SASMIRAS INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

FINAL PROJECT
ON
A study on CREDIT RATINGS IN BANKS
BY
Kapil Ramesh Prabhu
MMS 2011-13 SEMESTER 4
SPECIALISATION: Finance
ROLL NO - 108

CREDIT RATING IN BANKS

A
PROJECT REPORT
ON
A Study on CREDIT RATING IN BANKS
IN PARTIAL FULFILLMENT OF THE REQUIREMENT OF
MASTER OF MANAGEMENT STUDIES
CONDUCTED BY
UNIVERSITY OF MUMBAI
THROUGH
SASMIRAS INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH
UNDER THE GUIDANCE OF
Dr. Amit Oak
SUBMITTED BY
Kapil Ramesh Prabhu
MMS/Finance
BATCH: 2011-2013

CREDIT RATING IN BANKS

DECLARATION
I, Mr. Kapil.Ramesh.Prabhu hereby declare that this project report is the record of
authentic work carried out by me during the period from January 2013 to April
2013 and has not been submitted to any other university or institute for the award of
any degree/diploma etc.

Signature
Name of the student

CREDIT RATING IN BANKS

CERTIFICATE OF THE GUIDE
This is to certify that Mr. Kapil.Ramesh.Prabhu of SASMIRAs Institute of Management Studies
and Research has successfully completed the project work titled A Study on Credit Rating in
Banks in partial fulfillment of the requirement for Master in Management Studies as prescribed
by Mumbai University.
This project report is the record of authentic work carried out by him/her during the period from
January 2013 to April 2013 under my guidance.

Signature
Name of Faculty Guide
Date

ACKNOWLEDGEMENT
4

CREDIT RATING IN BANKS

It is my privilege to express my gratitude and respect to those who guided and inspired me in the
completion of this project.
A great deal of appreciation goes to the contribution of my faculty guide Dr.Amit Oak for his
guidance in writing this research project.
I am grateful to the Director, Faculties, Administrative staff and the Librarian of SASMIRAs
Institute of Management Studies and Research for providing me with all the support required for
the successful completion of this project.
- Kapil Ramesh Prabhu.

CREDIT RATING IN BANKS

RESEARCH METHODOLOGY

The research work for this project was done by the secondary source.

SECONDARY SOURCES:
It was done through the extensive use of

Websites

Various Books

Reference papers

Articles

CREDIT RATING IN BANKS

EXECUTIVE SUMMARY

Credit rating is the overall credit worthiness of a borrower measured on predefined scale accessed by
independent agencies and inform to lender.
The role of credit rating has taken a front seat in the current scenario where companies are crashing
and economies are collapsing.
This has pushed me to pursue the subject of CREDIT RATING IN BANKS.
The credit rating aroused in the U.S out of desire by the growing number of investing classes, to
have more information on financial market.
The credit rating establishes the link between risk and return. The need is because of the factors
affecting an economy. There are many advantages of credit rating, both to the borrowers, investors
and the rating company.
CRISIL and ICRA are the both engaged in rating of banks on the parameter known as CAMEL.
The credit rating process is highly quantitative and qualitative.
The credit has large economic impact on developing nations as they are procyclical.
The observation is that rating service serves a purpose in financial market.
Improvement can be made by encouraging more accurate ratings and more timely ratings.
There should be more stringent criteria for frequency of rating updates, disclosure, transparency
and ethical practices.

CREDIT RATING IN BANKS

INDEX

Sr. No

Particulars

Pg. No

INTRODUCTION

09

DEFINITIONS

10

ORIGIN OF CREDIT RATING

13

IMPORTANCE OF CREDIT RATING

15

NATURE OF CREDIT RATING

17

ADVANTAGE OF CREDIT RATING

20

CREDIT RATING OF BANKS

23

DISADVANTAGES OF CREDIT RATING

24

CREDIT RATING AGENCIES

26

10

CREDIT RATING AGENCIES OF FINANCIAL SYSTEM

28

11

FUNCTIONS OF CREDIT RATING AGENCIES

30

12

CREDIT RATING PROCEDURES & METHODS

32

13

CREDIT RATING AGENCIES IN INDIA

35

14

CRISIL

38

15

CREDIT RATING PROCESS

49

16

ECONOMIC IMPACT OF RATING

50

17

CONCLUSION

53

18

RECOMMENDATIONS

54

19

BIBLOGRAPHY

55

INTRODUCTION
8

CREDIT RATING IN BANKS

Overall credit worthiness of a borrower measured on a predefined scale assessed by an

independent agency and informed to lenders is called Credit Rating. Thus credit rating is
an evaluation of the likelihood of a borrower to default on a loan. It is an expression of
credit worthiness based upon present financial condition and past credit history.
Borrowers are rated by lenders according to the borrowers credit-worthiness or risk
profile. Credit ratings are expressed as later grades such as A-, B or C+. These ratings are
based on various factors such as borrowers payment history, foreclosures, bankruptcies
and charge-offs. There is no exact science to rating a borrowers credit, and different
lenders may assign different grades to the same borrower.

DEFINITIONS
9

CREDIT RATING IN BANKS

As per (SEBI):- Rating means an opinion regarding securities, expressed in

the form of standard symbols or in any other standardized manner, assigned by a
credit rating agency and used by the issuer of such securities, to comply with a
requirement specified by SEBI regulations.

