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CHAPTER – 4

CREDIT RATING – AN OVERVIEW

4.1 INTRODUCTION

In a market economy, financial markets play the role of an efficient intermediary.

They act as a link between savers and investors, mobilizing capital on the one hand, and

efficiently allocating them between competing users on the other. Such an efficient capital

allocation calls for the use of reliable market information. An investor in search of profitable

investment avenues has recourse to various sources of information, such as offer documents

of the issuer(s), research reports of market intermediaries, media reports etc. In addition, he

can also base the investment decisions on the grading offered by credit rating agencies.

Rating, usually expressed in alphabetical or alphanumeric symbols, is a simple and easily

understood tool enabling the investor to differentiate between debt instruments on the basis of

their underlying credit quality.

Credit rating establishes a link between risk and return. Thus, provide a yard

stick against which to measure the risk inherent in an instrument. An investor uses the rating

to assess the risk level and compares the offered rate of return with his expected rate of return

(for the particular level of risk) to optimise his risk-return trade off. And also Credit Rating is

concerned with pre-estimating the repayment capacity and ability of borrower for a particular

debt planned to be raised1.

4.2 MEANING AND DEFINITION OF CREDIT RATING

Credit rating is the opinion of the rating agency on the relative ability and willingness

of tile issuer of a debt instrument to meet the debt service obligations as and when they arise.

Rating is usually expressed in alphabetical or alphanumeric symbols. Symbols are simple and

1
Samuel Joseph C (2002), “Credit Rating in Tamilnadu”, JIMS 8M, July-September, PP.41-45.
 96

easily understood tool which help the investor to differentiate between debt instruments on

the basis of their underlying credit quality. Rating companies also publish explanations for

their symbols used as well as the rationale for the ratings assigned by them, to facilitate

deeper understanding. In other words, the rating is an opinion on the future ability and legal

obligation of the issuer to make timely payments of principal and interest on a specific fixed

income security. The rating measures the probability that the issuer will default on the

security over its life, which depending on the instrument may be a matter of days to thirty

years or more.

In fact, the credit rating is a symbolic indicator of the current opinion of the relative

capability of the issuer to service its debt obligation in a timely fashion, with specific

reference to the instrument being rated. It can also be defined as an expression, through use of

symbols, of the opinion about credit quality of the issuer of security/instrument.

4.3 ORIGIN OF CREDIT RATING AGENCY

The first mercantile credit agency was set up in New York in 1841 to rate the ability

of merchants to pay their financial obligations. Later on, it was taken over by Robert Dun.

This agency published its first rating guide in 1859. The second agency was established by

John Bradstreet in 1849 which was later merged with first agency to form Dun & Bradstreet

in 1933, which became the owner of Moody’s Investor’s Service in 1962. The history of

Moody’s can be traced back about 100 years ago. In 1900, John Moody laid stone of

Moody’s Investors Service and published his ‘Manual of Railroad Securities2’.

Early 1920’s saw the expansion of credit rating industry when the Poor’s Publishing

Company published its first rating guide in 1916. Subsequently Fitch Publishing Company

and Standard Statistics Company were set up in 1924 and 1922 respectively. Poor and

2 Federico Parmeggiani (2013), Rating Triggers, Market Risk and the Need for More Regulation” Centro Studi

di Banca e Finanza (CEFIN) (Center for Studies in Banking and Finance) from Universita di Modena e Reggio
Emilia, Facoltà di Economia "Marco Biagi"
 97

Standard merged together in 1941 to form Standard and Poor’s which was subsequently taken

over by McGraw Hill in 1966. Between 1924 and 1970, no major new rating agencies were

set up. But since 1970’s, a number of credit rating agencies have been set up all over the

world including countries like Malaysia, Thailand, Korea, Australia, Pakistan and Philippines

etc. In India, CRISIL (Credit Rating and Information Services of India Ltd.) was setup in

1987 as the first rating agency followed by ICRA Ltd. (formerly known as Investment

Information & Credit Rating Agency of India Ltd.) in 1991, and Credit Analysis and

Research Ltd. (CARE) in 1994. All the three agencies have been promoted by the All-India

Financial Institutions. The rating agencies have established their creditability through their

independence, professionalism, continuous research, consistent efforts and confidentiality of

information. Duff and Phelps has tied up with two Indian NBFCs to set up Duff and Phelps

Credit Rating India (P) Ltd. in 1996.

4.4 CREDIT RATINGS AND STRUCTURED FINANCE

Credit rating agencies may also play a key role in structured financial transactions.

Unlike a "typical" loan or bond issuance, where a borrower offers to pay a certain return on a

loan, structured financial transactions may be viewed as either a series of loans with different

characteristics, or else a number of small loans of a similar type packaged together into a

series of "buckets" with the "buckets" or different loans called "tranches". Credit ratings often

determine the interest rate or price ascribed to a particular tranche, based on the quality of

loans or quality of assets contained within that grouping.

