Financial Services: Credit Rating Agencies | Commerce & Accountancy Optional Notes for UPSC PDF Download

Introduction

• Credit rating is a numerical assessment of a borrower's creditworthiness, either generally or in relation to a specific financial obligation. It is applicable to any entity seeking to borrow funds, whether an individual, corporation, state authority, or sovereign government.
• Individuals are scored by credit bureaus like Experian and TransUnion, using a 3-digit numerical scale via Fair Isaac (FICO) credit scoring. For companies and governments, credit assessment is typically done by credit rating agencies such as Standard & Poor's (S&P), Moody's, or Fitch. These agencies are compensated by the entity seeking a credit rating for itself or its debt issues.

Credit Rating Definition

• Credit rating entails an analysis of credit risks associated with a financial entity or instrument. It assesses an entity based on its credentials and the financial soundness demonstrated in past borrowing and lending activities.
• Typically presented as a detailed report, it evaluates an entity's creditworthiness and ability to meet debt obligations based on its financial statements. These ratings are published by various credit rating agencies like Standard & Poor's, Moody's Investors Service, and ICRA.

How Credit Rating Functions

• Credit ratings determine the likelihood of a borrower fulfilling their contractual obligation to repay a loan without default. A high credit rating indicates a strong possibility of full repayment, while a poor rating suggests a history of repayment issues and potential future difficulties. This rating impacts the borrower's chances of loan approval and the terms offered.
• Credit ratings apply to businesses and governments, while credit scores apply solely to individuals. Credit scores are derived from credit history maintained by agencies like Equifax, Experian, and TransUnion, reported as a number between 300 and 850. Sovereign credit ratings apply to national governments, while corporate credit ratings are for corporations.
• Short-term credit ratings predict default likelihood within a year, increasingly important in recent years. In contrast, long-term ratings predict default likelihood over a more extended period. Credit rating agencies use letter grades, with Standard & Poor's scale ranging from AAA (excellent) to C and D. Debt instruments with ratings below BB are considered speculative or junk bonds, more likely to default.

Key Takeaways

• Credit ratings assess a borrower's creditworthiness for a loan or debt obligation.
• They determine loan approval and interest rates.
• They apply to entities seeking to borrow money, including individuals, corporations, and governments.
• Individual credit is rated numerically, while corporate and government bonds are rated on a letter-based scale.

Credit Rating Agency

• A credit rating agency, also known as a ratings service, is a private entity that evaluates the creditworthiness of significant borrowers, such as companies or countries. It assesses the borrower's ability to repay loans effectively.
• A credit rating agency assigns credit ratings, which gauge a debtor's capacity to make punctual payments of principal and interest and the likelihood of default. These agencies may rate the creditworthiness of debt issuers, debt instruments, and sometimes, the servicers of the underlying debt, but they do not rate individual consumers.
• Debt instruments rated by credit rating agencies include government bonds, corporate bonds, certificates of deposit (CDs), municipal bonds, preferred stock, and securities backed by mortgages or other debt obligations.
• Various entities, such as corporations, special-purpose entities, state or local governments, non-profit organizations, or sovereign nations, can issue these obligations or securities. Credit ratings facilitate secondary market trading of securities and impact the interest rate paid by securities, with higher ratings leading to lower interest rates.
• Individual consumers' creditworthiness is rated by credit bureaus, also known as consumer reporting agencies or credit reference agencies, which generate credit scores.
• The value of credit ratings for securities has been extensively debated. During the 2007-2008 financial crisis, hundreds of billions of securities with the highest ratings were downgraded to junk status. EU officials blamed rating downgrades during the European sovereign debt crisis of 2010-2012 for hastening the crisis.
• The credit rating industry is highly concentrated, with the "Big Three" credit rating agencies controlling approximately 95% of the market. Moody's Investors Service and Standard & Poor's (S&P) control 80% of the global market, while Fitch Ratings controls an additional 15%.

Characteristics of Credit Ratings

• Assessment of the issuer's repayment capacity: It evaluates the issuer's ability to meet its financial obligations, such as interest payments and principal repayment.
• Data-based: Credit rating agencies assess the borrower's financial strength based on financial data.
• Symbol-based: Ratings are expressed using symbols like AAA or BBB, which are understandable to laypeople.
• Expert assessment: Credit ratings are conducted by experts from reputable, accredited institutions.
• Investment guidance, not recommendation: Credit ratings provide guidance to investors but do not recommend investing in any particular instrument.