A credit rating estimates the credit worthiness of an individual, corporation, or even

a country. It is an evaluation made by credit bureaus of a borrowers overall credit
history. A credit rating is also known as an evaluation of a potential borrower's ability
to repay debt, prepared by a credit bureau at the request of the lender

ORIGIN OF CREDIT RATING

10

CREDIT RATING IN BANKS

The use of credit ratings arose in the U.S. out of the desire by the growing
investing class to have more information about the many new securities especially
railroad bonds that were being issued and traded. In the middle of the 19th century, the
U.S. railroad industry began expanding across the continent and into undeveloped
territories. The industrys demand for capital exceeded the ability or willingness of
banks and direct investors to provide it. In order to reach a broader and deeper capital
market, railroads
and other corporations began raising new capital through the market for private corporate
bonds. The growth in the sale of many different corporate bonds to a broad investing
public generated the need for better, cheaper and more readily available information
about these debtors and debt securities. In response to this development, Henry Varnum
Poor first published in 1868 the Manual of the Railroads of the United States. His
publication contained operating and financial statistics for the major railroad companies,
and provided an independent source of information on the business conditions of these
corporate borrowers. John Moody took the process another step forward in 1909 by
issuing the first credit ratings in the United States
The first mercantile credit agency was set up in New York in1841 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 Moodys Investors Service in1962. The
history of Moodys can be traced back about 100 years ago. In 1900, John Moody laid
stone of Moodys Investors Service and published his Manual of Railroad Securities
.
Early 1920s saw the expansion of credit rating industry when the Poors Publishing
Company published its first rating guide in 1916. Subsequently Fitch Publishing
11

CREDIT RATING IN BANKS

Company and Standard Statistics Company were set up in 1924 and 1922 respectively.
Poor and Standard merged together in 1941 to form Standard and Poors which was
subsequently taken over by McGraw Hill in 1966. Between 1924 and 1970, no major
new rating agencies were set up. But since 1970s, 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 credit- ability 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.

IMPORTANCE OF CREDIT RATING

12

CREDIT RATING IN BANKS

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 todays world cannot be over- emphasised. 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 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
13

CREDIT RATING IN BANKS

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.
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:
i.

The growth of information technology.

ii.

Globalization of financial markets.

iii.

Increasing role of capital and money markets.

iv.

Lack of government safety measures.

v.

The trend towards privatization.

vi.

Securitization of debt.

NATURE OF CREDIT RATING

14

CREDIT RATING IN BANKS

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 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
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, 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
15

CREDIT RATING IN BANKS

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.
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 pre16

CREDIT RATING IN BANKS

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: T 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.

ADVANTAGES OF CREDIT RATING

17

CREDIT RATING IN BANKS

Different benefits accrue from use of rated instruments to different class of investors or
the company. These are explained as under:
A. Benefits to Investors
1. Safety of investments. 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.
2.

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.
3.

Freedom of investment decisions. Investors need not seek advise 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.
4. 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.
5.

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 independent of the issuer
18

CREDIT RATING IN BANKS

company, the rating given by it is always accepted by the investors.

6.

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.
7. 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.
8.

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.
1.

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.
2.

Reduced cost of borrowing. Investors always like to make investments in such

instrument, which ensure safety and easy liquidity rather than high rate of return. A
19

CREDIT RATING IN BANKS

company can reduce the cost of borrowings by quoting lesser interest on those fixed
deposits or debentures or bonds, which are highly rated.
3.

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.
4.

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

goodwill and corporate image inthe 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.
5. 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 orthrough credit from banks and FIs to finance their
expansion activities.
6.

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 brokers and other financial intermediaries to save time, energy costs and
manpower in convincing their clients.

CREDIT RATING OF BANKS

20

CREDIT RATING IN 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. A - A stands for asset quality. The loan is
examined to deter- mine non-performing assets. An asset/loan is considered nonperforming 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 RO!, Return on
Capital Employed (ROC E), Return on Assets (ROA) are calculated to comment upon
banks efficiency to utilise 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 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, manage- rial and operational soundness
of a bank, and D denotes that bank is in financial crisis and lacks managerial expertise
and is facing operational problems.

DISADVANTAGES OF CREDIT RATING

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CREDIT RATING IN BANKS

Credit rating suffers from the following limitations

1.

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

significant or material information, which is likely to affect the investors 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.
2.

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 has 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.
3. 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.
4. 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.
5.

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 companys interest.

6. 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
22

CREDIT RATING IN BANKS

qualitative aspects. This may further confuse the investors.

CREDIT RATING AGENCIES

23

CREDIT RATING IN BANKS

Credit rating agencies (subsequently denoted CRAs) specialize in analysing and

evaluating the

creditworthiness

securities. In the

of

corporate

and

sovereign

issuers

of

debt

new financial architecture, CRAs are expected to become more

important in the management of both corporate and sovereign credit risk. Their role has
recently

received a boost from the revision by the Basel Committee on Banking

Supervision (BCBS) of capital standards for banks culminating in Basel II.

