate of deposits for the Government entities as well as large
companies and financial institutions.

Registration of Merchant Bankers:

To function as a merchant banker, a business firm or company needs to register with SEBI and
comply with the following terms and conditions:

 The applicant should be a body corporate and should have a minimum net worth of Rs.5
crores.

 The applicant should not carry on any business other than those connected with the
securities market

 The applicant should have the necessary infrastructure like office space, equipment,
manpower etc

 The applicant must have at least two employees with prior experience in merchant
banking

 Any associate company, group company, subsidiary or the interconnected company of

the applicant should not have been a registered merchant banker.

 The applicant should not have been involved in any securities scam or proved guilt for
any offer.

Conclusion:

Hope the article would able to elaborate on the complete overview of merchant banking.
Merchant bankers establish a bridge between demand and supply of capital in the economy. The
merchant bankers also arrange the capital for the organisations which are unable to raise funds
from the public through private placement.

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Difference Between Commercial Bank and Merchant Bank

Banks are termed as the financial institutions, which act as intermediaries between depositors
and borrowers. Besides the usual function of accepting deposits and extending credit, many
value added services are also provided by the banks. Indeed, there are different types of banks set
up to perform different functions. Commercial banks are the banks that provide services to the
general public and companies as well.

Comparison Chart

BASIS FOR
COMMERCIAL BANK MERCHANT BANK
COMPARISON

Meaning Commercial bank is a banking company Merchant bank refers to the

established by a number of people for financial institution, that
providing the basic banking functions specializes in international
i.e. accepting deposits and lending trade and provide and array of
money to general public. services to its clients.

Governing Regulated by Banking Regulation Act, Rules and regulations designed

Act/body 1949. by SEBI.

Engaged in General banking business Consultancy type business

Nature of loan Debt-related Equity-related

extended

Exposure to risk Less Comparatively more

Role Financier Financial Advisor

Caters Needs of general public. Needs of corporate firms.

The merchant banker must fulfill the pre-issue and post issue obligations as provided under the
act. The following are the pre-issue and post-issue obligations:

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Obligations of Merchant Banker

Pre-Issue Obligations

1. Documents to be submitted along with Offer Document by the Merchant Banker:

 MOU

 Inter-se Allocation of Responsibilities

 Due-Diligence Certificate

 Certificates signed by Company Secretary or Chartered Accountant.

 List of Promoters’ Group & other details.

 Promoter’s individual shareholding.

 stock exchanges on which securities proposed to be listed, Permanent A/c No., Bank A/c
No. & passport No. of promoters.

1. Merchant Banker should not lead manage the issue, if he is a promoter or a director of
issuer company.

2. Merchant Banker should not lead manage the issue, if he is an associate of the issuer
company or is involved in marketing of the issue.

3. The lead merchant banker shall satisfy themselves about the ability of the underwriters to
discharge their underwriting obligations.

4. The issuer company must appoint authorized collection agents in consultation with the
lead merchant banker, subject to necessary disclosures including the names and addresses
of such agents are made in the offer document.

5. The merchant banker must ensure that the issuer company has entered into agreement
with the depositories before opening the issue.

Once all the pre-issue obligations are fulfilled the issuer company can open its offer to the
public. But it can only be done after getting the approval of the nodal securities authority. After
opening the issue to the public, the merchant banker must ensure that it is fully subscribed. After
the subscription of the securities the lead merchant banker must fulfill the post-issue obligations.
They are discussed under:

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POST-ISSUE OBLIGATIONS

 The post issue lead merchant banker shall ensure the submission of the post issue
monitoring reports.

 Due diligence certificate has to be submitted with the final post issue monitoring report.
The post-issue lead merchant banker shall file a due diligence certificate in the format
specified along with the final post issue monitoring report.

 The post-issue lead merchant banker shall maintain close coordination with the Registrars
to the Issue. Any act of omission or commission on the part of intermediaries shall be
reported to the securities agency.

 Post- issue lead merchant banker shall ensure that in all issues, advertisement giving
details relating to over-subscription, basis on allotment, number, value and percentage of
application received etc. is released within 10 days.

