S.S.

COLLEGE OF
BUSINESS STUDIES

INTRODUCTION

Objective:

The objective of this study is to find out (a) the need of credit rating (b) how the
credit rating agencies function (c) the limitations of credit rating. An analysis of
credit rating is also included in the study.

CREDIT RATING-An Introduction

The role of financial markets in a market economy is that of an efficient

intermediator, mediating between savers and investors, mobilizing capital on hand
and efficiently allocating them between competing uses on the other. Such an
allocative role hinges crucially on the availability of reliable information.

The doctrine of “efficient market allocation” in fact has as its bedrock, what
economists label “ perfect information”. An investor in search of investment
avenues has recourse to various sources of information- offer documents of the
issuer(s), research reports of market intermediaries, media reports etc. In addition
to these sources, Credit Rating Agencies have come to occupy a pivotal role as
information providers, particularly for credit related opinions in respect of debt
instruments; a role that has been strengthened by the perception that their opinions
are independent, objective, well researched and credible.

The impetus for the growth of Credit Rating came from the high levels of default
in the US Capital markets after the Great Depression. Further impetus for growth
came when regulatory agencies began to stipulate that institutions such as
Government Pension Funds and Insurance Companies could not buy securities
rated below a particular grade.

Merchant bankers, underwriters and other intermediaries involved in the debt

market also found rating useful for planning and pricing the placement of debt

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instruments. The other factors leading to the growing importance of the credit
rating system in many parts of the world over the last two decades are

1. The increasing role of capital and money markets consequent to

disintermediation;

2. Increasing securitization of borrowing and lending consequent to

disintermediation;

3. Globalisation of the credit market; The continuing growth of information

technology;

4. The growth of confidence in the efficiency of the market mechanism: and

5. The withdrawal of Government safety nets and the trend towards

privatization.

It was this growing demand on rating services that enabled credit rating agencies to
charge issuers for their services. This was much in variance with the mode of
financing used hitherto-with no fees charged to the issuers, a credit rating agency
used to provide rating information through the sale of their publication and other
materials.

Historical perspective: The Origins

The origins of credit rating can be traced to the 1840’s. Following the financial
crisis of 1837, Louis Tappan established the first mercantile credit agency in New
York in 1841. The agency rated the ability of merchants to pay their financial
obligations. It was subsequently acquired by Robert Dun and its first rating guide
was published in 1859. Another similar agency was set up by John Bradstreet in
1849, which published a ratings book in 1857. These two agencies were merged
together to form Dun & Bradstreet in 1933, which became the owner of Moody’s
Investors Service in 1962. The history of Moody’s Investors Service, and in 1909
published his ‘Manual of Railroad Securities’. This was followed by the rating of

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utility and industrial bonds in 1914, and the rating of bonds issued by U.S cities
and other municipalities in the early 1920s.

Further expansion of the credit rating industry took place in 1916, when the Poor’s
Publishing Company published its first ratings, followed by the Standard Statistics
Company in 1922, and Fitch Publishing Company in 1924. The Standard Statistics
Company and the Poor’s Publishing company merged in 1941 to form Standard &
Poor’s.

Credit Rating: The Concept

Ratings, usually expressed in alphabetical or alphanumeric symbols, are a simple

and easily understood tool enabling the investor to differentiate between debt
instruments on the basis of their underlying credit quality. The credit rating is thus
a symbolic indicator of the current opinion of the relative capability of the issuer to
service its debt obligation in a timely fashion, with specific reference to the
instrument being rated. It is focused on communicating to the investors , the
relative ranking of the default loss probability for a given fixed income investment,
in comparison with other rated instruments.

A rating is specific to a debt instrument and is intended as a grade, an analysis of

the credit risk associated with the particular instrument. It is based upon the
relative capability and willingness of the issuer of the instrument to service the
debt obligations( both principal and interest) as per the terms of the contract. Thus
a rating is neither a general purpose evaluation of the issuer, nor an overall
assessment of the credit risk likely to be involved in all the debts contracted or to
be contracted by such entity.

The primary objective of rating is to provide guidance to investors/ creditors in

determining a credit risk associated with a debt instrument/credit obligation. It
does not amount to a recommendation to buy, hold or sell an instrument as at does
not take into consideration factors such as market prices, personal risk preferences
and other considerations which may influence an investment decision. The rating

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process is itself based on certain ‘givens.’ The agency, for instance, does not
perform an audit . Instead It is required to rely on information provided by the
issuer and collected by analysts from different sources, including interactions in-
person with various entities. Consequently, the agency does not guarantee the
completeness or accuracy of the information on which the rating is based.

The Use of Credit Rating

By Investors

For the investor, the rating is an information service , communicating the relative
ranking of the default loss probability for a given fixed income investment in
comparison with other rated instruments. In the absence of a credit rating system ,
the risk perception of a common investor vis-à-vis debt instruments largely
depends on his/her familiarity with the names of the promoters or the
collaborators. Such “name recognition”, often used to evaluate credit quality in the
underdeveloped markets can not be an effective surrogate for systematic risk
evaluation ; it suffers from a number of avoidable limitations it is not true that
every venture promoted by a well known name will be successful and free from
default risk. Nor is it true that every venture promoted by a relatively lesser known
entity is disproportionately risk prone. While on one hand , “name recognition “
restricts the options available to the investor, on the other it denies relatively lesser
known entrepreneurs access to a wider investor base. What is therefore required for
efficient allocation of resources is systematic risk evaluation. It is rarely, if ever,
feasible for the corporate issuer of debt instrument to offer every prospective
investor the opportunity to undertake a detailed risk evaluation. A professional
credit rating agency is equipped with the required skills, the competence and the
credibility, all of which eliminates, or at least minimizes, the role of ‘name
recognition’ and replaces it with well researched and scientifically analysed
opinions as to the relative ranking of different debt instruments in terms of their
credit quality. A rating provided by a professional credit rating agency is of
significance not just for the individual/small investor but also for an organized