The logic underlying the existence of CRAs is to solve the problem of the informative
asymmetry between lenders and borrowers regarding the creditworthiness of the
latter. 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.
The rating agencies fall into two categories: (i) recognized; and (ii) non-recognized. The
former are recognized by supervisors in each country for regulatory purposes. In the
United States, only five CRAs of which the best known are Moodys and Standard and
Poors (S&P) are recognized by the Security and Exchange Commission (SEC). The
majority of CRAs such as the Economist Intelligence Unit (EIU), Institutional Investor
(II), and Euromoney are "non- recognized". There is a wide disparity among CRAs.
They may differ in size and scope (geographical and sectorial) of coverage.

There

are also wide differences in their methodologies and definitions of the default risk,
which renders comparison between them difficult.
Regarding their role vis--vis developing countries, the rating of country and sovereign is
particularly important. As defined by Nagy (1984), "Country risk is the exposure to a
loss in cross-border lending, caused by events in a particular country which are at least
24

CREDIT RATING IN BANKS

to some extent under the control of the government but definitely not under the control
of a private enterprise or individual". Under this definition, all forms of cross-border
lending in a country
i.

whether to the government, a bank, a private enterprise or an individual are

included. Country risk is therefore a broader concept than sovereign risk. The
latter is restricted to the risk of lending to the government of a sovereign nation.

ii.

However, sovereign and country risks are highly correlated as the government is
the major actor affecting both. Rare exceptions to the principle of the sovereign
ceiling that the debt rating of a company or bank based in a country cannot
exceed the countrys sovereign rating do occur.
The failure of big CRAs to predict the 19971998 Asian crisis and the recent

bankruptcies of Enron, WorldCom and Parmalat has raised questions concerning the
rating process and the accountability of CRAs and has prompted legislators to scrutinize
rating agencies. This report gives an overview of the sovereign credit rating
industry: (i) analyses its impact on developing countries; and (ii) assesses some of the
CRAs' shortcomings in the context of concerns that have recently been raised.

CREDIT RATING AGENCIES IN THE FINANCIAL SYSTEM

25

CREDIT RATING IN BANKS

A. Asymmetry of information and CRAs as "opinion" makers

A credit rating compresses a large variety of information that needs to be known about
the creditworthiness of the issuer of bonds and certain other financial instruments. The
CRAs thus contribute to solving principal agent problems by helping lenders "pierce the
fog of asymmetric information that surrounds lending relationships and help borrowers
emerge from that same fog"1.
CRAs stress that their ratings constitute opinions. They are not a recommendation to buy,
sell or hold a security and do not address the suitability of an investment for an investor.
Ratings have an impact on issuers via various regulatory schemes by determining the
conditions and the costs under which they access debt markets. Regulators have
outsourced to CRAs much of the responsibility for assessing debt risk. For investors,
ratings are a screening tool that influences the composition of their portfolios as well as
their investment decisions.

B.

Credit ratings and Basel II

Directive Regulatory changes in banks capital requirements under Basel II have resulted
in a new role to credit ratings.

Ratings can be used to assign the risk weights

determining minimum capital charges for different categories of borrower. Under the
Standardized Approach to credit risk, Basel II establishes credit risk weights for each
supervisory category which rely on "external credit assessments" . Moreover, credit
ratings are also used for assessing risks in some of the other rules of Basel II.
The importance of ratings-based regulations is particularly visible in the United States,
where it can be traced back to the 1930s. These regulations not only affect banks but
26

CREDIT RATING IN BANKS

also insurers, pension funds, mutual funds and brokers by restricting or prohibiting the
purchase of bonds with "low" ratings. Examples are:
(i) non-investment grade or speculative-grade ratings easing
conditions

or

disclosure

requirements

for

securities

carrying

the

issuance

a "satisfactory"

rating; and
(ii) an investment-grade rating.While ratings-based regulations are less common in
Europe, they are part of the new Capital Requirements through the EU that will
implement Basel II.

FUNCTIONS OF CREDIT RATING AGENCY

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CREDIT RATING IN BANKS

A credit rating agency serves following functions:

1.

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:
i.

It has no vested interest in an issue unlike brokers, financial intermediaries

ii.

Its own reputation is at stake.

2. 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:
i.

It has highly trained and professional staff who has better ability to assess risk.

ii.

It has access to a lot of information which may not be publicly available.

3.

Provides information at low cost: Most of the investors rely on the ratings

assigned by the ratings agencies while taking investment decisions. These 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.
4.

Provide 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.
5.

Provide basis for investment: An investment rated by a credit rating enjoys

associated with a particular rated issue while investing money in them.

6.

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.
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CREDIT RATING IN BANKS

7.

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.

CREDIT RATING PROCEDURES AND METHODS

A.

Quantitative and qualitative methods

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CREDIT RATING IN BANKS

The processes and methods used to establish credit ratings vary widely among
CRAs. Traditionally, CRAs have relied on a process based on a quantitative and
qualitative assessment reviewed and finalized by a rating committee. More recently,
there has been increased reliance on quantitative statistical models based on publicly
available data with the result that the assessment process is more mechanical and
involves less reliance on confidential information. No single model outperforms all
the others. Performance is heavily influenced by circumstances.
A sovereign rating is aimed at "measuring the risk that a government may default on its
own obligations in either local or foreign currency. It takes into account both the ability
and willingness of a government to repay its debt in a timely manner.3" The key
measure in credit risk models is the measure of the Probability of Default (PD) but
exposure is also determined by the expected timing of default and by the Recovery Rate
(RE) after default has occurred:

