Q.

Credit ratings help potential investors and the borrowers in evaluating the strengths and
weaknesses of each other and help them react quickly to the changing financial institution.
On this background, discuss the role of international credit rating agencies.

INTERNATIONAL CREDIT RATING AGENCIES

INTRODUCTION
Credit rating agencies specialize in analyzing and evaluating the creditworthiness of
corporate and sovereign issuers of debt securities. In the financial architecture, credit rating
agencies are important in the management of both corporate and sovereign credit risk. Their
role has received a boost from the revision by the Basel Committee on Banking Supervision
of capital standards for banks culminating in Basel II. The logic underlying the existence of
credit rating agencies is to solve the problem of the informative asymmetry between lenders
and borrowers regarding the creditworthiness of the latter. Both investors and borrowers are
benefited by the information given by the agencies, enabling both to take an informed
decision.
WHAT IS RATING
Credit rating is a numerical representation of the creditworthiness of an individual or a
business. It is an individual assessment of the credit worthiness of any security by a credit
rating agency. The credit rating is a key aspect that makes or break a loan application. Credit
rating agencies when doing the rating of corporations measures the probability of the timely
repayment of principal and interest of a debt, the credit risk.
Ratings provide the information about the credit quality of corporates, foreign corporations
and governments. The rating done by the credit rating agencies is independent and
unconnected with the issuer’s business and done objectively, thereby lending credence to its
judgment. Moreover, ratings determine the eligibility of debt and other financial instruments
for the portfolios of certain institutional investors due to national regulations that restrict
investment in speculative-grade bonds.
WHY CREDIT RATINGS ARE USEFUL
Credit ratings may play a useful role in enabling corporations and governments to raise
money in the capital markets. Instead of taking a loan from a bank, these entities sometimes
borrow money directly from investors by issuing bonds or notes. Investors purchase these
debt securities, such as municipal bonds, expecting to receive interest plus the return of their
principal, either when the bond matures or as periodic payments.
Credit ratings may facilitate the process of issuing and purchasing bonds and other debt
issues by providing an efficient, widely recognized, and long-standing measure of relative
credit risk. Credit ratings are assigned to issuers and debt securities as well as bank loans.
Investors and other market participants may use the ratings as a screening device to match the
relative credit risk of an issuer or individual debt issue with their own risk tolerance or credit
risk guidelines in making investment and business decisions.
For instance, in considering the purchase of a municipal bond, an investor may check to see
whether the bond’s credit rating is in keeping with the level of credit risk he or she is willing
to assume. At the same time, credit ratings may be used by corporations to help them raise
money for expansion and/or research and development, as well as help states, cities, and
other municipalities to fund public projects.
RELATIONSHIP OF THE CREDIT RATING AGENCIES
Credit rating agencies does not create any fiduciary relationship between the credit rating
agency and the user. They perform the isolated function of credit risk evaluation, thus playing
a limited and specific role in evaluation and thereby helping investors taking an informed
decision.
It helps the investors analyze the risks with fixed income securities and other obligations such
as insurance polices and derivative transactions, by providing credible and independent
assessments of credit risk. Further, a rating agency, along with investors, financial publishers,
portfolio managers, etc. use the materials prepared by accountants, auditors who attest the
accuracy and completeness of the process of sale and purchase of an issue. Regulatory
authorities, banks, financial institutions take into account the credit ratings while undertaking
investments in overseas money markets or debt instruments issued by foreign states.
International Rating Agencies
 Standard & Poor’s: this credit rating agency was established in 1860 and it provides
financial consulting, numerous analytical materials on securities, companies, banks.
 Moody’s investor service: established in 1900, it provides credit ratings, research and
risk analysis.
 Fitch Rating Agency: Founded in 1913 and merged with IBCA ltd. in 1997. It
provides ratings to corporates, municipal bonds, preferred stocks and also to non
commercial organizations.
FACTORS UNDERTAKEN FOR RATINGS
 Credit rating agencies formulate and disseminate ratings opinions that are used by investors
and other market participants who may consider credit risk in making their investment and
business decisions. To do so, they consider following factors while giving ratings:
 Likelihood of payment capacity and willingness of obligor to meet its financial commitments
on an obligation in accordance with the terms of the obligation.
 Nature and provision of the obligation.
 Protection given to the obligation in the event of bankruptcy, reorganization and other
arrangement under the laws of bankruptcy affecting the creditors rights.
 Management Philosophy: an appraisal of the management’s performance not only just on
the company’s earnings and financial position but also on its ability to achieve the planned
objectives and to maintain sound financial strategies. Company’s adopted policy to reduce
various risk exposure is also discussed.
 Degree of importance of the issuer in his own country: if support from the regulatory
authorities such as acting as a lender of the last resort is expected to be forthcoming, then
higher rating may be given.
 Issuer’s industry: whether a particular industry segment is stable, future possibilities for
growth, labor relations, size of the work force, strength of the trade union representatives,
will be the other factors.
 The issuer’s operating efficiency & Marketing position: profitability parameter is critical.
Comparison with competitors on profit margins, cost of production, management strategies.
 The accounting policies: the basic area of difference are foreign exchange and currency
deposits and goodwill and fixed assets and these statistics and ratios are compared with the
competitors.
Rating methodologies adopted by Credit Rating Agencies
1. Model driven ratings- some credit rating agencies focus on quantitative data, which
they incorporate into a mathematical model. For ex, an agency using this approach to
assess the credit worthiness of a bank or other financial institution might evaluate that
entity’s asset quality, funding and profitability based primarily on data from the
institution’s public financial statement and regulatory filings.
At country level, while assessing sovereign risk, credit rating agencies check risk parameters
of varying importance such as economic and political flexibility, fiscal and monetary
flexibility, and the debt burden. Economic risk addresses the ability to repay its obligations
 on time and is a function of both quantitative and qualitative factors. Political risk addresses
the sovereign’s willingness to repay debt.
Willingness to pay is a qualitative issue that distinguishes sovereigns from most other types
of issuers. Partly because creditors have only limited legal redress, a government can (and
sometimes does) default selectively on its obligations, even when it possesses the financial
capacity for debt service. In practice, political risk and economic risk are related. A
government that is unwilling to repay debt is usually pursuing economic policies that weaken
its ability to do so. Willingness to pay, therefore, encompasses the range of economic and
political factors influencing government policy.

