Credit Rating Agencies: Concept
A credit rating agency is an independent company that assesses the financial strength of debt instruments and measures the credit worthiness of large scale borrowers. A credit rating agency rate debt instruments issued by the borrower and the rating assigned to a given instrument shows the level of confidence of the agency towards the ability of the borrower to honor its debt obligation when matured.
The trace of rating agency can be found since 1841 when Lewis Tappan formerd world’s first rating agency ‘ The Mercantile Agency’. In 1909, John Moody published a credit rating by making an opinion on creditworthiness of corporate debt issued by railroad companies. Standard and Poor’s (S&P) in 1924 introduced a new rating scale ‘AAA’ to ‘D’, which is still in practice. With the financial distress over the time, the need of credit rating agencies has grown over time. Almost every country has some kind of rating agencies operating in the market. Majorly, there are three major rating agencies operating known as ‘Big Three’ which includes Standard and Poor (S&P), Moody’s and Fitch Group.
Every agency has their own procedure and parameters for assessing the quality of the debt instrument. Some of the common parameters for evaluation of debt and rating of debt are:
- Subjective evaluation of the capacity of the company to repay the debt.
- Overall total debt of the company and its impact on the financial position.
- Past debt repayment history of the company.
- A general study of the economy and industry in which the company is operating.
- The willingness of the company to repay its debt.
‘Big Three’ rating agencies have three different approaches for credit ratings:
- Standard and Poor’s (S&P) rating captures only the forward-looking probability of the occurrence of default. S&P provide no assessment of the expected time of default or mode of default resolution.
- Moody’s Ratings focus on Expected Loss (EL).
- Fitch’s Rating has more explicitly hybrid character i.e. forward-looking and considers possible discontinuities between past track and future trends.
Moody’s and Standard and Poor’s (S&P) credit ratings are assigned by rating committees not by individual analysts.
In India, there are six Credit Rating Agencies that are registered and authorised to compute and share credit reports with financial institutions and applicants. They are:
- Credit Rating Information Services of India Limited (CRISIL)
- Indian Ratings and Research Pvt. Ltd. (IRR)
- Investment Information and Credit Rating Agency (ICRA)
- Credit Analysis and Research Limited (CARE)
- Small and Medium Enterprises Rating Agency of India (SMERA)
- Brickwork Ratings india Pvt. Ltd.
- Infomerics Valuation and Rating Pvt. Ltd.
Functions of Credit Rating Agencies (CRA)
- Credit Rating Agencies provide unbiased opinion on the financial instrument on review.
- CRAs provide reliable information to investors for making an informed decision. CRAs collect information that can define the creditworthiness of the instrument and provide information to the desired party.
- CRAs analyse and publish the ratings publicly and hence provide the information to the concerned party at minimal cost.
- CRAs provide information to the public and promote new investment and base for investment decisions.
- Credit Rating Agencies facilitate the corporate ecosystem. CRAs rate the financial instruments and provide their worthiness in the market. Corporate (Issuer) finds Credit rating methods as an easier and cheaper way of raising funds.
- CRAs work for superior dissemination of information. CRA is an independent organization with professional working and handling operations. Hence, the output i.e. rating and other reports have high credibility.