Standard and Poor's ratings seek to capture only the forward-looking probability of

the occurrence of default. They provide no assessment of the expected time of default or
mode of default resolution and recovery values;

By contrast, Moody's ratings focus on the Expected Loss (EL) which is a function of

both Probability of Default (PD) and the expected Recovery Rate (RE). Thus EL = PD
(1- RE); and

Fitch's ratings also focus on both PD and RE (Bhatia, 2002). They have a more

explicitly hybrid character in that analysts are also reminded to be forward-looking and
to be alert to possible discontinuities between past track records and future trends.
The credit ratings of Moody's and Standard and Poor's are assigned by rating committees
and not by individual analysts. There is a large dose of judgement in the committees
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CREDIT RATING IN BANKS

final ratings. CRAs provide little guidance as to how they assign relative weights to each
factor, though they do provide information on what variables they consider in
determining sovereign ratings. Identifying the relationship between the CRAs' criteria
and actual ratings is difficult, in part because some of the criteria used are neither
quantitative nor quantifiable but qualitative. The analytical variables are interrelated and
the weights are not fixed either across sovereigns or over time. Even for quantifiable
factors, determining relative weights is difficult because the agencies rely on a large
number of criteria and there is no formula for combining the scores to determine ratings.
In assessing sovereign risk, CRAs highlight several risk parameters of varying
importance:
(i) economic; (ii) political; (iii) fiscal and monetary flexibility; and (iv) the debt burden .
Economic risk addresses the ability to repay its obligations on time and is a function of
both quantitative and qualitative factors.

Political risk addresses the sovereign's

willingness to repay debt. Willingness to pay is a qualitative issue that

distinguishes sovereigns from most other types of issuers. Partly because creditors have
only limited legal redress, a government can (and sometimes does) default selectively on
its obligations, even when it possesses the financial capacity for debt service. In
practice, political risk and economic risk are related. A government that is unwilling to
repay debt is usually pursuing economic policies that weaken its ability to do so.
Willingness to pay, therefore, encompasses the range of economic and political factors
influencing government policy. Broadly speaking, the economic variables aim at
measuring three types of performance:
(i) measures of domestic economic performance; (ii) measures of a country's external
position and its ability to service its external obligations; and (iii) the influence
of external developments. Bhatia (2002), notes that CRAs analyses prior to the Asian
financial crisis focused on traditional macroeconomic indicators with limited emphasis
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CREDIT RATING IN BANKS

on contingent liability and international liquidity considerations. Moreover, private

sector weaknesses were not included in the analyses of sovereign rating.
In practice, a small number of variables such as: (i) GDP per capita; (ii) real GDP growth
per capita; (iii) the Consumer Price Index (CPI); (iv) the ratio of government fiscal
balance to GDP; and (v) government debt to GDP have a large impact on credit ratings.
The relationship between these indicators and Standard and Poor's ratings are illustrated
in figures 1-5 of Annex 1. By and large: (i) higher GDP per capita leads to higher
ratings; higher CPI inflation to lower ratings, the lower the rating, the lower the
government balance as a ratio to GDP; and
(ii) higher fiscal deficits and government debt in relation to GDP to lower ratings.

CREDIT RATING AGENCIES IN INDIA

CREDIT RATING AGENCIES IN INDIA In India, at present, there are four

credit Rating Agencies:
i)

Credit Rating and Information Services of India Limited (CRISIL).

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CREDIT RATING IN BANKS

ii)

Investment Information and Credit Rating Agency of India Limited

(ICRA).

iii)

iv)

Credit Analysis and Research Limited (CARE).

Duff and Phelps Credit Rating of India (Pvt.) Ltd. CRISIL : This

was set-up by ICICI and UTI in 1988, and rates debt instruments.
Nearly half of its ratings on the instruments are being used.

CRISIL's

market share is around 75%. It has launched innovative products for credit
risks assessment viz., counter party ratings and bank loan ratings.
CRISIL rate s debentures, fixed deposits, commercial papers,
preference shares and structured obligations.

Of the total value of

instruments rated, debentures' accounted for 31.196, fmed deposits for

42.3% and commercial paper 6.6%. CRISIL publishes CRISIL rating in
SCAN that is a quarterly publication in Hindi and Gujarati, besides English.
CRISIL evaluation is carried out by professionally qualified persons and
includes data collection, analysis and meeting with key personnel in
the company to discuss strategies, plans and other issues that may
effect ,evaluation of the company. The rating ,process ensur ensures
confidentiality. , Once . - the company decides to use rating, CRISIL is
obligated to monitor the rating over the life of the debt instrument.

ii)

ICRA : ICRA was promoted by IFCI in 1991. During the year 1996-

97, ICRA rated 261 debt instrument s of manufacturing companies,

finance companies and financial institutions equivalent to Rs. 12,850 crore
a s compared to
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CREDIT RATING IN BANKS

293 instruments covering debt volume of Rs. 75,742 crore in 1995-96. This
showed a decline

of

83.0% over the year in the volume of rated debt

instruments. Of the total amount rated cumulatively until March-end 1997,

the share in terms of number of instruments was 28.5% for debentures
(including long ternr'instruments), 49.4% for Fixed Deposit programme
(including medium- term instruments), and
22.1% for Commercial Paper Programme (including short- term
instmments). The corresponding figures of amount involved for these
three broad rated categories was 23..8% for debentures, 52.2% for fixed
deposits, and 24.0% for
Commercial Paper.
The factors that ICRA takes into consideration for rating depend on
the

nature

of borrowing

entity.