 In a public issue of securities, the managing director along with the lead merchant banker
and the registrar to the issue, shall ensure that basis of allotments is finalized in a fair and
proper manner.

If the lead merchant banker complies with all the pre-issue and post issue obligations the only the
issue will be considered as valid

Explain the SEBI guidelines in respect of Merchant Banking?

SEBI has made the following reforms for the Merchant banker.

1. Multiple categories of merchant banker will be abolished and there will be only one equity
merchant banker.

2. The merchant banker is allowed to perform underwriting activity. For performing portfolio
manager, the merchant banker has to seek separate registration from SEBI.

3. A merchant banker cannot undertake the function of a non banking financial company, such as
accepting deposits, financing others’ business, etc.

4. A merchant banker has to confine himself only to capital market activities.

Recognition by SEBI on merchant bankers SEBI will grant recognition a merchant banker
after taking into account the following aspects.

1. Professional competence of merchant bankers.

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2. Their capital adequacy.

3. Track record, experience and general reputation of merchant bankers.

4. Adequacy and quality of personal employed by them and also the available infrastructure.
After considering the above aspects,

SEBI will grant permission for the merchant banker to start functioning. Conditions by SEBI has
laid for merchant bankers SEBI the following conditions on the merchant bankers, for
conducting their operations.

They are:

a. SEBI will give authorization for a merchant banker to operate for 3 years only. Without
SEBI’s authorization, merchant bankers cannot operate..

b. The minimum net worth of merchant banker should be Rs. 1 crore.

c. Merchant banker has to pay authorization fee, annual fee and renewal fee.

d. All issue of shares must be managed by one authorized merchant banker. It should be the lead
manager.

e. The responsibility of the lead manager will be clearly indicated by SEBI.

f. Lead managers are responsible for allotment of securities, refunds, etc.,

g. Merchant banker will submit to SEBI all returns and send reposrts regarding the issue of
shares.

h. A code of conduct for merchant bankers will be given by SEBI which has to be followed by
them.

i. Any violation by the merchant banker will lead to the revocation of authorization by SEBI.

Conditions by SEBI pertaining to pre issue obligations: Recent regulations by SEBI on

Merchant bankers with regard to pre issue obligations involve the following;

1. Registration

2. Capital structure decision

3. Public issue

4. Rights issue

5. Prospectus, etc.,

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1. Registration: All merchant bankers must compulsorily register themselves with SEBI. SEBI
has classified merchant bankers under categories. They are given below:

registration to merchant bankers under following conditions;

1. Merchant bankers should be a body corporate and should not be a NBFC.

2. They must have necessary infrastructure for maintaining an office. 3.

3. They must have employed a minimum of two persons with experience in merchant banking
business.

4. They should not be connected with any company directly or indirectly.

5. They should not have involved in any litigation connected with Stock Exchanges.

6. They must have a professional qualification in finance, law or business management.

7. Their registration must be in public interest.

Capital structure decision: According to SEBI, they must have a minimum net worth (paid up
capital + Free reserves) of Rs. 5 crores. But this will vary according to the category Rs. 5 crores
for first category and none for the fourth category. Registration fee to be paid to SEBI:

1. For category, 1 Rs. 2.5 crores per annum for the first 2 years and Rs. 1 lakh for the third year
have to paid to SEBI towards registration fee.

2. For category 2. Rs.1.5 lajhs for the first 2 years per annum and Rs. 50,000 for the third year.

3. For category 3 Rs. 1 lakh per annum for the first 2 years and Rs. 25,000 for the third year.

4. From 1999 onwards, Rs.2.5 lakhs for every year, failing which the registration will be
suspended for all categories.

Role of Merchant banker in public issue: While acting as a banker to an issue, a merchant
banker has to disclose full detail to SEBI. The details should contain the following.

1. Furnishing information:

a. Number of issues for which the merchant banker is engaged axis banker to issue.

b. Number of applications received and details of application money received.

c. Dates on which applications from investors were forwarded to issuing company.

d. Details of amount as refund to investors.