Companies involved in structured financing arrangements often consult with credit

rating agencies to help them determine how to structure the individual tranches so that each

receives a desired credit rating. For example, a firm may wish to borrow a large sum of

money by issuing debt securities. However, the amount is so large that the return investors

may demand on a single issuance would be prohibitive. Instead, it decides to issue three
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separate bonds, with three separate credit ratings—A (medium low risk), BBB (medium risk),

and BB (speculative) (using Standard & Poor's rating system).

The firm expects that the effective interest rate it pays on the A-rated bonds will be

much less than the rate it must pay on the BB-rated bonds, but that, overall, the amount it

must pay for the total capital it raises will be less than it would pay if the entire amount were

raised from a single bond offering. As this transaction is devised, the firm may consult with a

credit rating agency to see how it must structure each tranche—in other words, what types of

assets must be used to secure the debt in each tranche—in order for that tranche to receive the

desired rating when it is issued3.

Structured transactions that involve the bundling of hundreds or thousands of similar

(and similarly rated) securities tend to concentrate similar risk in such a way that even a slight

change on a chance of default can have an enormous effect on the price of the bundled

security. This means that even though a rating agency could be correct in its opinion that the

chance of default of a structured product is very low, even a slight change in the market's

perception of the risk of that product can have a disproportionate effect on the product's

market price, with the result that an ostensibly AAA-rated security can collapse in price even

without there being any default or significant chance of default. This possibility raises

significant regulatory issues because the use of ratings in securities and banking regulation

assumes that high ratings correspond with low volatility and high liquidity.

The rating agencies respond that their advice constitutes only a "point in time"

analysis, that they make clear that they never promise or guarantee a certain rating to a

tranche, and that they also make clear that any change in circumstance regarding the risk

factors of a particular tranche will invalidate their analysis and result in a different credit

3
Marek Hanusch and Paul M. Vaaler (2013) “Credit rating agencies in emerging democracies: Guardians of
fiscal discipline ?” No 6379, Policy Research Working Paper Series from The World Bank
 99

rating. In addition, some CRAs do not rate bond issuances upon which they have offered such

advice.

Rating agencies state that rather than being an opinion on the volatility of a security

and the wisdom of investing in that it, their ratings are opinions and thus protected free

speech — granted to them by the "personhood" of corporations. This arguement has been

effective in American courts, and since the crisis, "41 legal actions targeting S&P have been

dropped or dismissed".

4.5 NEED FOR CREDIT RATING

Credit ratings establish a link between risk and return. They thus provide a yardstick

against which to measure the risk inherent in any instrument. An investor uses the ratings to

assess the risk level and compares the offered rate of return with his expected rate of return

for the particular level of risk to optimise his risk-return trade-off. The risk perception of a

common investor, in the absence of a credit rating system, largely depends on his familiarity

with the names of the promoters or the collaborators. It is not feasible for the corporate issuer

of a debt instrument to offer every prospective investor the opportunity to undertake a

detailed risk evaluation. It is very uncommon for different classes of investors to arrive at

some uniform conclusion as to the relative quality of the instrument. Moreover they do not

possess the requisite skills of credit evaluation.

Thus, the need for credit rating in today’s world cannot be overemphasized. It is of

great assistance to the investors in making investment decisions. It also helps the issuers of

the debt instruments to price their issues correctly and to reach out to new investors.

Regulators like Reserve Bank of India (RBI) and Securities and Exchange Board of India

(SEBI) use credit rating to determine eligibility criteria for some instruments. For example,

the RBI has stipulated a minimum credit rating by an approved agency for issue of

commercial paper. In general, credit rating is expected to improve quality consciousness in

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the market and establish over a period of time, a more meaningful relationship between the

quality of debt and the yield from it.

Credit Rating is also a valuable input in establishing business relationships of various

types. However, credit rating by a rating agency is not a recommendation to purchase or sale

of a security. Investors usually follow security ratings while making investments. Ratings are

considered to be an objective evaluation of the probability that a borrower will default on a

given security issue, by the investors. Whenever a security issuer makes late payment, a

default occurs. In case of bonds, non-payment of either principal or interest or both may

cause liquidation of a company. In most of the cases, holders of bonds issued by a bankrupt

company receive only a portion of the amount invested by them)4.

Thus, credit rating is a professional opinion given after studying all available

information at a particular point of time. Such opinions may prove wrong in the context of

subsequent events. Further, there is no private contract between an investor and a rating

agency and the investor is free to accept or reject the opinion of the agency. Thus, a rating

agency cannot be held responsible for any losses suffered by the investor taking investment

decision on the basis of its rating. Thus, credit rating is an investor service and a rating

agency is expected to maintain the highest possible level of analytical competence and

integrity. In the long run, the credibility of rating agency has to be built, brick by brick, on the

quality of its services provided, continuous research undertaken and consistent efforts made.

