Performance of credit rating agencies

Introduction

With an increase in market orientation of the Indian economy, investors value a systematic assessment of two types of risks

  1. Business risk arising out of the "open economy".
  2. Payments risk which is a linkage between money, capital and foreign exchange markets.

India is considered as the initiator 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.

Origin of credit rating agencies in India.

Speaking of internationally, the first mercantile credit agency was set up in New York in 1841 to rate the ability of merchants to pay their financial obligations.

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.

Promotion of Credit Rating Agencies (CRAs)

CRAs can be promoted by public financial institutions (FIs), Schedules commercial banks (SCBs), foreign banks operating in India and foreign CRAs recognized in the country of their incorporation and having at least five years experience in rating. Besides this, any company or a corporate body having continuous net worth of minimum Rs. 100 crore as per the audient annual accounts for the previous five years can set up a CRA.

A CRA in which a bank, financial institution and its group holds more than 5% stake, would not be allowed to rate any instrument of any promoter and his associates. Due to this provision CRISIL and ICRA cannot rate instruments of IDBI and IFCI respectively, anymore.

Meaning and Definition

Credit rating is a codified rating assigned to an issue by authorized credit rating agencies. In other words, Credit rating is an opinion of the rating agency on the relative ability and willingness of the 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. Rating companies also publish explanations for their symbols used as well as the rationale for the ratings assigned by them, to facilitate deeper understanding.

So, credit rating agencies (subsequently denoted CRAs) are the firms specialized in analyzing and evaluating the creditworthiness of corporate and sovereign issuers of debt securities.

Need of credit rating agencies

Credit ratings establish a link between risk and return. Credit rating is useful for investors, banks and other financial institutions and investment advisers as it helps them taking business decision.

Credit rating by an authorized competent authority gives a bird's- eye view of the financial strength of an organization and thus provide a yardstick against which to measure the risk inherent in its instruments. Credit ratings are used by a wide variety of market participants for a variety of reasons.

Credit rating helpful for the investors

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).

The risk perception of a common investor, in the absence of a credit rating system, totally depends on his familiarity with the names of the promoters or the collaborators. Corporate issuers of a debt instrument cannot offer every prospective investor the opportunity to undertake a detailed risk evaluation. It is very difficult for investors to arrive at some uniform conclusion as to the relative quality of the instrument. Moreover most of the investors do not possess the requisite skills of credit evaluation.

Thus, the need for credit rating in today's world cannot be ignored.

It is of great assistance to the investors in making investment decisions.

Credit rating helpful for the issuer

Issuers value credit ratings because it lowers the costs issuers pay for capital. Credit ratings reassure investors both about the risks they face while making an investment and by serving to reassure them about the competence and responsibility of management.

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 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 helpful for the regulators

Financial regulators use credit ratings for a variety of purposes. These uses vary from setting capital requirements for banks and other financial institutions to rules governing money markets funds, pension funds and collective investment schemes, and in regulating asset-backed securities. Recently, the Basel Committee on Banking Supervision proposed permitting banks to use ratings from CRAs in determining capital requirements under the new Basel Capital Accord.

Major international rating agencies

As capital flows have become increasingly global and turbulence in one economy has had contagion effects across the globe, credit ratings have spread outside the domain of the home country to overseas markets. Credit ratings are in use in financial markets of most developed economies and several emerging market economies as well. Major internationally known rating agencies are:

  1. Mood's Investors Services U.S.A
  2. Fitch Investors Service U.S.A
  3. Standard and Poor's Corporation U.S.A
  4. Canadian Bond Rating Service CANADA
  5. Thomson Bank Watch U.S.A
  6. Japan Bond Rating Institute JAPAN
  7. Duff and Phelps Credit Rating U.S.A
  8. Japanese Credit Rating Agency JAPAN
  9. IBCA Ltd U.K

Over time, the agencies have expanded the depth and frequency of their coverage. The leading U.S credit rating agencies rate not only the long term bonds issued by the corporations in the U.S, but also a wide variety of debt including for example, municipal bond asset-backed securities, private placements, commercial paper programmes and bank certificates of deposits (CDs). In addition the leading agencies play an important role in evaluating sovereign ratings.

Most of the rating agencies have their own symbols- some of them use alphabets, other use numbers, many use a combination of both for ranking the risk of default. The default risk varies from extremely safe to highly speculative. Gradually, a rough correspondence among the ratings of the major agencies has emerged. To provide finer rating gradations to help investors distinguish more carefully among issuers, Standard & Poor Corporation in 1974 and Moody's in 1982started attaching plus and minus symbols to their ratings.