2. Books to be maintained:

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a. Books of accounts for a minimum period of 3 years.

b. Records regarding the company.

c. Documents such as company applications, names of investors, etc.,

3. Agreement with issuing company:

a. Number of collection centers.

b. Application money received.

c. Daily statement by each branch which is a collecting centre.

4. Action by RBI:

Any action by RBI on Merchant banker should be informed to SEBI by the Merchant banker
concerned.

5. Code of Conduct:

a. Having high integration in dealing with clients.

b. Disclosure of all details to the authorities concerned. Avoiding making exaggerated

statements.

c. Disclosing all the facts to its customers.

d. Not disclosing any confidential matter of the clients to third parties.

Responsibilities of Merchant Banker in Right Issue:

1. The merchant banker will ensure that when Rights issues are taken by a company, the
merchant banker who is responsible for the right issue shall see that an advertisement regarding
the same is published in an English national daily, in an Hindi national daily and in a regional
daily. These newspapers should be in circulation in the city/town where the registered office of
the company is located.

2. It is the duty of the merchant banker to ensure that the application forms for Rights issue
should be made available to the shareholders and if they are not available, a duplicate composite
application form is made available to them within a reasonable time.

3. If the shareholders are not able to obtain neither the original not the duplicate application for
Rights shares, they can apply on a plain paper through the merchant banker.

4. The details that should be furnished in the plain paper , while applying for rights shares shoul
be provided by the merchant banker.

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5. The merchant banker should mention in the advertisement, the company official to whom the
shareholders should apply for Rights shares.

6. The merchant banker should also inform that no individual can apply twice, in standard form
as well as in plain paper.

Role of Merchant banker in the issue of prospectus: It is the duty of the lead merchant banker
to ensure that the prospectus are properly made and should not contain any false information.
The merchant banker will also ensure that

a. the application form issued will be accompanies by abridged prospectus by the issuer
company.

b. In the abridged prospectus, application form may be inked as a perforated part.

c. Unconnected matters should not be furnished in the prospectus.

Managing public issue:

1. No merchant banker is permitted to carry on business other than that in the securities market
with effect from December 1997.

2. The maximum number of lead managers is related to the size of the issue. For an issue of Rs.
50 crores two lead managers are appointed.

3. Between Rs. 50 crores to Rs. 100 crores, three lead managers and Rs. 100 to Rs. 200 crores 4
lead managers are appointed.

4. 5 or more lead managers are appointed, if size of the issue is between Rs. 200 and Rs. 400
crores

Unit-4
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Credit Rating Agencies:

A credit rating agency (CRA, also called a ratings service) is a company that assigns credit
ratings, which rate a debtor's ability to pay back debt by making timely principal and interest
payments and the likelihood of default. An agency may rate the creditworthiness of issuers of
debt obligations, of debt instruments and in some cases, of the servicers of the underlying debt
but not of individual consumers.. Read more at: https://www.fincash.com/l/credit-rating-
agencies,

The debt instruments rated by CRAs include government Bonds, corporate bonds, CDs,
municipal bonds, preferred stock, and collateralized securities.

1. What are Credit Rating Agencies? Credit rating agencies are agencies which
provide ratings to represent objective analyses and independent assessments of
companies, entities or countries that issue such debt securities. These ratings are
an indication to the buyers of this debt how likely they are to be paid back.
2. Core Functions -Compiling financial data essential for loan decisions and
insurance. -Statistical assessment that is involved in ascribing a rating to a
borrower. -Providing investors an objective analysis of the organization’s ability
to pay back .
3. What are These Ratings? A credit rating issued by a rating agency is an
assessment of the creditworthiness of securities issued by corporations,
governments and other entities

How do credit rating agencies work?

Credit rating agencies assign a value to the credit risk of different securities such as bonds and
loans. For example, AAA is seen as the industry standard as the highest rating, and AAA, AA, A
and BBB are widely seen as investment-quality securities.