Credit Ratings used by Credit Rating Agencies in India
|Highest Safety||AAA||Instruments carry lowest credit risk.|
|High Safety||AA||Instruments carry very low credit risk.|
|Adequate Safety||A||Instruments carry low credit risk.|
|Moderate Safety||BBB||Instruments carry moderate credit risk.|
|Moderate Risk||BB||Instruments carry moderate risk of default regarding financial obligations.|
|High Risk||B||Instruments have high risk of default regarding timely servicing of financial obligation.|
|Very High Risk||C||Instruments have very high risk of default regarding timely servicing of financial obligation.|
|Default||D||Instruments are in default or are expected to be in default soon.|
Rating Methodology by Credit Rating Agencies
Every Rating Agencies adapt and consider different parameters for credit rating. Some of the common Credit Rating parameters are:
- Business Risk
- Industry Risk
- Competitive Position
- Cash Flow Analysis
- Accounting Practices
- Promoters and Management Quality
Moody’s Ratings consider the following parameters while evaluating any debt or bank’s instruments:
|Macro Profile||Financial Profile||Qualitative Factors|
|a. Economic Strength|
b. Institutional Strength
c. Susceptibility to Event Risk
d. Credit Conditions
e. Funding Conditions
f. Industry Structure
|a. Asset Risk|
b. Capital Adequacy
c. Profitability Performance
d. Funding Structure
e. Liquidity Position
|a. Business Diversification|
b. Opacity and Complexity
c. Corporate Behaviour
|Growth Dynamics |
Scale of Economy
Growth in private sector
Access to capital
Quality of market funding,
Quality of deposit funding
Quality of liquid assets,
Complex Exposure to other financial institutions
Evaluation of Credit Rating Agencies in India
India started its journey of credit rating in 1987 with the establishment of CRISIL (Credit Rating Information Services of India Limited). CRISIL was promoted by ICICI Limited, UTI and many such financial institutions. The agency started its operation in 1988.
Credit Rating is a relatively new concept in the history of Indian Corporate Sector. Securities and Exchange Board of India (SEBI) is responsible for regulating credit rating agencies in India under SEBI (Credit Rating Agencies) Regulation, 1999. SEBI regulates the functioning of credit rating agencies in order to protect the interest of investors and to make the system more helpful to them. The need for credit rating agencies emerged globally after the crisis of 2007. India had a major upturn in credit rating after 2007 with regular changes in frameworks for credit rating agencies. After this, along with SEBi, three other regulatory agencies were involved in regulatory mechanism of CRAs in India:
- Reserve Bank of India (RBI)
- Insurance Regulatory and Development Authority (IRDA)
- Pension Fund Regulatory and Development Authority (PFRDA)
Importance of Credit Rating Agency in India
Credit ratings help investors to make an informed decision and also categorize the instruments and issuers as per their ability to fulfill the credit obligation. Such agencies help to foster the growth, stability and efficiency of the global and domestic capital market. Credit Rating Agencies are important for the following reasons:
- Reducing NPAs:
Indian economy has been regularly suffering from the problem of Non-Performing Assets. The regular defaults in payment from the corporate and increasing bankruptcy applications reflect the true standing of Indian Credit System. Credit Rating Agencies, with their ratings, certainly by measuring the instruments and rating them. Such functions of CRAs builds confidence among the savers and enhances the market efficiency and market ability to understand the financial environment. Ratings reduce uncertainty in giving credits.
- Bond Market:
Credit Rating Agencies are the major players in promoting and facilitating bond markets in any economy. Along with rating the bond instruments, CRAs assess all the risks prevailing in the market and make the bond market more engaging.
- Foreign Direct Investment:
Foreign Direct Investment (FDI) as equity investment has many regulatory requirements. Debt investment is comparatively an easy form of investment by foreign investors. Credit Rating Agencies provide support to such investors by providing them the details on the issued debt instrument and by attracting them to participate in the financial markets.
2. Investors and Savers
- Default risk protection
It is difficult for any investors to get information regarding the default risk of any fixed income securities before making any investment. Credit Rating Agencies, through their ratings, provide information about the cumulative performance of the certain instruments and their probability of defaults. In the absence of ratings, the investment decision is totally based on reputation and historical financial information of the borrower that may have little bearing to future financial condition of the borrower.
- Compare risk and returns offered
There is always a difficult situation while evaluating any investment instrument. The risk and return trade-off is always difficult for both investors while making an investment and for the issuer for valuing an investment. Lower return on high risk instruments will not attract any investors similarly, higher return in low risk instruments has high cost for the issuer. Credit Rating Agencies assist in comparing risks and returns.