Credit Rating

Need, Process and Limitations

Snehal Khetan | Rupam Bora | Tilak Sondagar

Gaurav Jagetia | Shubham Patle | Shashank Chavali
What is Credit Rating?
A credit rating is a quantified
assessment of the creditworthiness of
a borrower in general terms or with
respect to a particular debt or financial
obligation. A credit rating can be
assigned to any entity that seeks to
borrow money—an individual,
corporation, state or provincial
authority, or sovereign government.
Credit Ratings and 2008
Financial Crisis
The role of the credit ratings agencies
during the financial crisis remains
highly criticized and mostly
unaccountable. The agencies have been
blamed for exaggerated ratings of risky
mortgage-backed securities, giving
investors false confidence that they
were safe for investing.

During the 2008 financial crisis, a lot of worthless mortgage-related securities

were given AAA ratings: the highest and safest investment grade.
 Objectives
The main objective is to provide superior and low cost information to
investors for taking a decision regarding risk return trade off, but it also
helps to market participants in the following ways:

★ Improves a healthy discipline on borrowers

★ Lends greater credence to financial
representations
★ Encourages greater information disclosure, better
accounting standards and improved financial
information
★ Helps merchant bankers, brokers, regulatory
authorities in discharging their functions related to
debt issues,
★ Acts as a marketing tool
 Types of Ratings
SOVEREIGN SHORT TERM CORPORATE
CREDIT RATING RATING CREDIT
Indicates the risk level of Probability factor of an
the investing individual going into
RATINGS
environment of a country default within a year Financial indicator to
and is used by investors potential investors of
looking to invest abroad. debt securities such as
bonds

Apart from these we have Equity rating, Preference share rating, Commercial paper rating, Bond
rating, Fixed deposit rating, borrowers rating, Individual rating.
 Credit Rating Agencies
Standard &
Poor’s (S&P)
S&P Corporation was
formed in 1941 merging
Standard Statistics and
Poor’s Publishing. S&P
ratings ranges from AAA
to D.
Headquarter: New York
Moody’s Investor
Service
Created in 1914 and
initially provided ratings
for government bonds.
Moody’s ratings system
ranges from Aaa to Caa3.
Headquarter: New York
Fitch ratings
John Knowles Fitch
started Fitch ratings in
1924. Fitch ratings
system ranges from
symbol AAA to D.
Headquarter: NY &
London

These Big Three CRAs account for 95% market share, with S&P and Moody’s sharing 80% of it.
Other CRAs of the world are Dun & Bradstreet, A.M.Best, Baycorp Advantage,etc
Similarly major CRAs of India are: CRISIL, ICRA, CARE and Fitch India
 Grades of
Ratings
INVESTMENT SPECULATIVE
GRADE RATING GRADE RATING
Investment is considered Investment is considered
solid by the rating of lower safety and
agency and the issuer is higher risk and the issuer
likely to honor the terms is likely to default on the
of repayment. investment in future.
Typically ranges from Typically ranges from BB
AAA to BBB (S&P) to D(S&P)

These symbols of ratings are different for different credit rating agencies and are also different
with respect to debentures, fixed deposits, short term instruments, bond funds, bank loans,etc .
A typical Credit Rating
Scale
 Why Credit Ratings are
❖
needed
Better Investment Decision: In view of the growing number of cases of
defaults, lenders are worried about the borrowers. With credit rating, they
get an idea about the creditworthiness of the entity and the risk factor
associated with them.
Safety assurance: High credit ratings means that the issuer is very likely to
pay back the money on time with interest which gives an assurance to the
lender.
Easy Loan Approval: For the borrower, a high credit rating helps in easy
approval of the loan as it is viewed as a low/no risk entity.
Considerate Rate of Interest: Borrowers with good repayment history and
higher credit ratings are offered lower interest on loans as they are viewed
as low/no risk entity.
The Process involved in credit
rating
Step 1: Request from issuer and analysis
Step 2: Rating committee
Step 3: Communication to management and appeal
Step 4: Pronouncement of rating
Step 5: Monitoring of the assigned rating
Step 6: Rating Watch
Step 7: Rating Coverage
Step 8: Rating Scores
 Rating Process
Issuer Rating Agency

Request for a rating

Rating team assigned. Team collates
Signs rating agreement, provides information, conducts preliminary analysis
information and rating fees

Management meetings within the Team conducts site visits and perform analysis
rating team

Analysis presented to rating committee

Accepts the rating or Appeal Rating assigned and communicated to issuer

Rating disseminated and carried in

www.crisil.com

All ratings kept under continuous surveillance

throughout validity
 Credit Rating
Methodology
Consists of 4 areas:

➔ Business Analysis
Covers an analysis of industry risk, market position in
the country, operating efficiency and legal position

➔ Financial Analysis
Analysis of accounting quality, earnings protection,
cash flow adequacy and financial flexibility

➔ Management Evaluation
Study of track record of management’s capacity to
overcome adverse situations, goals, philosophies and
strategies.

➔ Fundamental Analysis
Analysis of liquidity management, asset quality,
profitability and interest and tax sensitivity
 Business Risk Analysis
It begins with an assessment of
company’s environment focussing on
the strength of industry prospects,
business cycle as well as competitive
Tip factors affecting the industry.
Tell the audience
about the problem If the company is involved in more
through a story, than one business , each segment is
ideally a person.
analyzed separately.
Financial Risk Analysis
Is analyzed mainly through financial
ratios. Emphasis is placed on the
ability of the company to
maintain/improve its future financial
performances.
 Management Risk
The analyst compares company’s
business strategies and financial plans
Tip to provide insights into a
Show how your management’s ability to forecast and
solution helps the implement plans.
person in
the story reach his or
her goals.
Fundamental Analysis
Includes an analysis of liquidity
management, profitability and
financial position, interests and tax
sensitivity of the company.