Functions/Importance of Credit Rating

• Unbiased Opinion to Investors: Credit rating agencies provide an unbiased opinion because they have no vested interest in the rated company.
• Quality and Dependable Information: They employ highly qualified, trained, and experienced staff to assess risks and have access to vital information, ensuring accurate creditworthiness assessments.
• Easy-to-Understand Language: Ratings are presented in easy-to-understand symbols like AAA, BB, C, avoiding technical language or lengthy reports.
• Free or Nominal Cost Information: Credit ratings are published in newspapers and advertisements of rated companies at no cost to the public. They are also available from agencies for a nominal fee, which would otherwise be costly for individual investors to gather.
• Investment Decision Support: Ratings assist investors in assessing risks and making investment decisions.
• Corporate Borrower Discipline: Higher credit ratings increase a borrower's goodwill, encouraging other companies to follow suit, thereby promoting financial discipline and ethical practices.
• Formation of Public Policy on Investment: Regulators like SEBI and RBI can establish policies based on credit ratings, dictating securities eligibility for investment by institutions like mutual funds and provident funds. For instance, a mutual fund may be restricted from investing in debentures unless the issuer has a AAA rating.

Benefits of Credit Rating

Benefits to Investors

• Risk Assessment: Investors can assess investment risks through credit ratings. Small individual investors lack the skills, time, and resources for detailed risk evaluation, making credit rating agencies with their expertise and manpower a valuable resource. Ratings, expressed in symbols like AAA, BB, are easily understandable for investors.
• Low-Cost Information: Credit ratings are widely published in financial newspapers and available from rating agencies for nominal fees. This provides investors with credit information about borrowers at little to no cost.
• Continuous Monitoring: Credit rating agencies typically don't rate securities only once. They continuously monitor and update ratings based on changing circumstances.
• Investment Choice: Credit rating agencies help investors gather information about the creditworthiness of various companies, giving investors the freedom to choose where to invest.
• Dependable Ratings: Rating agencies have no vested interest in the securities they rate and no business links with the management of the issuer company. Therefore, their ratings are unbiased and credible.

Benefits to the Rated Company

• Ease in Borrowings: Companies with high credit ratings for their securities can raise funds more easily in the capital market.
• Borrowing at Cheaper Rates: A favorably rated company enjoys investor confidence and can borrow at lower interest rates.
• Facilitates Growth: Encouraged by a favorable rating, promoters are motivated to pursue expansion, diversification, and growth plans. Highly rated companies also find it easier to raise funds from the public through future ownership or credit securities issues and from banks.
• Recognition of Lesser-Known Companies: Favorable credit ratings for instruments of lesser-known or unknown companies provide credibility and recognition in the eyes of the investing public.
• Adds to the Goodwill of the Rated Company: A high rating from rating agencies automatically increases a company's goodwill in the market.
• Imposes Financial Discipline on Borrowers: Companies know that they will receive a high credit rating only if they manage their finances in a disciplined manner, maintaining good operating efficiency, appropriate liquidity, and high-quality assets. This fosters a sense of financial discipline among companies seeking to borrow.
• Greater Information Disclosure: To obtain a credit rating from an accredited agency, companies must disclose extensive information about their operations. This encourages greater information disclosure, better accounting standards, and improved financial information, ultimately protecting investors.

Benefits to Intermediaries

• Simplified Tasks for Merchant Bankers and Brokers: Without credit ratings, merchant bankers and brokers must persuade investors about a borrowing company's financial standing. A borrowing company's credit rating by a reputable agency simplifies the tasks of merchant bankers and brokers.

Benefits to the Business World

• Increased Investor Participation: If investors receive reliable guidance on investing in debt instruments through credit ratings, more people are encouraged to invest their savings in corporate debts.
• Guidance for Foreign Investors: Foreign collaborators or financial institutions are more likely to invest in companies with high credit ratings. Credit ratings allow them to instantly assess a company's position.

What Credit Rating Is Not?

• Not Applicable to Entire Company: Credit rating is assigned to a specific instrument, such as a particular class of debentures, rather than the entire company. It's possible for two instruments issued by the same company to have different ratings.
• No Fiduciary Relationship: Credit rating does not establish a fiduciary relationship (a relationship of trust) between the credit rating agency and the investor.
• No Verification of Information: A rating doesn't imply that the credit rating agency verifies the truthfulness of information provided by the rated company.
• Not Permanent: Credit rating isn't a one-time risk assessment that remains valid for the entire life of a security. It can change over time.

Compulsory Credit Rating:

Obtaining a credit rating is mandatory in the following cases:

• Debt Securities: The Reserve Bank of India and SEBI have made credit rating mandatory for all non-government debt securities with maturities exceeding 18 months.
• Public Deposits: Credit rating of deposits in companies has also been made mandatory.
• Commercial Papers (CPs): Credit rating is compulsory for commercial papers. According to Reserve Bank of India guidelines, a rating of P2 by CRISIL, A2 by ICRA, or PP2 by CARE is necessary for commercial papers.
• Fixed Deposits with Non-Banking Financial Institutions (NBFCs): Under the Companies Act, credit rating is mandatory for fixed deposits with NBFCs.