Ratings of BB or below are speculative grades which denote a higher credit risk or risk of default
in the underlying security, but this often comes with a potentially higher return on an initial
investment.

While they use alphabetical ratings, credit rating agencies will often not give a numerical
probability to the risk of default such as 10%, 20% or 30%. Instead, they will use statements
such as ‘the obligor’s (borrower’s) capacity to meet its financial commitments on the obligation
(to repay the lender) is extremely strong’.1

However, it is generally accepted that AAA and AA rated securities have a default risk of less
than 1%, and the probability of default increases for each subsequent rating.

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Credit ratings agencies usually have analysts who recommend a rating, and then a committee
which votes on the recommendation. Analysts will use information such as background data,
management forecasts, risk reports and performance forecasts.

They can also consider macroeconomic data, data provided by a company, bank or government
which is being reviewed, or any information which is publicly available about the security which
is being reviewed for a rating. Once the analysts have gathered enough data and information to
give a recommendation, there will be a pre-committee and then a committee stage.

The pre-committee stage serves to assess whether the full rating process should proceed – if
there is not enough information available to grant a recommendation, then the ratings process
may be suspended. If it is decided that the process should proceed, then the recommended rating
will be submitted to a committee for review.

The committee is often provided with a review package which contains the analysts’ findings
and rationale for a recommended rating. The committee will consider the findings in the review
package and determine whether the recommendation provided by the analysts is correct.

This determination will be achieved through a vote of the committee members, who are chosen
based on experience and seniority – but different agencies might have slightly different criteria
for selecting committee members. The members will then vote on the recommended rating and
agree on either that rating, or they’ll assign a different credit rating based on a majority decision.

The ratings themselves are also only ever presented as opinions of a particular agency, but
market participants will use multiple agencies to determine an aggregate credit risk rating.

Role of Credit Ratings in Capital Markets:

One of the fundamental principles of an economy that allows capital markets to thrive is that
businesses need regular financing. While in an ideal scenario, a business should be able to
sustain its costs and growth plans, in the real world, most businesses need to raise capital for
meeting operational costs and/or implementing expansion plans.

Companies can raise the required finance by various means like issuing shares, applying for a
bank loan, trade financing, lines of credit, issuing bonds or fixed deposits, etc.

In the capital market, every investor assesses investment risks differently based on his/her skills
for credit evaluation. For the markets to function smoothly and to boost investor confidence, it is
important to ensure that the regulators protect the interests of the investors against any
malpractices. This leads to the need for credit ratings in the capital markets.

Credit Rating Agencies in India

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The concept of credit rating has been widely discussed and debated in India in recent times.
Since the setting up of the first credit rating agency. Credit Rating and Information Services of
India Ltd. (CRISIL) in India in 1987, there has been a rapid growth of credit rating agencies in
India. The major players in the Indian market, apart from CRISIL include Investment
Information and Credit Rating agency of India Ltd. (ICRA), promoted by IDBI in 1991 and
Credit Analysis and Research Ltd. (CARE), promoted by IFCI in 1994. Duff and Phelps has tied
up with two Indian NBFCs to set up Duff and Phelps Credit Rating India (P) Limited in 1996

Role of Credit Ratings in Capital Markets

There are four entities that are impacted by a debt instrument:

I. The investor

II. The issuer

III. The financial intermediaries

IV. The regulator

Credit ratings offer benefits to all these parties. Here is the importance of credit rating
agencies in the capital markets. 

1. Benefits of Credit Ratings to Investors

Investors use credit ratings to make investment decisions. They derive the following benefits
from them:

 Assistance in decision-making – A quick look at the credit rating of an instrument tells

investors about the risks associated with it. This allows them to choose instruments based
on their risk tolerance and expected returns.

 Regular reviews of ratings – Credit rating agencies regularly review the ratings to
ensure that it is relevant to the existing condition of the issuer and market. Hence, if an
investor has purchased an instrument with the highest rating but finds it to be
downgraded, then he can decide to sell the instrument to curb his losses.

 Assurance of safety – An instrument with a high credit rating assures investors of the
safety of their investment and the financial strength of the issuer.