The Rating Process

The processes used by CRAs vary widely, depending on the CRA itself and the methodologies used. Some CRAs emphasizes on quantitative models, where the rating process is more mechanical in nature and based on statistical analysis of an issuer's financial disclosures. Whereas other CRAs (including many of the larger CRAs) rely on the processes whereby analysts form an assessment based on quantitative and qualitative indicators and then report this assessment to a rating committee.

In some cases, the exact processes used by a CRA may be proprietary. It is important to note that no one method is necessarily superior to another and that any consideration of the activities of CRAs should recognize that new developments (e.g., technological, statistical, or methodological) may yield new and different approaches in the future.

Despite the various approaches that CRAs may take in rating issuers, the largest international CRAs tend to follow similar rating procedures for similar types of instruments. The rating process itself is designed to facilitate analytical consistency and capitalize on area expertise. The rating process used by the larger international CRAs is a rating committee.

Rating committees are generally formed as required to initiate, withdraw or change a rating. They typically are composed of a lead analyst, managing directors or supervisors and junior analytical staff. Rating decisions are made upon a simple majority vote of the committee and represent the CRA's opinion regarding the likelihood the issuer will repay its financial obligations.

Step 1) At the start of the rating process, the CRA will assign a lead analyst to prepare the rating. The analyst requests information from the issuer and researches other available sources for information to provide the analyst with a better understanding of the issuer and its industry/economic environment. Analysts typically meet with senior management (or government officials, if the issuer is a government entity) and visit the issuer's offices. The analyst will then prepare a draft report and recommendation with respect to the issuer and/or its securities. This report is submitted to the rating committee, which then assigns the credit rating.

Step 2) Once the rating committee decides on a rating, the analyst typically informs the issuer of the rating and may provide the issuer with a draft of the rating press release and/or report so that the issuer can review it for factual verification and, to the extent the rating release/report will be made publicly available, to ensure that no non-public information originally provided by the issuer is disclosed that the issuer wishes to keep confidential. If the issuer disagrees with the proposed rating, it can request that the rating committee reconsider its decision. However, CRAs may be reluctant to reconsider a decision unless the issuer presents new material information or points out the CRAs reliance on incorrect information.

Step 3) After receiving the comments from the issuer, appropriate changes are made (if required), the larger CRAs issues press releases containing the rating and the rationale behind it. The CRA generally continue to monitor the issuer and/or its securities on an ongoing, albeit less intensive, level and continue to meet with senior management/officials on a periodic basis.

Nature of Credit Rating

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 specialized financial and credit analysts. Rating agencies also ensure that the rating process is free from any possible clash of interest.

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 is important pre-requisites. The rating agency must keep information of confidential nature possessed during the rating process, a secret.

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, 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.

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 e.g., 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'.

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.

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.

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.

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 of 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.

Rating not applicable to equity shares:

By definition, credit rating is an opinion on the issuer's 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.

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 specialized professionals who are highly qualified and experienced. The final rating is assigned keeping in view the number of factors.

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 issuer's 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.

Instruments for Rating

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

  1. Equity shares issued by a company.
  2. Preference shares issued by a company.
  3. Bonds/debentures issued by corporate, government etc.
  4. Commercial papers issued by manufacturing companies, finance companies, banks and financial institutions for raising sh0l1-term loans.
  5. Fixed deposits raised for medium-term ranking as unsecured borrowings.
  6. Borrowers who have borrowed money.
  7. Individuals.
  8. 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.

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:

  • 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.

  • 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 scrutinizes 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 properties built by the builder, financial strength and 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.

  • 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.

  • 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.

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

    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, Adequacy of Provision & Debt Service Coverage Ratio are also calculated to know exact picture of quality of asset of a bank.

    M - M stands for management evaluation. Here, the efficiency and effectiveness of management in framing plans and policies is examined. Ratios like ROI, Return on Capital Employed (ROC E) and Return on Assets (ROA) are calculated to comment upon bank's efficiency to utilize the assets.

    L - L indicates liquidity position. Liquid and current ratios are determined to find out banks ability to meet its short-term claims.

    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 analyzed 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.