Fundamental analysis is undertaken

for rating debt instruments of financial
institutions, banks and NBFC’s.
Factors involved in credit
rating
❖ Overall fundamental and earning capacity of the company and the volatility
of the same.
Overall macroeconomic and business environment
Liquidity position of the company (as distinguished from the profits)
Requirements of funds to meet irrevocable commitments.
Financial flexibility of the company to raise funds from outside sources to
meet temporary financial needs
Guarantee/support from financially strong external bodies
Level of existing leverage(borrowings) and financial risk
 Benefits of Credit Rating
BENEFITS TO INVESTOR
➔ Safeguard against Bankruptcy: Credit rating gives assurance to the
investors against any bankruptcy and provide safety of their investment.
➔ Recognition of Risk: The various symbols help the investors to carry the
information in easily recognizable manner.
➔ Credibility of Issuer: Rating symbols also give an idea about the credibility
of the issuer.
➔ Rating Facilities Quick Investment Decisions: This includes that the
investors can take up quick decisions about the investments to be made in
various instruments.
➔ No need to depend on Investment Advisors or Professionals: This
includes no dependence on investment advisors as the rating symbol
suggest the credit worthiness of the instruments.
➔ Choice of Investment: This includes making choice from various
instruments depending upon the risk profile and the diversification plan.
➔ Benefits of Rating Surveillance: This includes benefit of credit rating
agencies of on going rating surveillance of different companies.
Benefits of Credit Rating to Issuer Company.
Lowers Cost of Borrowing: Companies that have high credit rating for their debt instruments will get funds
at lower costs from the market. High rating will enable the company, to offer low interest rates on fixed
deposits, debentures and other debt securities.
Wider Audience for Borrowing: A company with high rating for its instruments can get a wider audience
for borrowing. It can approach financial institutions, banks, investing companies.
Self Discipline by Companies: Credit rating is beneficial to the non-popular companies, such as closely-
held companies. If the credit rating is good, the public will invest in these companies, even if they do not
know these companies.
Rating as a Marketing Tool: Credit rating not only helps to develop a good image of the company among
the investors, but also among the customers, dealers, suppliers, etc. High credit rating can act as a marketing
tool to develop confidence in the minds of customers, dealer, suppliers, etc.

Motivation for Growth: Credit rating enables a company to grow and expand. This is because better credit
rating will enable a company to get finance easily for growth and expansion.
Benefits to financial Intermediaries
The rated instruments speak themselves about the financial soundness and
strength of a company. Because of this the financial intermediaries and the
brokers are able to save their time, cost and energy in convincing the client to
invest in that company.

Other Benefits
Identification of Strength and Weakness of the Issuer Company
Liquidity and Marketability of Debt Securities
Positive Impact on Capital Market
 Case of IL&FS
➔ IL&FS Group is a vast conglomerate with a complex corporate structure that funds
infrastructure projects across the world’s fastest-growing major economy. The
financier, set up in 1987, and its listed subsidiaries have powered India’s
infrastructure boom - including the Chenani-Nashri road tunnel, India’s longest - and
raised billions of dollars from the country’s corporate debt market.
IL&FS is a huge borrower, accounting for 2% of outstanding commercial paper, 1% of
debentures and as much as 0.7% of banking system loans. The group itself in turn
acts as a key source of capital to non-bank lenders.
Until July 2018, India’s credit rating companies had investment grade ratings on
billions of dollars of corporate debt raised by the IL&FS Group and its subsidiaries.
The first signs of trouble came in June, when the special purpose vehicles tied to
IL&FS Transportation Networks Ltd., a group subsidiary, defaulted on its debt
obligations. More defaults in other parts of the empire followed in August and
September.
In August 2018, major credit rating companies such as ICRA, a unit of Moody’s, Fitch-
owned India Ratings & Research and CARE began to cut their rating for the group’s
parent company, Infrastructure Leasing & Financial Services
➔ The “issuer-pays" model affords the rating companies access to the borrower’s
management and helps to factor in regular inputs about the issuer, according to
S&P’s India unit, which said it collects fees upfront and hasn’t assessed IL&FS. Other
models such as “investor-pays" and “regulator or government pays" haven’t been
tested, it said in a emailed statement.
IL&FS group’s investment grade rating was based on the strength of the investors in
the parent company, according to an official at a rating company. The lender’s
investors include Life Insurance Corp., India’s largest life insurer; State Bank of India,
its largest bank; and Housing Development Finance Corp, its largest mortgage lender.
Japan’s Orix Corp. is the company’s second-largest shareholder
For IL&FS, rating company ICRA, flagged the group’s “elevated leverage" in March but
kept its investment grade rating because of “experienced senior management team
and its significant track record of operations in the infrastructure domain.
Limitations
➔ Biased rating and
misrepresentations
➔ Concealment of material
information
➔ Rating is no guarantee for
soundness of company
➔ Human bias
➔ Reflection of temporary adverse
conditions
➔ Difference in rating of two
agencies
Possible
solutions
➔ The regulators should seriously consider
mandatory rotation of the rating agency
of an issuer just like the rotation of
auditors
➔ This will allay the concern that a very
long association between issuer and
rating agency may allow scope for
complacency
➔ We should look at alternative models like
investors or regulator paying to rate
issuances of a company
➔ Another model proposed to prevent
‘rating shopping’ is that regulators create
a centralised clearing platform for rating
agencies. While issuers still pay the
rating fee, the centralised clearing
platform would assign a rating firm for an
issue using its discretion.