The increasing levels of default resulting from easy availability of finance, has led to the

growing importance of the credit rating. The other factors are: the growth of information

technology, globalisation of financial markets, increasing role of capital and money markets,

4
Ragunathan V and Somdeb Lahiri (2013), “Crisil Rating: When Does AAA Mean B?” No WP1991-09-
01_01041, IIMA Working Papers from Indian Institute of Management Ahmedabad, Research and Publication
Department
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lack of government safety measures, the trend towards privatization, and securitisation of

debt.

4.6 INDICATIONS OF THE ASSIGNED RATINGS

Rating symbols assigned to a security issue is an indicator of the following: The

nature and terms of the particular security being issued, the ability and the willingness of the

issuer of a security to make payments in time, the probability that the issuer will make a

default in payments; and the degree of protection available to the investors if the security

issuer company is liquidated, re-organised or declared bankrupt.

4.7 FACTORS AFFECTING ASSIGNED RATINGS

The following factors generally influence the ratings to be assigned by a credit rating

agency: The security issuer’s ability to service its debt. In order, they calculate the past and

likely future cash flows and compare with fixed interest obligations of the issuer, the volume

and composition of outstanding debt, the stability of the future cash flows and earning

capacity of company. The interest coverage ratio i.e. how many number of times the issuer is

able to meet its fixed interest obligations, ratio of current assets to current liabilities i.e.

current ratio (CR)) is calculated to assess the liquidity position of the issuing firm, the value

of assets pledged as collateral security and the security’s priority of claim against the issuing

firm’s assets, market position of the company products is judged by the demand for the

products, competitors market share, distribution channels etc, operational efficiency is judged

by capacity utilisation, prospects of expansion, modernisation and diversification,

availability of raw material etc, track record of promoters, directors and expertise of staff also

affect the rating of a company.

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4.8 NATURE OF CREDIT RATING5

1. Rating is based on information

Any rating based entirely on published information has serious limitations and the success

of a rating agency will depend, to a great extent, on its ability to access privileged

information. Cooperation from the issuers as well as their willingness to share even

confidential information are important pre-requisites. The rating agency must keep

information of confidential nature possessed during the rating process, a secret.

2. Many factors affect rating

Rating does not come out of a predetermined mathematical formula. Final rating is given

taking into account the quality of management, corporate strategy, economic outlook and

international environment. To ensure consistency and reliability a number of qualified

professionals are involved in the rating process. The Rating Committee, which assigns the

final rating, consists of specialised financial and credit analysts. Rating agencies also ensure

that the rating process is free from any possible clash of interest.

3. Rating by more than one agency

In the well developed capital markets, debt issues are, more often than not, rated by more

than one agency. And it is only natural that ratings given by two or more agencies differ from

each other for example a debt issue, may be rated ‘AA+’ by one agency and ‘AA’ or ‘AA-’

by another. It will indeed be unusual if one agency assigns a rating of AA while another gives

a ‘BBB’.

4. Monitoring the already rated issues

A rating is an opinion given on the basis of information available at particular point of

time. Many factors may affect the debt servicing capabilities of the issuer. It is, therefore,

5
Stephane Rousseau (2012), “A Question of Credibility: Enhancing the Accountability and Effectiveness of
Credit Rating Agencies” Stéphane Rousseau: Université de Montréal C.D. Howe Institute Commentary, issue
356
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essential that rating agencies monitor all outstanding debt issues rated by them as part of their

investor service. The rating agencies should put issues under close credit watch and upgrade

or downgrade the ratings as per the circumstances after intensive interaction with the issuers.

5. Publication of ratings

In India, ratings are undertaken only at the request of the issuers and only those ratings

which are accepted by the issuers are published. Thus, once a rating is accepted it is

published and subsequent changes emerging out of the monitoring by the agency will be

published even if such changes are not found acceptable by the issuers.

6. Right of appeal against assigned rating

Where an issuer is not satisfied with the rating assigned, he may request for a review,

furnishing additional information, if any, considered relevant. The rating agency will

undertake a review and thereafter give its final decision. Unless the rating agency had over

looked critical information at the first stage chances of the rating being changed on appeal are

rare.

7. Rating of rating agencies

Informed public opinion will be the touchstone on which the rating companies have to be

assessed and the success of a rating agency is measured by the quality of the services offered,

consistency and integrity.

8. Rating is for instrument and not for the issuer company

The important thing to note is that rating is done always for a particular issue and not for

a company or the Issuer. It is quite possible that two instruments issued by the same company

carry different ratings, particularly if maturities are substantially different or one of the

instruments is backed by additional credit reinforcements like guarantees. In many cases,

short-term obligations, like commercial paper (CP) carry the highest rating even as the risk

profile changes for longer maturities.