The inherent protective

factors,

marketing strategies, competitive edge, competence a n d effectiveness

of

management,

h u m a n resource development policies and practices,

hedging of risks, trends in cash flows and potential liquidity, financial

flexibility, asset quality and past record of servicing of debt as well as
government policies affecting the industry are examined.
Besides determining the credit risk associated with a debt instrument,
ICRA ha s also formed a group under Earnings Prospects and Risk
Analysis (EPRA).

Its goal is to provide authentic information on the

relative quality of the equity. This requires examination of almost all

parameters pertaining to the fundamentals of the company including
relevant sectoral perspectives. This qualitative analysis is reinforced and
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CREDIT RATING IN BANKS

completed by way of the unbiased opinion and informed perspective of

one

analyst

an d

wealth

of judgement

of committee

members.

ICRA opinions help the issuing company to broaden the market for
their equity.

As the name recognition is replaced by objective opinion,

the lesser know compapies are also able to access the equity market.
iii) CARE : CARE is a credit rating and information services company
promoted

by IDBI jointly

finance companies.

with investment institutions, banks and

The company commenced its operations in October

1993. 'In January

1994,

CARE

commenced

publication

of

CAREVIEW,

a quarterly

journal of CARE ratings. In additioh to the rationale of all accepted

ratings, CAREVIEW often carries special features of interest to issuers of
debt instruments, investors and other market players.

CRISIL
CRISIL is India's leading Ratings, Research, Risk and Policy Advisory company.

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CREDIT RATING IN BANKS

At the core of CRISIL are its unimpeachable credibility and unmatched analytical rigour.
Leveraging these core strengths CRISIL delivers opinions and solutions that:
Make markets function better, and,
Help clients mitigate and manage their business & financial risks
Help shape public policy.

CRISIL offers domestic and international customers a unique combination of local

insights and global perspectives, delivering independent information, opinions and
solutions that help them make better informed business and investment decisions,
improve the efficiency of markets and market participants, and help shape infrastructure
policy and projects. Its integrated range of capabilities includes credit ratings; research
on India's economy, industries and companies; investment research outsourcing; fund
services; risk management and infrastructure advisory services more .
CRISIL's majority shareholder is Standard & Poor's, the world's foremost provider of
independent credit ratings, indices, risk evaluation, investment research and data.

Values
Today, CRISIL inspires trust and confidence across industry for upholding values that
serve as tenets across the Group Companies. Epitomising the collective character of our
people, these core values have been instrumental in delivering us success.
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CREDIT RATING IN BANKS

Our commitment, analytical rigour and passion for innovation are exemplified by the
thought leadership provided by our Centres of Excellence. Dedicated teams for
innovative products and methodologies across businesses repeatedly and regularly create
new industry standards.
At the core of our credibility, assiduously built over the years, are our unimpeachable
integrity and independence of individual thinking. Objectivity, neutrality of views and
opinions backed by rigour of analysis are encouraged and rewarded internally, and
appreciated by clients.
Analytical Rigour
Independence
Integrity
Innovation
Commitment

Analytical Rigour
The service offerings are underlined by analytical rigour. We blend in-depth conceptual
understanding the science of building analytical frameworks with the art of
evaluation.

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CREDIT RATING IN BANKS

CRISIL combines an extensive knowledge base, understanding of the dynamics of

business and the market place, expertise, judgment and experience to offer world-class
solutions to clients.
Policy level assignments in the area of Infrastructure Advisory are but one example of
this.
Independence
We pride on being non-partisan and unbiased.
culture fosters objectivity and neutrality of views and opinions.
Independence and objectivity are ingrained in our processes and call for a participatory
approach, individual thinking and transparency for arriving at logical conclusions.
Integrity
The credibility in the market place is the result of unimpeachable integrity, honesty and
transparency in our work and dealings.
The people are characterised by a strong sense of fairness and ethics. CRISIL seeks to
become the benchmark on integrity by adopting the best professional practices regarding
client confidentiality, integrity of analysis and lack of bias
Innovation
The dedicated Centres of Excellence provide thought leadership. The core teams lead the
way by developing and sharing insights from the extensive corpus available, building
innovative analytical frameworks and developing new methodologies and products in
line with requirements of the market place.
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CREDIT RATING IN BANKS

Commitment
They are committed to
Setting standards for integrity, analytical rigour and best practices in the marketplace
Consistently providing value to constituents through analytically relevant and reliable
opinions and solutions
Upholding independent evaluation processes and a non-partisan, unbiased and fearless
approach to functioning
What they do?
At this important milestone, we reflect on our journey thus far and look into the horizon
beyond.
We began our journey as India's first rating agency. Today, we are a diversified global
analytical platform with leadership positions in the ratings, research and advisory
domains. Along the way, our growth has been closely intertwined with India's
development milestones.
We started in 1987 as a credit rating agency, at a time when lending rates in India were
fixed, and there was, therefore, little demand for credit ratings. We firmly established
ourselves as the country's leading rating agency, respected for our fiercely independent,
highly credible, and analytically rigorous views. Shouldering the mantle of a pioneer and
a market leader, we facilitated the development of India's credit market and built investor
confidence in our risk assessment capabilities.