 Ease of understanding – Credit rating agencies have a standard way of rating

instruments. Hence, investors can easily understand the investment proposal.

 Saves time & effort – Analyzing an issuing company’s financial strength can take a lot
of effort and time and requires some financial competence too. However, the credit rating

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 provided by these professional agencies ensures that all the important factors are taken
into consideration. Hence, investors can rely on these ratings and save a lot of time and
effort.

2. Benefits of Credit Ratings to Issuers

The issuing company derives the following benefits from credit ratings:

 Creates corporate image – For an issuing company, it’s better to have a corporate image
based on facts as opposed to perception. Credit ratings ensure that the company gets a
true corporate image in the market.

 Can reduce the cost of borrowing – If a company has low risk according to the credit
rating agency, then it will give it a high credit rating. This means that investors will buy
debt instruments from the company if they are looking at low-risk investments and will
willingly accept lower interest rates. Hence, the issuing company can raise capital at a
lower cost.

 More avenues for borrowing – If a company has a good credit rating, then there is no
shortage of avenues to approach for raising funds. This is because most organizations
offering financing options accept credit ratings provided by recognized agencies.

 Helps promote non-popular companies – Many companies are not popular among
investors. Hence, when they issue a debt instrument, the reach is limited since investors
are not aware of them. However, if a company has a high credit rating, then investors will
invest in them even if they have never heard their names before.

3. Benefits of Credit Ratings to Financial Intermediaries

The financial intermediaries derive the following benefits from credit ratings:

 No need to explain the risk/return of a debt instrument – Credit ratings are self-
explanatory and easy to understand. If an investor looks at an instrument with an AAA
rating, he expects lower interest rates and purchases it if his risk tolerance is low. Hence,
stockbrokers and other financial intermediaries don’t have to explain risks or returns to
their clients.

 Reduces dependency – Investors can choose instruments based on their investment plan
by looking at the credit rating of various instruments. This allows them to be independent
and reduces the load on investment advisors.

4. Benefits of Credit Ratings to Regulators

The regulators derive the following benefits from credit ratings:

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  Increases transparency – Credit rating agencies use all possible information on the
issuing company (quantitative and qualitative) to assign a credit rating to it. This includes
information that is not easily available to regular investors. Hence, it makes the process
of investing in such instruments more transparent.

 Creates a differentiation between companies – Credit ratings allow regulators to easily

differentiate between performing and non-performing companies without additional
effort or cost.

 Timely action – Credit ratings allow regulators to take timely action against defaulting
companies.

As you can see, credit ratings benefit all parties involved in capital markets. However, before
making an investment decision based on credit ratings, it is important to keep the following
points in mind.

Importance of Credit Rating

Here are the benefits of credit rating:

For The Money Lenders

1. Better Investment Decision: No bank or money lender companies would like to give
money to a risky customer. With credit rating, they get an idea about the credit
worthiness of an individual or company (who is borrowing the money) and the risk factor
attached with them. By evaluating this, they can make a better investment decision.

2. Safety Assured: High credit rating means an assurance about the safety of the money and
that it will be paid back with interest on time.

For Borrowers

1. Easy Loan Approval: With high credit rating, you will be seen as low/no risk customer.
Therefore, banks will approve your loan application easily.

2. Considerate Rate of Interest: You must be aware of the fact every bank offers loan at a
particular range of interest rates. One of the major factors that determine the rate of
interest on the loan you take is your credit history. Higher the credit rating, lower will the
rate of interest.

Methodology of Credit Rating

The process of credit rating begins with the prospective issuer approaching the rating agency for
evaluation. The experts in analyzing banks should be given a free hand and they will collect data
and informant and will investigate the business strength and weaknesses in detail. The entire

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process of rating stands on the for of confidentiality and hence even the most
confidential business strategies, marketing plans, future outlook etc., are revealed to the steam of
analysis.

