CREDIT RATING

Prof Madhu Vij

FMS
• What is credit rating?
• How does a credit rating agency differ from a credit
bureau?
• Is a credit rating a recommendation to invest in a debt
instrument?
• How does a credit rating differ from an audit?
• Does a credit rating assure repayment?
• Who pays for a credit rating?
• Who regulates a rating agency?
• Is competition desirable in the credit rating industry?
• How do investors benefit from a credit rating?
• What is the validity period of a rating? How are rating
changes communicated?
• Does the minus sign in a rating symbol have negative
connotations
• SEC Examinations Find Shortcomings in
Credit Rating Agencies' Practices and
Disclosure to Investors, July 8, 2008
• The SEC staff's examinations found that rating
agencies struggled significantly with the increase
in the number and complexity of subprime
residential mortgage-backed securities (RMBS)
and collateralized debt obligations (CDO) deals
since 2002. The examinations uncovered that
none of the rating agencies examined had
specific written comprehensive procedures for
rating RMBS and CDOs. Furthermore, significant
aspects of the rating process were not always
disclosed or even documented by the firms, and
conflicts of interest were not always managed
appropriately.
 Major CRA
• CRISIL, Credit Rating Information services of India LTD. From a pioneering
step taken in 1987, to playing an integral role in India's development
milestones, CRISIL has emerged as India's leading Ratings, Research, Risk
and Policy Advisory company.

• CARE Credit Analysis & Research Ltd. (CARE), incorporated in April 1993,
is a credit rating, information and advisory services company promoted by
Industrial Development Bank of India (IDBI), Canara Bank, Unit Trust of
India (UTI) and other leading banks and financial services companies. In all
CARE has 14 shareholders

• ICRA , Investment Credit Rating Agency of India Ltd (an Associate of

Moody's Investors Service) was incorporated in 1991 as an independent
and professional company. ICRA is a leading provider of investment
information and credit rating services in India. ICRA’s major shareholders
include Moody's Investors Service and leading Indian financial institutions
and banks.
• CRISIL’s association with
Standard & Poor’s, a division of The
McGraw-Hill Companies, dates back to
1996 when both companies started working
together on rating methodologies and joint
projects. S&P is the world's foremost
provider of independent credit ratings,
indices, risk evaluation, investment
research, data and valuations. This
partnership has now culminated in
Standard & Poor’s acquiring a majority
shareholding in CRISIL.
• CARE has been granted registration by SEBI
under the Securities & Exchange Board of India
(Credit Rating Agencies) Regulations,1999.
• The rating coverage has extended beyond
industrial companies, to include public utilities,
financial institutions, infrastructure projects,
special purpose vehicles, state governments
and municipal bodies. CARE's clients include
some of the largest private sector manufacturing
and financial services companies as well
financial institutions of India. CARE is well
equipped to rate all types of debt
 Importance
• Provide information and guidance to institutional
and individual investors/creditors.
•   Enhance the ability of borrowers/issuers to
access the money market and the capital market
for tapping a larger volume of resources from a
wider range of the investing public.
• Assist the regulators in promoting transparency
in the financial markets.
• Provide intermediaries with a tool to improve
efficiency in the funds raising process.
 Issues
• CRA are not auditors

• Credit rating changes with time

• Judgment in India is a mix of quantitative and qualitative

factors

• Is it necessary to regulate CRA

• Solicited or Unsolicited ratings

• Regulating the Raters

 Factors contributing to success of
rating system
• Credibility arises from objectivity of
resource allocation
• Rating agencies are not and should not
assume the role of regulators
• Continued growth and evolution of the
credit rating business would depend on
the size and the growth of the debt market.
Are Indian Credit Ratings Credible
• CR involves subjective judgment with
objective analysis
• Rating shopping is a cause of concern
• Lack of transparency on the part of CRA
• In most country’s CRA are not regulated
• Credibility arises from objectivity of
resource allocation
 Difference in Rating
• Fuzziness of data
• Readiness/ Reluctance of the company in
disclosing information
• Proper control systems are not in place
• Credibility of the agencies carrying out the
rating
• Industry is still young
• Fuzziness of data
 The silence of the agencies
• In this unprecedented world credit crisis we have heard
very little from Moody’s and Standard & Poor’s yet both
share blame for the current market opacity.
• In the past weeks we have seen the largest transfer of
private risk to public risk in financial history. Yet the
agencies have said nothing. Fannie Mae, Freddie Mac,
AIG and Lehman bonds alone account for $1,800bn
nominal of agency-rated corporate debt.
• Sadly in the current crisis there is no first-mover
advantage for the agencies to call attention to the fact
they were operators in the current credit meltdown.
• But they cannot remain silent forever. To
avoid the heavy burden of a regulatory fate,
the rating agencies must take action soon.
• The world of independent credit opinion
needs more competitors for their own
survival outside the regulatory impulses of
the government.
• S&P and Moody’s and Fitch should issue
an advisory opinion discouraging risk
managers from depending solely on their
opinions and ratings as the foundations for
risk model inputs.
 ALTMAN’S MODEL

• Z = 1.2 X1 + 1.4 X2 + 3.3 X3 +0.6 X4 + 1.0 X5

• Where
• X1 = W.K. / TA
• X2 = RE / TA
• X3 = EBIT / TA
• X4 = MV of equity / BV of debt
• X5 = Sales / TA
• Z is less than 1.81
• Z is greater than 2.99
• Z score and CRA
•
• Total Correc marginally
• misclassif Classif misclassif
• Crisil 8.5% 44.5% 44.3%

• Icra 14.2% 45.7% 40%

• Care 7.1% 30.2% 57%

• Conclusions
• Still Young
• Foreign CRA entering India, quality will
improve
• No credit rating association
• Attempt to develop core competencies
 Discussion Questions

• Do rating agencies conduct a primary

audit?

• Is it mandatory for the rating agencies to

follow international norms?

• Can the rating agencies demand

information as a matter of right?
• Is an appraisal in continuum required?