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CREDIT RATING IN BANKS

India's transformation into a market-led economy greatly increased its need for capital,
and required extensive reforms and institution building. Accordingly, we diversified into
the infrastructure advisory and business research domains, and quickly built up a
reputation for independent, reliable and incisive information, research, models and
advisory services. Today, our services are key inputs in informed decision-making and
the shaping of public policy in India.
With increasing globalisation, we also focused on making our income streams more
global. We acquired Irevna, a pioneer in the investment research outsourcing space;
Irevna has since been voted No.1 in highend investment research and analytics
outsourcing by the US-based Brown and Wilson Group two years in a row in 2006 and
2007. We have a thriving business that meets increasing global demand for better
understanding of the Indian business environment, through the services offered by our
research and advisory groups.
Guided by our core values of integrity, independence, innovation, analytical rigour and
commitment, we are proud to have built a globally-acknowledged institution of repute
over these 20 years. We have facilitated the setting up of credit rating agencies in several
countries around the world. Our association and integration with Standard & Poor's has
further enhanced our capabilities and opened up newer vistas of opportunity, for our
businesses and people.
The macro environment trends, both in India and globally, present myriad business
opportunities. At a youthful 20, we are ideally positioned to service the needs of our
expanding client base by maintaining our focus on our mission:
Making markets function better
Helping clients manage and mitigate business and financial risks
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CREDIT RATING IN BANKS

Shaping public policy

CRISIL GROUP businesses:
Ratings
Research
Advisory
Ratings
CRISIL Ratings
CRISIL Ratings is the only ratings agency in India to operate on the basis of sectoral
specialisation. It reflects our sharpness of analysis, the responsiveness of the process and
the large-scale dissemination of opinion.
CRISIL Ratings plays a leading role in the development of the debt markets in India.
The Rating Criteria & Product Development Centre, responsible for policy research, new
product development and ratings' quality assurance, has developed new ratings
methodologies for debt instruments and innovative structures across sectors.
CRISIL Ratings provides technical know-how to clients worldwide. We have helped set
up ratings agencies in Malaysia (RAM), Israel (MAALOT) and in the Caribbean.

Research
CRISIL Research is India's largest independent integrated research house providing
accurate and reliable research, analysis and forecasts on the Indian economy, industries
and companies to over 500 Indian and international clients across financial, corporate,
consulting and public sectors.
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CREDIT RATING IN BANKS

CRISIL Research leverages on its unique, integrated research platform and capabilities
spanning the entire economy-industry-company spectrum to deliver superior perspectives
and insights to its clients, through both, subscription products and customised solutions.
CRISIL Research also offers consistent, high quality financial data analysis to users
within and outside the CRISIL group, enhancing the efficacy of the conventional
financial analysis frameworks adopted in the marketplace.
Fund Services
CRISIL FundServices is India's leading provider of fund evaluation services and risk
solutions to the mutual fund industry.
Through innovative analytics, benchmarks and analytical tools, CRISIL FundServices
plays a significant role in shaping investor confidence and facilitating the introduction of
best practices in the mutual fund industry.
Widely reputed as the industry standard, CRISIL Fund Services is the official provider of
valuation tools and market benchmarks.

Economic Research
The Centre for Economic Research is uniquely positioned to provide benchmarks and
analyses for India's policy and business decision makers.

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CREDIT RATING IN BANKS

Manned by a team of senior economists, the Centre applies economic principles to live
business applications, creating conceptual and contextual linkages that are unique to
CRISIL.
The Centre also works with other CRISIL businesses, contributing to both the range and
depth of products, services and consulting assignments that CRISIL offers.

Investment Research Outsourcing

CRISIL added equity research to its wide canvas of work, by acquiring Irevna, a leading
global equity research and analytics company.
Irevna, a division of CRISIL, provides high-end customised equity research and
analytics, and knowledge process outsourcing, to the world's leading financial
institutions, investment banks, private equity firms and consulting companies, helping
them achieve sustainable competitive advantage.
Irevna offers investment research services to the world's leading investment banks and
financial institutions. Founded in 2001, Irevna pioneered the 'outsourced research'
concept, where the firm helps large financial institutions to carry out investment
research, at a time when accepted wisdom did not consider this possible.

Infrastructure Advisory
Our Infrastructure Advisory enhances CRISIL's franchise in the areas of policy-making
and economic development. Our spectrum of activities includes catalysing economic
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CREDIT RATING IN BANKS

development through creation of appropriate policy frameworks, sector reforms,

regulatory support, project structuring and global competitive bid process management
for large and complex projects.

CRISIL Infrastructure Advisory blends the best global practices with analytical
excellence and a deep understanding of the local environment to provide policy,
regulatory and transaction level advice to governments and leading organisations across
sectors.
We work closely with our clients to facilitate an environment for public-private
partnerships and ensure the success of projects undertaken.

Investment and Risk Advisory

CRISIL Risk Solutions business provides integrated risk management solutions and
advice to Banks and Corporates by leveraging the experience and skills of CRISIL in the
areas of credit and market risk.
Taking cognisance of the market needs for integrated solutions that quantify and manage
complex risks, CRISIL Risk Solutions uses cutting-edge research and
methodologies. Also, the Group brings together the experience of all business teams to
offer modular or integrated solutions and advisory services that are customised to meet
client needs.
How they do it ?
At the core of our success are our unimpeachable credibility and unmatched analytical
rigour.