The rating is based on the investigation analysis, study and interpretation of various factors. The
world of investment is exposed to the continuous onslaught of political, economic, social and
other forces which does not permit any one to understand sufficiently certainty. Hence a logical
approach to systematic evaluation is compulsory and within the framework of certain common
features the agencies employ different methodologies. The key factors generally considered are
listed below:

1. Business Analysis or Company Analysis

This includes an analysis of industry risk, market position of the company, operating efficiency
of the company and legal position of the company.

 Industry risk: Nature and basis of competition, key success factors; demand supply
position; structure of industry; government policies, etc.

 Market position of the company within the Industry: Market share; competitive

advantages, selling and distribution arrangements; product and customer diversity etc.

 Operating efficiency of the company: Locational advantages;  labor  relationships; cost

structure and manufacturing as compared to those of competition.

 Legal Position: Terms of prospectus; trustees and then responsibilities; system for timely
payment and for protection against forgery/fraud, etc.

2. Economic Analysis

In order to evaluate an instrument an analyst must spend a considerable time in investigating the
various economic activities and also analyze the characteristics peculiar to the industry, whose
issue the analyst is concerned with. It will be an error to ignore these factors as the individual
companies are always exposed to changing environment and the economic activates affect
corporate profits, attitudes and expectation of investors and the price of the instrument. hence the
relevance of the economic variables such as growth rate, national income and expenditure cannot
be ignored. The analysis, while doing the economic forecasting use surveys, various economic
indicators and indices.

3. Financial Analysis

This includes an analysis of accounting, quality, earnings, protection adequacy of cash flows and
financial flexibility.

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  Accounting Quality: Overstatement/under statement of profits; auditors qualification;
methods of income  recognition’s  inventory valuation and depreciation policies,
off balance sheet liabilities etc.

 Earnings Protection: Sources of future earnings growth; profitability ratios; earnings in

relation to fixed income changes.

 Adequacy of cash flows: In relation to dept and fixed and working capital needs;
variability of future cash flows; capital spending flexibility working capital
management etc.

 Financial Flexibility: Alternative financing plans in ties of stress; ability to raise funds

asset redeployment.

4. Management Evaluation

 Track record of the management planning and control system, depth of managerial

talent, succession plans.

 Evaluation of capacity to overcome adverse situations

 Goals, philosophy and strategies.

5. Geographical Analysis

 Location advantages and disadvantages

 Backward area benefit to the company/division/unit

6.  Fundamental Analysis

Fundamental analysis is essential for the assessment of finance companies.  This includes an
analysis of liquidity management, profitability and financial position and interest and tax
sensitivity of the company.

 Liquidity Management: Capital structure; term matching of assets and liabilities policy

and liquid assets in relation to financing commitments and maturing deposits.

 Asset Quality: Quality of the company’s credit-risk management; system for monitoring

credit; sector risk; exposure to individual borrower; management of problem credits etc.

 Profitability and financial position: Historic profits, spread on fund deployment

revenue on non-fund based services accretion to reserves etc.

 Interest and Tax sensitivity: Exposure to interest rate changes, hedge against interest

rate and tax low changes, etc.

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Country’s Credit Rating

Country’s credit rating denotes its ability to source debt from the international market at a
reasonable cost. Low rated nations will have discounts, offer high yield and are treated as risky
investment. Risk relates to default. Country’s credit rating involves evaluation of external
financial accounts and macro economic factors and is directed towards future trends. Credit
rating of any country involves evaluation of:

 Economic growth and development : Gross national product and gross domestic

product, population growth, Infrastructure development, good financial management,
saving growth rate, industrial production, agricultural production, growth of services
sector etc.

 Balance of trade and balance of payments : Export products, export prices,

diversification of products and export market, global competition, import substitution,
etc.

 Debt service ratio : This indicates the country’s external vulnerability. This is a ratio of
external debt to total external earnings including export earning and earning from
tourism, etc.

 Debt composition :  Soft loans, commercial borrowings, interest rate structure,

proportion of external debt.

 Liquidity :  Level of reserves, foreign exchange reserves, import coverage ratio,

currency backed by assets such as gold.