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9. Rating not applicable to equity shares

By definition, credit rating is an opinion on the issuers capacity to service debt. In the

case of equity there is no pre-determined servicing obligation, as equity is in the nature of

venture capital. So, credit rating does not apply to equity shares.

10. Credit vs. financial analysis

Credit rating is much broader concept than financial analysis. One important factor which

needs consideration is that the rating is normally done at the request of and with the active

co-operation Of the issuer. The rating agency has access to unpublished information and the

discussions with the senior management of issuers give meaningful insights into corporate

plans and strategies. Necessary adjustments are made to the published accounts for the

purpose of analysis. Rating is carried out by specialised professionals who are highly

qualified and experienced. The final rating is assigned keeping in view the number of factors.

11. Time taken in rating process

The rating process is a fairly detailed exercise. It involves, among other things analysis of

published financial information, visits to the issuers offices and works, ‘intensive discussion

with the senior executives of issuers, discussions with auditors, bankers, creditors etc. It also

involves an in-depth study of the industry itself and a degree of environment scanning. All

this takes time, a rating agency may take 6 to 8 weeks or more to arrive at a decision. For

rating short-term instruments like commercial paper (CP), the time taken may vary from 3 to

4 weeks, as the focus will be more on short-term liquidity rather than on long-term

fundamentals. Rating agencies do not compromise on the quality of their analysis or work

under pressure from issuers for quick results. Issuers are always advised to. approach the

rating agencies sufficiently in advance so that issue schedules can be adhered to.
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12. Instruments for Rating

Rating may be carried out by the rating agencies in respect of the following Equity shares

issued by a company, preference shares issued by a company, bonds/debentures issued by

corporate, government etc, commercial papers issued by manufacturing companies, finance

companies, banks and financial institutions for raising sh0l1-term loans fixed deposits raised

for medium-term ranking as unsecured borrowings. Borrowers who have borrowed money,

individuals, and Asset backed securities are assessed to determine the risk associated with

them. The objective is to determine quantum of cash flows emerging from the asset that

would be sufficient to meet committed payments.

13. Rating Other than Debt Instruments

Credit Rating has been extended to all those activities where uncertainty and risk is

involved. Now-a-days credit rating is not just limited to debts instruments but also covers the

following:

14. Country Rating

A country may be rated whenever a loan is to be extended or some major investment is to

be made in it by international investors to determine the safety and security of their

investments. A number of factors such as growth rate, industrial and agricultural production,

government policies, inflation, fiscal deficit etc. are taken into consideration to arrive at such

rating. Any upgrade movement in such—ratings has a positive impact on the stock markets.

Morgan Stanlay, Moodys etc. give country ratings.

15. Rating of Real Estate Builders and Developers

CRISIL has started assigning rating to the builders and developers with the objective of

helping and guiding prospective real estate buyers. CRISIL thoroughly scrutinises the sale

deed papers, sanctioned plan, lawyers’ report government clearance certificates before

assigning rating to the builder or developer. Past experience of the builder, number of
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properties built by the builder, financial strength, time taken for completion are some of the

factors taken into consideration by the CRISIL before giving a final rating to the real estate

builder/ developer.

16. Chit Funds

Chit funds registered as a company are sometimes rated on their ability to make timely

payment of prize money to subscribers. The rating helps the chit funds in better marketing of

their fund and in widening of the subscribers base. This service is provided by CRISIL.

17. Rating of States

States of India have also approached rating agencies for rating. Rating helps the State to

attract investors both from India and abroad to make investments. Investors find safety of

their funds while investing in a state with good rating. Foreign companies also come forward

and set up projects in such states with positive rating. Rating agencies take into account

various economic parameters such as industrial and agricultural growth of the State,

availability of raw material, labor etc. and political parties agenda with respect to industry,

labor etc., relation between Centre and State and freedom enjoyed by the states in taking

decisions while assigning final rating to the states. States like Maharashtra, Madhya Pradesh,

Tamil Nadu, Andhra Pradesh and Kerala have already been rated by CRISIL.

18. Rating of Banks

CRISIL and ICRA both are engaged in rating of banks based on the following six

parameters also called CAMELS. C - C stands for capital adequacy of banks. A bank need to

maintain at least 10 % capital against risky assets of the bank.

1. A - A stands for asset quality. The loan is examined to determine non-performing

assets. An asset/loan is considered non-performing asset where either interest or

principal is unpaid for two quarters or more. Ratios like NPA to Net Advances,
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Adequacy of Provision and Debt Service Coverage Ratio are also calculated to

know exact picture of quality of asset of a bank.