Factors Considered in Credit Rating

• Issuer’s Debt Servicing Ability: Credit rating agencies evaluate the issuer company's past and projected cash flows, interest obligations, earnings, outstanding debts, short-term solvency through the current ratio, and the value of assets pledged as collateral. They also consider factors such as raw material availability, geographical advantage, and the expertise of the staff.
• Market Position: Agencies assess the company's market share, stability, competitive advantages like distribution networks and research facilities, and the customer base.
• Management Quality: The track record, strategies, competency, and philosophy of senior management are also taken into account.
• Legal Aspects: Agencies verify the legal validity of the issued instrument, terms and conditions, protection from fraud, and the terms of the debenture trust deed.
• Industry Risks: The demand-supply dynamics, international competition, future prospects, and regulatory environment of the industry are analyzed.
• Regulatory Environment: Factors such as government regulation, price controls, government support, and tax concessions are considered.
• Other Factors: Additional factors include the company's cost structure, insurance coverage, accounting quality, market reputation, working capital management, human resource quality, funding policy, leverage, flexibility, and exchange rate risks.

Types of Credit Ratings

• Bonds and Debentures: Credit ratings are commonly applied to bonds and debentures, and practically all credit rating agencies offer this service.
• Equity Shares: While not mandatory in India, ICRA has a system for equity rating, and SEBI has no immediate plans for compulsory credit rating of initial public offerings (IPOs).
• Preference Shares: Preference shares are not typically rated in India, but Moody's Investor Service has been rating them since 1973, and ICRA has provisions for it.
• Medium-Term Loans (Public Deposits, CDs, etc.): Fixed deposits taken by companies are often rated on a regular scale in India.
• Short-Term Instruments (Commercial Papers): Credit rating for short-term instruments like commercial papers has been mandatory since 1990, and it is conducted by CRISIL, ICRA, and CARE.
• Borrowers: Ratings of borrowers, whether individuals or companies, are known as borrower's ratings.
• Real Estate Builders and Developers: CRISIL has initiated a system to rate builders and developers to ensure the proper development of colonies or construction of flats.
• Chit Funds: CRISIL rates chit funds based on their ability to make timely payments of prize money to subscribers.
• Insurance Companies: ICRA rates insurance companies based on their claim-paying ability, which ranges from high to weak.
• Collective Investment Schemes: ICRA assesses the success potential of collective investment schemes.
• Banks: CRISIL and ICRA rate banks to help depositors determine their financial soundness.
• States: States in India are also rated to assess their investment suitability, with good ratings attracting investors.
• Countries: Moody’s and Morgan Stanley rate countries to help foreign investors and lenders assess the country's financial stability and investment potential.

Credit Rating Agencies in India

There are six credit rating agencies registered with SEBI in India: CRISIL, ICRA, CARE, Fitch India, Brickwork Ratings, and SMERA.

CRISIL (Credit Rating and Information Services of India Limited)

• Established in 1987, CRISIL is India's first credit rating agency, initially promoted by ICICI Ltd, UTI, and other financial institutions.
• It began operations in 1988 and is headquartered in Mumbai.
• CRISIL is a leading provider of ratings, data, research, analytics, and solutions, with a strong focus on growth and innovation.
• It delivers independent opinions and efficient solutions and operates in eight countries worldwide, including the USA, Argentina, Poland, UK, India, China, Hong Kong, and Singapore.
• CRISIL's majority shareholder is Standard & Poor's, and it collaborates with governments and policy-makers in India and other emerging markets, particularly in the infrastructure sector.

ICRA (Investment Information and Credit Rating Agency)

• Established in 1991, ICRA was set up by leading financial and investment institutions, commercial banks, and financial services companies.
• It is a public limited company headquartered in New Delhi.
• ICRA's majority shareholder is Moody's.

CARE (Credit Analysis & Research Ltd.)

• Established in 1993, CARE is the second-largest credit rating agency in India.
• It is headquartered in Mumbai and is one of the five partners of an international rating agency called ARC Ratings.

ONICRA

• ONICRA is a private sector agency established by Onida Finance.
• It is headquartered in Gurgaon and provides ratings, risk assessment, and analytical solutions to individuals, MSMEs, and corporates.
• ONICRA is one of only seven agencies licensed by NSIC (National Small Industries Corporation) to rate SMEs.
• It has a pan-India presence with offices in over 125 locations.