 Political and internal stability :  Socio-religious conflicts, majority government strong

opposition, unequal economic distribution, relations with neighboring countries, political
factors are not predictable and is prone to unexpected events.

 Inflation and price stability.

Political challenges, economic transformation and policy consensus, fiscal imbalances and
imposing public sector debt burdens are all factors which enhance or inhibit the credit rating of a
country while political and economic forces are clearly a key determination of sovereign credit
risk in emerging market countries, the financial pressures due to fiscal indiscipline pose threat to
liquidity problems and default. Fiscal control is the key indicator of improving or deteriorating
credit quality.

Drawbacks of Credit Rating

Following are some of the drawbacks of credit rating:

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  The ratings process attempts to provide a guidance to investors/creditors in determining
the risks associated with the instrument/credit obligation. It does not attempt to provide a
recommendation and does not take into account factors like market prices, personal
risk/reward preferences that might influence investment decisions.

 The ratings process is based on certain primitives. The agency, for instance, does not
perform an audit. Instead, it has to rely solely on information provided by the user.
Consequently, to the extent that the information provided is inaccurate and incomplete,
the rating process is compromised.

 To the extent that a certain instrument of a specific company attracts a lower rating, the
company has an incentive to shop around for the best possible rating, compromising the
authenticity of the rating process itself.

Credit Rating Agency

An institution that allocates the credit ratings of a borrower is known as the credit rating agency.
Mainly, the basis for these types of ratings is the debt repayment capacity of a borrower. Also, it
involves the likelihood of customer defaulting and the timely payment of interest rates.

Significance of Credit Rating Agency

The credit rating agency determines the risk that is associated with the investing companies.
Thus, it helps in making informed investment decisions. Also, the credit rating agency gives a
fair judgment of the ability of an organization to fulfill its commitment.

So, when the ratings are high, it means that the possibility of giving loans is also very high.
Furthermore, credit rating helps the organization in deciding the eligibility of loan for the
borrower.

Also, there are various factors that gave rise to the importance of credit agencies. One of them is
the easy availability of finance that resulted in increasing levels of default.

Credit rating agency plays a very important role in financial markets. The analyze the credit risk
of a government or a corporate. For this, there is various relevant information available regarding
the economic conditions of a borrower. This is called a credit rating.

It represents the likelihood that a borrower is going to meet the financial obligations. There are
various credit rating agencies in India. Below is the information on these agencies.

1.CRISIL – Credit rating and information services of India limited

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CRISIL is a global company that provides the research, rating, risk related advisory services. The
main objective of CRISIL is to rate the quality of bonds, deposits, debentures, etc. These are
assessed when companies use these tools to raise debt capital.

Thus, this rating helps an investor to understand the risk of the debt related to the company. The
main shareholder of CRISIL is Standard and Poors. They are also one of the leading credit
agency in India.

CRISIL – It is the largest credit rating agency in India headquartered at Mumbai and comprises
more than 60% of the market share. It was established in 1987 and the full form is Credit Rating
Information Services of India. CRISIL has become a global analytical company that gives ratings
to companies, researches the markets and provides risk and policy advisory services to its clients.
The world’s biggest credit rating agency i.e. Standard & Poor’s has majority stake in CRISIL.
CRISIL works with the government as well as with the governments of other developing nations
to enhance the rating infrastructure.

CRISIL Limited:
Credit Rating Information Services of India Limited (CRISIL), one of the oldest credit rating
agencies, was set up in 1987. The agency stepped on to infrastructure rating in 2016. CRISIL has
been operational in countries such as USA, UK, Poland, Hong Kong, China, and Argentina in
addition to India.
Credit Rating Information Services of India Limited (CRISIL)

CRISIL is one of the oldest credit rating agencies in India. It was launched in the country in 1987
following which the company went public in 1993. Headquartered in Mumbai, CRISIL ventured
into infrastructure rating in 2016 and completed 30 years in 2017. CRISIL acquired 8.9% stake
in CARE credit rating agency in 2017. It launched India's first index to benchmark performance
of investments of foreign portfolio investors (FPI) in the fixed-income market, in the rupee as
well as dollar version in 2018. The company’s portfolio includes, mutual funds ranking, Unit
Linked Insurance Plans (ULIP) rankings, CRISIL coalition index and so on.