2. M - M stands for management evaluation. Here, the efficiency and effectiveness

of management in framing plans and policies is examined. Ratios like RO!, Return

on Capital Employed (ROC E), Return on Assets (ROA) are calculated to

comment upon bank’s efficiency to utilise the assets.

3. L - L indicates liquidity position. Liquid and current ratios are determined to find

out banks ability to meet its short-term claims.

4. S - S stands for Systems and Control. Existing systems are studied in detail to

determine their adequacy and efficacy.

Thus, the above six parameters are analysed in detail by the rating agency and then final

rating is given to a particular bank. Ratings vary from A to D. Where A denotes financial,

managerial and operational soundness of a bank, and D denotes that bank is in financial crisis

and lacks managerial expertise and is facing operational problems.

19. Rating for Equities

These days analysts specialised in equity ratings make a forecast of the stock prices of

a company. They study thoroughly the trend of sales, operating profits and other variables

and make a forecast of the earning capacity and profitability position of a company. They use

financial statement analysis tools like ratio analysis, trend analysis, fund flow analysis and

cash flow analysis to comment upon company’s liquidity, solvency, profitability and overall

efficiency position. Analysts suggests a target price of the stock giving signal to the investor

to swing into action whenever the stock hits that particular price. The following are some of

the recommendations made by the equity analysts for its investors:

It shows the stock is worth buying at its current price, buy on Declines: This

recommendation indicates stock is basically good but overpriced now. The investor should go
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for buying whenever the price declines, long-term Buy: This recommendation suggests that a

stock should be bought and held for a longer period at least a year in order to realise gains.

strong Buy: This buy recommendation strongly favors the purchase of a stock because

analysts expect a steep rise in the prices of stock from its current price, out-performer: This

recommendation shows that whatever may be the mood of the stock market the stock will

perform better than the market, overweight: This refers to that investor can increase the

quantum or weight of that stock in his portfolio. This recommendation is applicable to those

investors who keep number of stocks in their portfolio, hold: This recommendation is a

suggestion to the investor to exit because stock prices are not likely to be appreciated

significantly from the current price level.

4.9 FUNCTIONS OF A CREDIT RATING AGENCY

A credit rating agency serves following functions: Provides unbiased opinion: An

independent credit rating agency is likely to provide an unbiased opinion as to relative

capability of the company to service debt obligations because of the following reasons: It has

no vested interest in an issue unlike brokers, financial intermediaries. Its own reputation is at

stake6.

a. Provides quality and dependable information: A credit rating agency is in a

position to provide quality information on credit risk which is more

authenticate and reliable because: It has highly trained and professional staff

who has better ability to assess risk. It has access to a lot of information which

may not be publicly available.

b. It provides information at low cost: Most of the investors rely on the ratings

assigned by the ratings agencies while taking investment decisions. These

6
Suzana Baresa, Sinisa Bogdan and Sasa Ivanovic (2012), “Role, Interests and Critics of Credit Rating
Agencies” UTMS Journal of Economics, vol. 3, issue 1, pages 71-82
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ratings are published in the form of reports and are available easily on the

payment of negligible price. It is not possible for the investors to assess the

creditworthiness of the companies on their own. It provides easy to understand

information: Rating agencies first of all gather information, then analyse the

same. At last these interpret and summarise complex information in a simple

and readily understood formal manner. Thus in other words, information

supplied by rating agencies can be easily understood by the investors. They

need not go into details of the financial statements.

c. It provide basis for investment: An investment rated by a credit rating enjoys

higher confidence from investors. Investors can make an estimate of the risk

and return associated with a particular rated issue while investing money in

them.

d. Healthy discipline on corporate borrowers: Higher credit rating to any credit

investment enhances corporate image and builds up goodwill and hence it

induces a healthy/ discipline on corporate.

e. Formation of public policy: Once the debt securities are rated professionally, it

would be easier to formulate public policy guidelines as to the eligibility of

securities to be included in different kinds of institutional port-folio.

4.10 ADVANTAGES OF CREDIT RATING

Different benefits accrue from use of rated instruments to different class of investors

or the company. These are explained as under7:

7
Steven Scalet and Thomas Kelly (2012), “The Ethics of Credit Rating Agencies: What Happened and the Way
Forward” Journal of Business Ethics, vol. 111, issue 4, pages 477-490
 110

A. Benefits to Investors

Credit rating gives an idea in advance to the investors about the degree of financial

strength of the issuer company. Based on rating he decides about the investment. Highly rated

issues gives an assurance to the investors of safety of Investments and minimizes his risk.

a. Recognition of risk and returns. Credit rating symbols indicate both the returns

expected and the risk attached to a particular issue. It becomes easier for the

investor to understand the worth of the issuer company just by looking at the

symbol because the issue is backed by the financial strength of the company.