Code of conduct formed by SEBI demands the following:

  • A credit rating agency shall render at all times high standards of service, exercise due diligence, ensure proper care and exercise independent professional judgment. It shall disclose wherever necessary, disclose to the clients, possible sources of conflict of duties and interests, while providing unbiased services.
  • The credit rating agency shall avoid any conflict of interest of any member of its rating committee participating in the rating analysis. Any potential conflict of interest shall be disclosed to the client.

Working of Credit Rating Agencies

Staff independence:

Any CRA's Ratings division and other divisions such as Advisory Division function entirely independent of one another, with separate manning and with strong firewalls among their activities.

For example, In CRISIL, It has independent teams comprising Managers and Heads for each of the business groups, who in turn are monitored by the Directors of the respective business groups.

At an overall level, the Ratings Division and the Advisory (and other) divisions report to different Executive Directors Every CRISIL rating is assigned only by a Rating Committee and not by an individual. CRISIL's Rating Committee is constituted and operates in such a manner that any member of the Committee who may have a pecuniary or fiduciary interest in the rated entity will not deliberate, analyze, contribute or vote on the matter of its rating. CRISIL strongly adheres to SEBI's code of conduct for rating agencies which demands that a credit rating agency shall avoid any conflict of interest of any member of its rating committee participating in the rating analysis.

Director independence:

Every CRA follows the principle of director independence. CRA ratings decisions are independent and free from political or economic pressures and from conflicts of interest arising due to the CRA's ownership structure, business or financial activities, or the financial interests of the CRA's employees. CRAs, as far as possible, avoid activities, procedures or relationships that may compromise or appear to compromise the independence and objectivity of the credit rating operations.

For example, CRISIL has over the years, been practicing the principles of good corporate governance. The company had adopted global practices for corporate governance and disclosure standards. CRISIL went public in 1993 so that there is no concentration of shareholding, which may seek to influence its rating process.

Talking about Crisil, CRISIL's Board of Directors comprises 11 members, of whom only 3 are Executive Directors.

Independent Directors constituted 70% of this Board. The Chairman of the Board is a Non-Executive and independent Director. Among the stringent guidelines that rule the appointments to CRISIL's Board is the rule that any individual, who is a Director of a company rated by CRISIL, cannot hold office as a Director of CRISIL. Moreover, any individual or who is a director of a company which is a borrower of an entity holding more than 10% of the equity share capital of CRISIL, should not normally hold office as a Director of CRISIL. None of the Non-Executive Directors of the company have any pecuniary relationships or transactions with CRISIL.

Fee Structure:

Fees structure of CRAs varies from agency to agency.

For example fees structure of CRISIL is as follows:

  1. Issue Rating: The pricing is usually linked to the size of the issue, with a minimum fee and a cap on the maximum fee for a particular financial year. Moreover, once an issue is assigned a rating, it is monitored till the debt is redeemed. CRISIL charges two types of fees -initial rating fee and surveillance fee. For each instrument raised by a company or entity, initial rating fee is 0.1% of the size of the debt issue and the surveillance fee is 0.03% of the debt outstanding. In the case of very large issues or for a group of companies issuing large amounts of debt regularly, the fee structure could be negotiated.
  2. Issuer Ratings: CRISIL does not currently offer issuer ratings as the Indian debt market is not yet mature and large enough for issuer ratings.

Index of rating:

Different CRAs have adopted different rating parameters and symbols to show its rating.

For example, CRISIL has devised a separate eight-point risk continuum for grading microfinance institutions. The grading is CRISIL's opinion on the ability of a microfinance institution to conduct its operations in a scalable and sustainable manner. The grading scale is alphanumeric - mfR1 to mfR8; mfR1 denotes very high ability to scale up and sustain operations and mfR8 denotes very low ability to scale up and sustain operations.

Drawbacks of Credit Rating Process

In spite of the advantages that the ratings process offers, several drawbacks remain:

  1. The ratings process attempts to provide guidance to investors/creditors in determining the risks associated with the instrument/credit obligation. It does not attempt to provide a recommendation and does not take into account factors like market prices, personal risk/reward preferences that might influence investment decisions.
  2. The ratings process is based on certain primitives. The agency, for instance, does not perform an audit. Instead it has to rely solely on the information provided by the issuer. Consequently, to the extent that the information provided is inaccurate and incomplete, the ratings process is compromised.
  3. To the extent that a certain instrument of a specific company attracts a lower rating, the company has an incentive to shop around for the best possible rating, compromising the authenticity of the rating process itself.

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