2.Credit Analysis and Research limited (CARE)

Launched in 1993, CARE offers credit rating services to areas such as corporate governance,
debt ratings, financial sector, bank loan ratings, issuer ratings, recovery ratings, and
infrastructure ratings. Headquartered in Mumbai, CARE offers two different categories of bank
loan ratings, long-term and short-term debt instruments. The company also offers ratings for
Initial Public Offerings (IPOs), real estate, renewable energy service companies (RESCO),
financial assessment of shipyards, Energy service companies (ESCO) grades various courses of
educational institutions. CARE Ratings has also ventured into valuation services and offers
valuation of equity, debt instruments, and market linked debentures. Moreover, the company has
launched a new international credit rating agency ‘ARC Ratings’ by teaming up with four

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partners from South Africa Brazil, Portugal, and Malaysia. ARC Ratings has commenced
operations and completed sovereign ratings of countries, including India.

CARE – India’s second largest credit rating agency established in 1993 and headquartered at
Mumbai. Credit Analysis and Research limited (CARE) is 100% wholly owned subsidiary of
Fitch Group. CARE is tasked with the provision of ratings to debt instruments, loan ratings,
corporate governance ratings, credit analysis ratings and claims paying ability of insurance
companies. It also rates construction companies and maritime training institutes. CARE provides
ratings to State Governments, Municipal corporation bodies, banks and other financial
institutions. CARE also rates SMEs based on their financial health.

CARE:

Credit Analysis and Research Limited (CARE) is a credit rating agency that is operational from
April 1993. The agency provides credit rating that helps corporates to raise funds for their
investment requirements. Investors can make decisions based on credit risk and risk-return
expectations. In addition to the head office in Mumbai, the firm has regional offices in New
Delhi, Pune, Kolkata, Chandigarh, Jaipur, Ahmedabad, Bengaluru, Chennai, Coimbatore, and
Hyderabad.

3. ICRA – It is an independent and professional investment information and credit rating agency
established in 1991 and headquartered at Gurugram, Haryana. Investment Information and Credit
Rating Agency of India, ICRA was a joint venture between Moody’s and various Indian
commercial banks and financial services companies. ICRA provides ratings to Indian
Corporates, Hospitals, Construction and Real Estate companies as well as provides grading and
ranking to various mutual funds in India. It also assigns corporate governance ratings to
companies.

ICRA Limited:

The Investment Information and Credit Rating Agency (ICRA), a joint venture of Moody’s and
Indian Financial and Banking Service Organisation was established in 1991. The organisation is
known for assigning corporate governance rating, performance rating, mutual funds ranking, and
more.

ICRA Limited

ICRA Limited is a public limited company that was set up in 1991 in Gurugram. The company
was formerly known as Investment Information and Credit Rating Agency of India Limited.
Before going public in April 2007, ICRA was a joint venture between Moody’s and several
Indian financial and banking service organisations. The ICRA Group currently has four
subsidiaries - Consulting and Analytics, Data Services and KPO, ICRA Lanka and ICRA Nepal.
At present, Moody’s Investors Service, the international Credit Rating Agency, is ICRA’s largest

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shareholder. ICRA’s product portfolio includes rating for - corporate debt, financial rating,
structured finance, infrastructure, insurance, mutual funds, project and public finance, SME,
market linked debentures and so on.

ICRA – Investment information and credit agency

ICRA limited was set up in 1991 by the investment and financial institutions. It is a professional
investment information company that provides credit rating information. Also, the largest
investor in ICRA is Moody’s investors. They are internationally accredited rating agency.

The objective of ICRA is to provide guidance and information to individuals as well as

institutions. Furthermore, it wants to enhance the ability of issuers and borrowers to access the
capital and money market. Also, it assists in promoting transparency to the regulators in financial
markets.

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