b. Freedom of investment decisions. Investors need not seek advice from the

stock brokers, merchant bankers or the portfolio managers before making

investments. Investors today are free and independent to take investment

decisions themselves. They base their decisions on rating symbols attached to

a particular security. Each rating symbol assigned to a particular investment

suggests the creditworthiness of the investment and indicates the degree of

risk involved in it.

c. Wider choice of investments. As it is mandatory to rate debt obligations for

every issuer company, at any particular time, wide range of credit rated

instruments are available for making investment. Depending upon his own

ability to bear risk, the investor can make choice of the securities in which

investment is to be made.

d. Dependable credibility of issuer. Absence of any link between the rater and

rated firm ensures dependable credibility of issuer and attracts investors. As

rating agency has no vested interest in issue to be rated, and has no business

connections or links with the Board of Directors. In other words, it operates

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independent of the issuer company, the rating given by it is always accepted

by the investors.

e. Easy understanding of investment proposals. Investors require no analytical

knowledge on their part about the issuer company. Depending upon rating

symbols assigned by the rating agencies they can proceed with decisions to

make investment in any particular rated security of a company.

f. Relief from botheration to know company. Credit agencies relieve investors

from botheration of knowing the details of the company, its history, nature of

business, financial position, liquidity and profitability position, composition of

management staff and Board of Directors etc. Credit rating by professional

and specialised analysts reposes confidence in investors to rely upon the credit

symbols for taking investment decisions.

g. Advantages of continuous monitoring. Credit rating agencies not only assign

rating symbols but also continuously monitor them. The Rating agency

downgrades or upgrades the rating symbols following the decline or

improvement in the financial position respectively.

B. Benefits of Rating to the Company

A company who has got its credit instrument or security rated is benefited in the

following ways.

a. Easy to raise resources. A company with highly rated instrument finds it easy

to raise resources from the public. Even though investors in different sections

of the society understand the degree of risk and uncertainty attached to a

particular security but they still get attracted towards the highly rated

instruments. Reduced cost of borrowing. Investors always like to make

investments in such instrument, which ensure safety and easy liquidity rather
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than high rate of return. A company can reduce the cost of borrowings by

quoting lesser interest on those fixed deposits or debentures or bonds, which

are highly rated.

b. Reduced cost of public issues. A company with highly rated instruments has to

make least efforts in raising funds through public. It can reduce its expenditure

on press and publicity. Rating facilitates best pricing and timing of issues.

Rating builds up image. Companies with highly rated instrument enjoy better

goodwill and corporate image in the eyes of customers, shareholders, investors

and creditors. Customers feel confident of the quality of goods manufactured,

shareholders are sure of high returns, investors feel secured of their

investments and creditors are assured of timely payments of interest and

principal.

c. Rating facilitates growth. Rating motivates the promoters to undertake

expansion of their operations or diversify their production activities thus

leading to the growth of the company in future. Moreover highly rated

companies find it easy to raise funds from public through new issues or

through credit from banks and FIs to finance their expansion activities.

Recognition to unknown companies. Credit rating provides recognition to

relatively unknown companies going for public issues through wide investor

base. While entering into market, investors rely more on the rating grades than

on ‘name recognition’.

C. Benefits to Intermediaries

Stock brokers have to make less efforts in persuading their clients to select an

investment proposal of making investment in highly rated instruments. Thus rating enables
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brokers and other financial intermediaries to save time, energy costs and manpower in

convincing their clients.

4.11 DISADVANTAGES OF CREDIT RATING

Credit rating suffers from the following limitations;

a. Non-disclosure of significant information. Firm being rated may not provide

significant or material information, which is likely to affect the investor’s

decision as to investment, to the investigation team of the credit rating

company. Thus any decisions taken in the absence of such significant

information may put investors at a loss.

b. Static study. Rating is a static study of present and past historic data of the

company at one particular point of time. Number of factors including

economic, political, environment, and government policies have direct bearing

on the working of a company. Any changes after the assignment of rating

symbols may defeat the very purpose of risk indicativeness of rating.

c. Rating is no certificate of soundness. Rating grades by the rating agencies are

only an opinion about the capability of the company to meets its interest

obligations. Rating symbols do not pinpoint towards quality of products or

management or staff etc. In other words rating does not give a certificate of

the complete soundness of the company. Users should form an independent

view of the rating symbol.

d. Rating may be biased. Personal bias of the investigating team might affect the

quality of the rating. The companies having lower grade rating do not

advertise or use the rating while raising funds from the public. In such a case

the investors cannot get the true information about the risk involved in the

instrument.
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e. Rating under unfavorable conditions. Rating grades are not always

representative of the true image of a company. A company might be given low

grade because it was passing through unfavorable conditions when rated.

