CREDIT RATING

CREDIT RISK GRADING

• On completion of EIIF study, a rating grade/ score is assigned to the borrower.
• These grades depict the degree of credit risk associated with the borrower
• Assign weights to each EIIF factor and based on the outcome, a particular grade
may be assigned
• This would provide an essential framework for credit decision-making
• Risk grading / ratings provide an insight into the credit quality of the portfolio and
enable better monitoring of high risk customers
• Risk ratings enable calculating of PDs which in turn is useful in ensuring better
credit pricing and allocation of capital.
What is the reason for this downgrade?

1. Weak implementation of economic reforms since 2017

2. Relatively low economic growth over a sustained period

3. A significant deterioration in the fiscal position of governments (central and

state)

4. And the rising stress in India’s financial sector

 INDIA’S DOWNGRADE

What does negative outlook mean? Lowest investment grade

“The negative outlook reflects dominant, mutually-reinforcing, downside risks from deeper stresses in

the economy and financial system that could lead to a more severe and prolonged erosion in fiscal

strength than Moody’s currently projects

“negative” implies India could be rated down further.

Is the downgrade because of COVID impact?

No
What will be the implication of this downgrade?
• A rating downgrade means that bonds issued by the Indian governments are now
“riskier” than before, because weaker economic growth and worsening fiscal
health undermine a government’s ability to pay back.

• Lower risk is better because it allows governments and companies of that country
to raise debts at a lower rate of interest.
 PARAMETERS ASSESSED FOR SOVEREIGN RATINGS
• Macro-economic factors: inflation rate, economic growth, FDI, external debt, current account
debt and savings, real exchange rate, fiscal balance, foreign debt, public debt
Broadly 5 parameters

• Institutional assessment: how a government's institutions and policymaking affect a sovereign's

credit fundamentals. by delivering sustainable public finances, promoting balanced economic
growth, and responding to economic or political shocks.

• Economic assessment: The country's income levels as measured by its GDP per capita,
indicating broader potential tax and funding bases upon which to draw, which generally support
creditworthiness; growth prospects; and its economic diversity and volatility.

• External Assessment: The status of a sovereign's currency in international transactions; the

country's external liquidity, which provides an indication of the economy's ability to generate the
foreign exchange necessary to meet its public- and private-sector obligations
• Fiscal assessment: sustainability of a sovereign's deficits and its debt burden. This
measure considers fiscal flexibility, long-term fiscal trends and vulnerabilities, debt
structure and funding access, and potential risks arising from contingent liabilities.

• Monetary Assessment: The exchange rate regime, which influences a sovereign's

ability to coordinate monetary policy with fiscal and other economic policies to
support sustainable economic growth; and − The credibility of monetary policy as
measured, among other factors, by inflation trends over an economic cycle and the
effects of market-oriented monetary mechanisms on the real economy, which is
largely a function of the depth and diversification of a country's financial system
and capital markets.
 WHAT IS CREDIT RATING??

Rating is a tool that enables the investor to differentiate between debt

instruments on the basis of their underlying credit quality.

It is specific to a debt instrument and is intended as a grade, and an

analysis of the credit risk associated with the particular instrument.
 EXAMINE THREE FACTORS

 Probability of Default

 The terms and character of the security

 Degree of protection to the investor in the event of liquidation

 CREDIT RATING AGENCIES IN INDIA
CRISIL Limited

India Ratings and Research Pvt. Ltd. (formerly Fitch Ratings India Pvt. Ltd.)

ICRA Limited

Credit Analysis & Research Ltd. (CARE)

Brickwork Ratings India Pvt. Ltd

SMERA Ratings Limited

Infomerics Valuation and Rating Pvt. Ltd.

 FUNCTIONS OF CREDIT RATING AGENCIES

CRAs provide investors with risk-return analysis in choosing between

instruments

Safeguards against bankruptcy

For the issuers, it provides low cost and extensive information

They provide intermediaries with a tool to improve efficiency

They provide greater credence to financial institutions

They raise the possibility of lowering the cost of borrowing

 RATING PROCESS
Request for rating by a borrower/issuer

Documentation and Submission to the Credit Rating Agency

Credit Rating Agency assign analysts , conducts research

Plant visits and Management Meetings

Rating Committee assigns Rating

Appeal,
Rejection, Revision and its communication if any

Dissemination of Rating/Publication

Surveillance/Annual Reviews
 RATING METHODOLOGY

Business Risks Financial Risks

Funding Financial
Industry New policies
characteristics Operational projects flexibility
Efficiency
Leverage, Unutilized
Market credit limits,
position Management shareholder
control, interest group support
Demand quality
rates, currency management
drivers Raw material,
exposure reputation,
environment, scale of
Organization liquid
competition operations,
structure, investments
bargaining technology;
power of location information
suppliers systems
 RATING METHODOLOGY CONTD..

Analysis of past financial performance

Accounting quality

Cash flow analysis

Future cash flow adequacy

Focus on key issues in rating

 CHARACTERESTICS OF RATINGS

 Ratings are based on historical financial information: backward looking

 Based on financial information, they are more subjective to “creative

accounting practices”

 “Conflict of interest” for rating agencies

 Measured on an ordinal scale: not directly usable measures of default

probability (PD)

 Through the cycle methodology

 Ratings do not factor in “market variables”

 Updated periodically: rating rationales

 CONCEPTS IN RATING

Investment grade and speculative grades

Issuer vs Issue Ratings

Synthetic Ratings

Rating Migration Matrix

Rating Upgrades and Downgrades

Quantifying default using Gini coefficient, Lorenz curves

 SEBI NORMS FOR RATING AGENCIES

Disclosures on promoters support

Linkages with subsidiaries

Liquidity position: cash balances, liquidity coverage ratios.