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CREDIT RATING IN BANKS

CRISIL is a professionally managed company. It has adopted the best global practices for
corporate governance, under the active guidance of a visionary Board of Directors
comprising distinguished, independent professionals of proven competence and integrity.
Focus on Human Capital
Technologically oriented
Focus on Human Capital
Our people are our key assets. CRISIL has an unrivalled skill base spanning its business
areas. Functional skills include financial modeling, risk modeling, credit and equity
research, sector-specific research, policy and transaction advisory, and database
management, among others. A strong contextual understanding of business and markets
underpins the application of these skills. CRISIL encourages a value-driven and
performance-based culture, which attracts the best talent from the marketplace.
On a consolidated basis, total headcount in the CRISIL group increased to 1902 till July
2008. The growth in headcount was primarily to meet the growing demand for talented
people across CRISIL businesses.
As a Standard & Poor's Company, CRISIL faces the challenges of crosscultural
communication. The shift being an India-centric workforce to global workforce has
brought with several advantages as well, for its employees.
CRISIL is technologically oriented, with a view to
Propel CRISIL to Leadership Position
Mesh business areas and applications using IT capabilities to create a seamless enduser experience
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CREDIT RATING IN BANKS

Empower Businesses to function anytime, anywhere

Provide Business Process Efficiency to Clients of CRISIL
Our Technology Experience is diverse
Infrastructure Management
Management of heterogeneous infrastructure Microsoft, Sun, Digital -- Management
of Wide Area Network Voice & Data
-- Providing 24x365 access of Business Applications through Citrix
Software Solutions -- Varied experience in application development ranging from
Work process automation to product development
-- Possess internal resources in varied technologies like VB, VC, ASP, Java, Oracle, SQL
Server, XML
-- Development and Management of diverse applications ranging from real-time news to
electronic desktop products

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CREDIT RATING IN BANKS

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CREDIT RATING IN BANKS

ECONOMIC IMPACT OF RATINGS

Another major policy concern regards the impact of ratings on capital flows and the
overall economic performance of developing countries. Critics of the agencies argue that
ratings have a large economic impact because they are procyclical. They claim that
ratings increase the magnitudes of the business cycles because sovereigns are upgraded
during expansionary periods and downgraded contractionary periods.

Moodys,

Standard & Poors, and Fitch all claim to rate with a view across the business cycle, and
therefore their ratings are not significantly affected by purely cyclical influences.
The foundation for this policy concern is the economic relationship between credit
ratings
plus changes in those ratings and overall economic growth. If accurate ratings can
come out ahead of movements in the financial markets, the ratings can be very useful in
curbing or dampening the current direction of capital. During an economic expansion,
hot money can travel quickly into an emerging market country. A downgrade during this
expansionary period would have a sobering effect on exuberant expectations, and in turn
this would reduce the likelihood of a country experiencing a boom-bust cycle. The same
is true for a ratings upgrade during an economic contraction. The upgrade would likely
reduce capital outflows and help the country to finance their recession with lower interest
rates.
Conversely, if the ratings are inaccurate or are behind financial markets, the speed of
capital flows will likely increase and exacerbate the cycle. A downgrade during a period
of contraction in developing countries will hurt businesses from gaining trade credits.
Portfolio managers may be forced to shed their holdings of the downgraded debt due to
legal requirements or investment policies. These effects are greatly accelerated once the
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CREDIT RATING IN BANKS

important threshold of investment grade rating has been crossed.

An upgrade during expansion will also speed up capital this time an inflow and may
create a dangerous level of over-lending to the sovereign. Over-lending is a possible
explanation to Moras (2001) conclusion that higher ratings have led to a higher
probability of a crash once other factors are controlled for.
Reisen (2002) believes that agencies are, in fact, behind markets because the agencies
primarily use publicly available data in making their ratings. By only using public
information, the agencies will remain behind the markets if the markets follow the
strong- form efficient market hypothesis. The transition matrices in Tables 8 and 9 show
the ratings movement after one year. The first matrix is during the 1991 recession while
the second matrix is during the 1998 expansion. Although not conclusive, we see a
greater percentage of downgrades during the recession, especially from ratings at and
below BBB.
The Asian Crises is one of the most frequently cited examples of rating agencies having
been procyclical. From June of 1997 to November of 1998 several Asian countries
received downgrades ranging from four to eight levels. Critics argue that the agencies
should have foreseen the economic problems and downgraded the countries before and
not during the crisis. The agencies responded by arguing that only after start of the crisis
did the ability and willingness of the countries deteriorate substantially.
Empirical evidence on whether ratings agencies are indeed procyclical have been mixed.
Ferri, Lui and Stiglitz (1999) concluded that rating agencies are procyclical. Based on
Cantor and Packers paper of sovereign rating determinants, Ferri, Lui and Stiglitz used a
sample of ten countries from 1989-1999 to create a model to explain ratings. The
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CREDIT RATING IN BANKS

outcome was that before the crisis, ratings on the East Asian countries were on average
higher than those based on a model of economic fundamentals. After the crisis the
ratings were much worse than what their model predicted. Korea and Thailand which
were given ratings of Ba1 (the top speculative grade for Moody's) should have never
have fallen below investment grade (Baa3 lowest investment grade for Moody's)
according to the model. The authors concluded that the rating agencies must have given
more weight toward the qualitative factors in the agencies assessments and these
qualitative factors are what cause the procyclical nature.