Thus, misleading conclusions may be drawn by the investors which hampers

the company’s interest.

f. Difference in rating grades. Same instrument may be rated differently by the

two rating agencies because of the personal judgment of the investigating staff

on qualitative aspects. This may further confuse the investors.

4.12 ROLE OF CREDIT RATING IN BUSINESS DEVELOPMENT

Credit rating establishes a link between risk and return. They thus provide a yardstick

against which to measure the risk inherent in any instrument. An investor uses the ratings to

assess the risk level and compares the offered rate of return with this expected rate of return

for the particular level of risk to optimize his risk-return trade-off. The risk perception of a

common investor, in the absence of a credit rating system, largely depends on his familiarity

with the names of the promoters or the collaborators. It is not feasible for the corporate issuer

of a debt instrument to offer every prospective investor the opportunity to undertake a

detailed risk evaluation. It is very uncommon for different classes of investors to arrive at

some uniform conclusion as to the relative quality of the instrument. Moreover they do not

possess the requisite skills of credit evaluation. Thus, the need for credit rating in today’s

world cannot be overemphasized. It is of great assistance to the investors in making

investment decisions. It also helps the issuers of the debt instruments to price their issues

correctly and to reach out to new investors. The analysis is based on an all-round analysis of

quantitative as well as qualitative factors like past performance, economic environment,

market positioning, quality of management and predictions about future, and is thus as
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complete as can be. The increasing levels of default resulting from easy availability of

finance, has led to the growing importance of the credit rating. The other factors are:

The growth of information technology, globalization of financial markets, increasing

role of capital and money markets, lack of government safety measures, the trend towards

privatization, and securitization of debt.

CRAs' role has expanded with financial globalization and has received an additional

boost from Basel II which incorporates the ratings of CRAs into the rules for setting weights

for credit risk. Credit rating agencies (CRAs) specialize in analyzing and evaluating the

creditworthiness of corporate and sovereign issuers of debt securities. Issuers with lower

credit ratings pay higher interest rates embodying larger risk premiums than higher rated

issuers. 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. In making their ratings, CRAs analyze 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, CRAs lack transparency and do not provide clear

information about their methodologies. Ratings tend to be sticky, lagging markets, and then

to overreact when they do change. This overreaction may have aggravated financial crises in

the recent past, contributing to financial instability and cross-country contagion. The failure

of big CRAs to predict the 1997–1998 Asian crisis and the bankruptcies of Enron, WorldCom

and Parmalat has raised questions concerning the rating process and the accountability of the

agencies and has prompted legislators to scrutinize rating agencies.

4.13 CREDIT RATING IN INDIA

Credit ratings are playing an increasingly important role in financial markets. The

most significant change in the recent relates to emphasis on their accountability and more
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important, the caution in regulators' use of ratings. In India, rating is a more recent

phenomenon, but the changing global perspectives on the subject do impact the financial

system. India was perhaps the first amongst developing countries to set up a credit rating

agency in 1988. The function of credit rating was institutionalized when RBI made it

mandatory for the issue of Commercial Paper (CP) and subsequently by SEBI, when it made

credit rating compulsory for certain categories of debentures and debt instruments. In June

1994, RBI made it mandatory for Non-Banking Financial Companies (NBFCs) to be rated.

Credit rating is optional for Public Sector Undertakings (PSUs) bonds and privately placed

non-convertible debentures up to Rs. 50 million. Fixed deposits of manufacturing companies

also come under the purview of optional credit rating.

Rating agencies are constantly subject to scrutiny, evaluation and questioning by

investors, media and regulators. Since ratings are opinions, it is important that markets are

convinced about their robustness before acting on them. Rating agencies therefore publish

extensive data on rating default and transition statistics, and metrics on predictive capability

of ratings vis-a-vis macroeconomic and corporate performance. In India, CRISIL (Credit

Rating and Information Services of India Ltd.) was setup in 1987 as the first rating agency

followed by ICRA Ltd. (formerly known as Investment Information & Credit Rating Agency

of India Ltd.) in 1991, and Credit Analysis and Research Ltd. (CARE) in 1994. All the three

agencies have been promoted by the All-India Financial Institutions. The rating agencies

have established their creditability through their independence, professionalism, continuous

research, consistent efforts and confidentiality of information. Duff and Phelps has tied up

with two Indian NBFCs to set up Duff and Phelps Credit Rating India (P) Ltd. in 1996.

4.14 ROLE OF REGULATORS IN CREDIT RATING

In India, in 1998, the SEBI constituted a committee to look into a draft regulation for

CRAs prepared internally. The committee held the view that in keeping with international
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practice, the SEBI Act 1992 should be amended to bring CRAs outside the purview of SEBI

for a variety of reasons. According to the committee, a regulator will not be in a position to

objectively judge the appropriateness of one rating over another. The competency and the

credibility of a rating and the CRA should be judged by the market, based on historical

record, and not by a regulator. The committee suggested that instead of regulation, SEBI

could just recognize certain agencies for particular purposes only, such as allowing ratings by

CRAs recognized by it for inclusion in the public/rights issue offer documents.