Provide rationale for expectation from parent firm or the government

State the extent and rationale of consolidation in the case of subsidiaries.

Provide liquidity cash balances, adequacy of cash flows

Treat sharp deviations in bond spreads with benchmark yield as material event

Furnish data on sharp rating actions to help investors get the big picture

Publish historical average rating transition rates across various rating categories

Furnish data on sharp rating actions in investment-grade rating category to stock exchange and
depositories for disclosure on the website on a half yearly basis within 15 days from the end of half-
year.
 OTHER RATINGS

• Ratings of Corporate Governance

• Ratings of Mutual Funds

• Ratings of Hospitals

• Issuer Ratings
 TRANSITION MATRICES
• Improvement or deterioration risk/ upgrades or downgrades
• In each cell, the percentages are frequencies of transition between the initial rating
(rows) and the final rating (in columns).
• Next to the last row provides the frequency of defaulting per risk class.
• All transition probabilities, plus the percentage of withdrawn ratings , sum up to one
across rows because each row lists all possible final state.
• Cells across rows sum up to one because they group, together with the default state
all possible migrations.
• All migration probabilities are positive and lower than one.
• The transition between neighboring rating class are more frequent than between
distinct rating class, and their frequencies have higher values along the first diagonal
of the matrix.
 LIMITATIONS OF CREDIT RATINGS

 Issue specific

 Rating is not a performance evaluation of the rated company

 Not a recommendation

 Not an audit

 Confidentiality of rating reports

 Not a forecast of future performance

 ROLE OF RATING AGENCIES
• At the inception of the structuring process, the CRAs took
lower rated mortgage bonds combined with equity, to form
a Mezzanine CDO to enable it to receive a higher rating.
• During the second stage, these intermediate rated (AA or BB-)
Mezzanine CDO or normal CDOs were combined together
again to form AAA rated securities.
• Thus, the products created at every stage carried more risk and
illiquid securities than the previous ones, yet carried a rating of
AAA.
• CRAs used the same credit risk metric for all instruments.
• Using similar rating scale for structured products lead to an
underestimation of systemic risk as structured products have
downgrade dynamics, which are different than those of
corporate or sovereign bonds.
 CREDIT RATING AGENCIES UNDER A CLOUD?
ERRORS OF OMMISSION…
•Such structured products were fundamentally different from
vanilla debt offerings in design, liquidity, interest rate & credit
risks.
•This was particularly harmful as a majority of the final investors
lacked the knowledge to fully comprehend the structure of the
CDOs, much less the risks inherent in them.
•Lack of diligence in the ratings process.
•Weaknesses in the basic mortgage models used by the rating
agencies.
•CRAs may have applied a different rating scale to tranches of
structured products, thereby misleading investors about probability
of default.
• ERRORS OF COMMISSION
• Clear conflict of interest in rating agencies working closely
with the investment banks to design these cutting edge
sophisticated products.
• It would be difficult for the agency to assign a low rating to a
product it had itself designed!
• Rating agencies began to see spectacular profits from the boom
in these structured products.
• Credit default swaps (CDS) are financial instruments used as a
hedge and protection for debt holders, in particular MBS
investors, from the risk of default.
• CDS may either be used to hedge risks or to profit from
speculation.
• Ratings downgrades or their anticipation led to collateral calls,
with devastating effects on market participants.
• Credit derivative product companies typically need an AAA
rating to avoid posting collateral upon marked-to-market
changes in their derivatives positions.
• Thus, the rating downgrades led such companies, as per their
derivatives contract, to post more collateral.
 IMPLICATIONS FOR CREDIT RATING AGENCIES
Fundamental issues to be resolved:

• Who pays for the ratings – the issuer or the investor?

• Rating agencies to be competitive or government-mandated?

• Who regulates the rating agencies?

• Is it the reliability of the ratings on which the investors base their
decisions on whether to invest or not?
•Business models adopted by the CRAs
•Due diligence in the rating process
•Transparency and disclosure
•Who should be paying for the ratings, the issuer or the investor?
•Rating performance being indicator of default
 NEED FOR CREDIT RISK MODELS
• Rating reports are confidential
• Ratings are not quantifiable. Moreover across the same
symbols as AA+, AA and AA- the differentiation is not clearly
visible.
• Basel 2 requires revision of minimum requirement for banks
risk capital.
• Within the new revision, banks are allowed to determine their
capital charges due to the inherent risk of the credit borrower.
• This credit risk or the probability of default has taken the shape
of “internal rating based” Model or IRBs.
• These models are being developed by banks internally to
measure the credit risk and are being mapped to external rating.
• An alternate way to gauge default risk is to rely on models that attempt
to quantify the credit risk using accounting information and stock price
data.
• There has been an upsurge of mathematical models that do not rely on
ratings alone. However, despite a plethora of models available, there
has been little effort, specifically in the Indian scenario to link the
objective measures of credit risk obtained from these models to the
ratings assigned by the rating agencies.
• The requirement is felt with RBI’s stated objective in moving banks
towards IRB models.
ELEMENTS OF THE CREDIT RISK MODEL USED IN THE
STUDY Qualitative Data: AAA
Quantitative Data Management quality AA
A
Liquidity Financial Data and BBB
Profitability Ratios
BB
B
Solvency Rating C
D
Productivity Model

Value of Default
equity Characteristics of forecast
the firm model
Volatility of
stock

PD
%