2. Analyst driven ratings- in rating a corporation or municipality, agencies, using the

analyst driven approach generally assign an analyst, often in conjunction with a team
of specialists, to take the lead in evaluating the entity’s creditworthiness. Typically,
analysts obtain information from published reports, as well as from interviews and
discussions with the issuer’s management. They use that information and apply their
analytical judgment to assess the entity’s financial condition, operating performance,
polices, and risk management strategies.
ADVANTAGES OF CREDIT RATING AGENCIES
 at the consumer level, the agency’s ratings are used by banks to determine the risk premium
to be charged on loans and bonds. A good credit rating allows borrowers to easily borrow
money from the public debt market or financial institutions at a lower interest rate.
 Credit rating agencies helps the investors to decide on whether to buy or not to buy a
company’s securities.
 Although investors can also rely on the ratings given by financial intermediaries and
underwriters, ratings provided by international agencies are considered more reliable and
accurate since they can access lots of information that is not publicly available.
 At the country level, investors rely on the ratings given by the credit rating agencies to make
investment decisions. Many countries sell their securities in the international market and a
good credit rating can help them access high-value investors.
 Credit ratings also help in the development of financial markets. Rating agencies provide risk
measures for various entities, and this allows investors to understand the credit risk of various
borrowers.
DISADVANTAGES OF CREDIT RATING AGENCIES
 Possibility of Bias exist: The information collected by the rating agency may be subject to
personal bias of the rating team. However, rating agencies try their best to provide an
unbiased opinion of the credit quality of the company and/or instrument.
 Improper disclosure may happen: The company being rated may not disclose certain material
facts to the investigating team of the rating agency. This can affect the quality of credit rating.
 Difference in rating: There are cases, where different ratings are provided by various rating
agencies for the same instrument. These differences may be due to many reasons. This will
create confusion in the mind of the investor.
 Static study: Rating is done on the present and the past historical data of the company and
this is only a static study. Prediction of the company health through rating is momentary and
anything can happen after assignment of rating symbols to the company dependence for the
future result on the rating, therefore defeat the vary purpose of the risk indicative of the
rating.
 Credit ratings change: the reasons for rating adjustments vary, and may be broadly related to
overall shifts in the economy or business environment. Change in the business climate can
affect the credit risk of a wide array of issuers and securities.
Therefore, it is advisable that rating should be used only as guidelines but one should use its
own judgment to decide whether or not to invest in the company.
CONCLUSION
Credit rating agencies play a key role in financial markets by helping to reduce the
informative asymmetry between lenders and investors, and issuers about the creditworthiness
of companies (corporate risk) or countries (sovereign risk). It analyzes the public and non-
public financial and accounting data as well as information about economic and political
factors that may affect the ability and willingness of a government or firms to meet their
obligations in a timely manner. However, credit rating agencies lack transparency and do not
provide clear information about their methodologies. Moreover, the action of countries which
strive to maintain their rating grades through tight macroeconomic policies may be
counterproductive for long-term investment and growth.
Therefore, to ensure that rating does not affect the financial viability of the business and the
country and that credit rating agencies do not give wrong ratings, IOSCO, an international
body that regulates the world’s securities, has taken an initiative by publishing the IOSCO
Code of conduct. This code aims at developing governance rules for credit rating agencies to
ensure the quality and integrity of the rating process, the independence of the process and the
avoidance of conflict of interest and greater transparency. Regulatory action at the national
level may also be necessary to ensure that the agencies operate in accord with levels of
accountability and transparency matching the recommendations of the IOSCO Code.