CONCLUSION
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CREDIT RATING IN BANKS

Ratings agencies do serve a purpose in financial markets. Their value in assessing

default risk and thereby affecting credit spreads plays a critical role in financial markets
and especially the flow of capital to developing countries. Improvements can be made
by encouraging more accurate ratings and requiring more timely ratings. Additional
improvement can come through investor education about the method and meaning of
credit ratings, and greater transparency by the agencies to level the playing field for all
investors. Increasing competition may be one strategy to increase investment and more
accurate ratings, but its potential negative consequences will need to be monitored and
supervised to prevent "rate shopping." Another strategy is to improve the NRSRO
designation process; a formal regulation for NRSRO status can provide more stringent
criteria for frequency of rating updates, disclosures, transparency and ethical practices.

RECCOMENDATION
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CREDIT RATING IN BANKS

Not all problems dealing with rating agencies can be easily solved or reconciled. Ratings
from NRSRO agencies are still the best independent source of credit risk and thus have
value in capital markets. Consequently, more attention should be placed in modifying
the process to reduce unwanted side effects rather than eliminating them all together.
The effects of procyclical behavior in ratings can be reduced through more frequent
ratings updates. More frequent announcements will reduce the impact of downgrades
and will reduce the time-lag by which ratings fall behind market events. It will also
induce rating agencies to investment more in analysts and coverage. Additionally, a
more frequent approach to rating changes and announcements will reduce the tendency
of rating changes to cause yields to overshoot from a change in a stale rating. Investors
will know that ratings should reflect current economic fundamentals.
An additional measure to reduce the impact of ratings is more transparency and public
disclosures. Greater transparency on behalf of the agencies will let investors become
aware of the details that influence the agencies decisions.
Investor can then more accurately reconcile the agencies' ratings with their own opinion
and not have to be blindly led by the agencies. In addition to the benefits accruing to
investors, an increase in transparency will also assist banks and governments in planning
to prevent a downgrade or to reduce the impact of a downgrade. For example, a bank
can anticipate a ratings downgrade of its assets by issuing capital or reducing capital
charges elsewhere. This will hopefully reduce or prevent a capital crunch or a liquidity
crisis. Investors and institutions that have prepared for a downgrade will need to react
less when it occurs and this will mitigate the forces of contagion.
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CREDIT RATING IN BANKS

Furthermore, the SEC and the rating agencies need to communicate with investors more
clearly that ratings do not indicate price risk or market risk of the security. Doing so will
reduce the weight investors place on ratings in their assessments. Ratings are merely a
forward looking assessment, based on current information, of the ability and willingness
of the debtor to fulfill its payment obligations it is not a forecast of future performance.
For example, exogenous shocks that might occur in the future are not reflected in the
ratings. Investors should be informed through disclosures that unforeseen policy changes
in other countries can affect a sovereigns ability to pay. Changes in U.S. monetary
policy, such as that in 1994 which had a strong impact on Mexico, can adversely affect
several countries but these countries' ratings do not incorporate forecasts of future U.S.
monetary policy.
Another policy recommendation concerns the need to assure equal access to information
by all investors while also protecting against the conflict of interest caused by debtors
and debt issuers paying for ratings. While charging an issuer for a rating is not ideal,
charging users creates other problems of asymmetric information between those with
more and less information about the rating decisions. It also can create problems with
free-riders since the ownership of the information cannot easily be protected and it is
easily disseminated to non-subscribers. The better policy is to charge the debtor or debt
issuer but require a "Chinese Wall" to separate marketing and sales from research and the
decision making process that assigns ratings. Also, rating agencies should not consult
and should have limits on other outside services to firms they are rating. Finally, senior
management of credit rating agencies should not be allowed to sit on boards of
companies that the agency rates.
The last recommendation is to formalize the NRSRO process. Although it is uncertain
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CREDIT RATING IN BANKS

whether the process will in fact create more competition, a more formal procedure does
have benefits. Having the exact criteria laid out will have other agencies qualifying or
making changes that will eventually allow them to qualify. This can create competition
or at least present a credible threat of entry. A more credible threat of entry will force the
existing firms to invest more into methods and areas of coverage including developing
counties. In order to further stimulate competition, the SEC should modify the NRSRO
requirements to allow regional agencies, especially those located in developing countries,
and smaller, less recognized agencies that have a historically validated record of judging
creditworthiness. Along with a formal process should come the authority to monitor and
evaluate the behavior of credit reporting agencies. Currently, the responsibility lies
within the agencies to report changes in structure or in the ratings process that affect their
NRSRO status; the SEC needs to have a more proactive and more formal role in this
process.

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CREDIT RATING IN BANKS

BIBLOGRAPHY
BOOKS AND REFERENCES
FINANCIAL SERVICE MANAGEMENT DIPAK ABHYANKAR.
FINANCIAL POLICY FORUM SPECIAL REPORT 6 GAUTAM SHETTY.
RANDALL DODD.
UNITED NATION CONFERENCE ON TRADE AND DEVELOPMENT(2008)
--DISCUSSION PAPERMARWAN ELKHOURY .
IMF WORKING PAPERAMADOU N.R.
WEBSITES
www.crisil.com/
www.cibil.com/

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