In consultation with the Government, in July 1999, SEBI issued a notification

bringing the CRAs under its regulatory ambit in exercise of powers conferred on it by Section

30 read with Section 11 of the SEBI Act 1992. The Act now requires all CRAs to be

registered with SEBI. Regulators like Reserve Bank of India (RBI) and Securities and

Exchange Board of India (SEBI) use credit rating to determine eligibility criteria for some

instruments. For example, the RBI has stipulated a minimum credit rating by an approved

agency for issue of commercial paper. Reserve Bank of India has decided to review and

monitor the performance of credit rating agencies, for continuation of their accreditation. The

move is aimed at ensuring greater accountability in the quality of the rating process and

methodologies. According to the G-20 Working Group recommendations, all credit rating

agencies whose ratings are used for regulatory purposes will be subject to regulatory

oversight regime, which includes registration and compliance with the International

Organisation of Securities Commissions (IOSCO) Code of Conduct Fundamentals. The

Reserve Bank of India will liaise with SEBI, on the issue of rating agencies’ adherence to the

IOSCO Code of Conduct Fundamentals. RBI has accorded accreditation to four rating

agencies registered with market regulator SEBI. This will allow them to use their rating for

assigning risk weights within the framework of the Basel II Accord.

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4.15 CREDIT RATINGS AND BASEL II

Regulatory changes in banks’ capital requirements under Basel II have resulted in a

new role to credit ratings. The major objective of Basel II is to revise the rules of the 1988

Basel Capital Accord in such a way as to align banks’ regulatory capital more closely with

their risks, taking account of progress in the measurement and management of these risks and

the opportunities which these provide for strengthened supervision. Under Pillar 1 of Basel II,

regulatory capital requirements for credit risk are calculated according to two alternative

approaches: (i) the Standardized Approach; and (ii) the Internal Ratings-Based Approach.

Under the Standardized Approach (SA) the measurement of credit risk is based on external

credit assessments provided by External Credit Assessment Institutions (ECAIs) such as

credit rating agencies or export credit agencies. Under the Internal Ratings-Based Approach

(IRBA), subject to supervisory approval as to the satisfaction of certain conditions, banks use

their own rating systems to measure some or all of the determinants of credit risk. Under the

Foundation Version (FV), banks calculate the Probability of Default (PD) on the basis of

their own ratings but rely on their supervisors for measures of the other determinants of credit

risk. Under the Advanced Version (AV), banks also estimate their own measures of all the

determinants of credit risk, including Loss Given Default (LGD) and Exposure at Default

(EAD). Under the regulatory capital requirements for operational risk, there are three options

of progressively greater sophistication: under the Basic Indicator Approach (BIA), the capital

charge is a percentage of banks' gross income; under the Standardized Approach (SA), the

capital charge is the sum of specified percentages of banks' gross income from eight business

lines (or alternatively for two of these business lines, retail and commercial banking, of

different percentages of loans and advances) and under the Advanced Measurement

Approach (AMA), subject to the satisfaction of more stringent supervisory criteria, banks

estimate the required capital with their own internal systems for measuring operational risk.
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Pillars 2 and 3 of Basel II are concerned with supervisory review of capital adequacy and the

achievement of market discipline through disclosure.

4.16 CREDIT RATING - SERVICE TO INVESTORS

Credit rating is expected to improve quality consciousness in the market and establish

over a period of time, a more meaningful relationship between the quality of debt and the

yield from it. Credit Rating is also a valuable input in establishing business relationships of

various types. However, credit rating by a rating agency is not a recommendation to purchase

or sale of a security. Investors usually follow security ratings while making investments.

Ratings are considered to be an objective evaluation of the probability that a borrower will

default on a given security issue, by the investors. Whenever a security issuer makes late

payment, a default occurs. In most of the cases, holders of bonds issued by a bankrupt

company receive only a portion of the amount invested by them. Thus, credit rating is a

professional opinion given after studying all available information at a particular point of

time. Such opinions may prove wrong in the context of subsequent events. Further, there is

no private contract between an investor and a rating agency and the investor is free to accept

or reject the opinion of the agency. Thus, a rating agency cannot be held responsible for any

losses suffered by the investor taking investment decision on the basis of its rating. Thus,

credit rating is an investor service and a rating agency is expected to maintain the highest

possible level of analytical competence and integrity. In the long run, the credibility of rating

agency has to be built, brick by brick, on the quality of its services provided, continuous

research undertaken and consistent efforts made.