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institutional investor. Rating for them provides a low cost supplement to their own
in-house appraisal system. Large investors may use credit rating spectrum of
investment options. Such investors could use the information provided by rating
changes, by carefully watching upgrades and downgrades and altering their
portfolio mix by operating in the secondary market. Banks in some developed
countries use the ratings of other banks and financial intermediaries for their
decisions regarding inter-bank lending, swap agreements and other counter-party
risks.

By Issuers

The benefit of credit rating for issuers stems from the faith placed by the market
on the opinions of the rating provided and the widespread use of ratings as a guide
for investment decisions. The issuers of rated securities are likely to have access to
a much wider investor base as compared to unrated securities , as a large section of
investors not having the required resources an skills to analyse each and every
investment opportunity would prefer to rely on the opinion of a rating agency.
The opinion of a rating agency enjoying investor confidence could enable the
issuers of highly rated instruments to access the market even under adverse market
conditions. Credit rating provides a basis for determining the additional
return( over and above a risk free return) which investors must get in order to be
compensated for the additional risk that they bear. They could be a useful
benchmark for issue pricing.

The differential in pricing would lead to significant cost savings for highly rated
instruments.

By Intermediaries

Rating is a useful tool for merchant bankers and other capital market
intermediaries in the process of planning, pricing, underwriting and placement of
issues. The intermediaries, like brokers and dealers in securities, could use rating
as an input for their monitoring of risk exposures. Regulators in some countries
specify capital adequacy rules linked to credit rating of securities in a portfolio.

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By Regulators

Regulatory authorities worldwide have promoted the use of Credit Rating by

issuing mandatory requirements for issuers. Specific rules, for instance restrict
entry to the market of new issues rated below a particular grade, stipulate different
margin requirements for mortgage of rated and unrated instrument and prohibit
institutional investors from purchasing or holding of instruments rated below a
particular level.

In India , credit rating has been made mandatory for issuance of the following
instruments:

a) as per the requirements of SEBI, public issue of debentures and bonds

convertible/redeemable beyond a period of 18 months need credit
rating;

b) as per the guidelines of RBI, one of the conditions for issuance of CP in

India is that the issue must have a rating not below the P2 grade from
CRISIL/A2 grade from ICRA/PR2 from CARE;

c) as per the guidelines of RBI , NBFCs having net owned funds of more
than Rs. 2 crore must get their fixed deposit programmes rated by 31st
March 1995 and the NBFCs having net owned funds of more than Rs
50 lacs(but less than 2 crore) must get their fixed deposit programme
rated by 31st March 1996. The minimum rating required by the NBFCs
to be eligible to raise fixed deposits are FA(-) from CRISIL/ MA(-)
from ICRA/BBB from CARE. Similar regulations have been introduced
by National Housing Bank(NHB) for housing finance companies also;

d) there is a proposal for making the rating of fixed deposit programmes of

limited companies, other than NBFCs also mandatory, by amendment of
the Companies Act,1956.

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Code of Conduct for Credit Rating Agencies

SEBI (Credit Rating Agencies) REGULATIONS,1999)

1) A credit rating agency in the conduct of its business shall observe high
standards of integrity and fairness in all its dealings with its clients.

2) A credit rating agency shall fulfill its obligations in an ethical manner.

3) A credit rating agency shall render at all times high standards of

service, exercise due diligence, ensure proper care and exercise
independent professional judgment. It shall wherever necessary,
disclose to the clients, possible sources of conflict of duties and
interests, while providing unbiased services.

4) A credit rating agency shall avoid any conflict of interest of any member
of its rating committee participating in the rating analysis. Any potential
conflict of interest shall be disclosed to the client.

5) A credit rating agency shall not indulge in unfair competition nor shall
they wean away client of any other rating agency on assurance of higher
rating.

6) A credit rating agency shall not make any exaggerated statement,

whether oral or written, to the client about its qualification or its
capability to render certain services or its achievements in regard to
services rendered to other clients.

7) A credit rating agency shall always endeavour to ensure that all

professional dealings ate effected in a prompt and efficient manner.

8) A credit rating agency shall not divulge to other clients, press or any
other party any confidential information about its clients, which has
come to its knowledge, without making disclosure to the concerned person
of the rated company/client.

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9) A credit rating agency shall not make untrue statement furnished to the
Board or to public or to stock exchange.

10) A credit rating agency shall not generally and particularly in respect of
issue of securities rated by it be party to—

(a) creation of false market;

(b) passing of price sensitive information to brokers, members of the

stock exchanges, other players in the capital market or to any
other person or take any other action which is unethical or unfair
to the investors.

11) A credit rating agency shall maintain an arm’s length relationship

between its credit rating activity and any other activity.

12) A credit rating agency shall abide by the provisions of the Act,
regulations and circulars which may be applicable and relevant to the
activities carried on by the credit rating agency.

Source: Notification No. S.O .547(E), dated 7-7-1999,issued by SEBI

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METHODOLOGY

Objective:

The main objective of this study is to find out how the Credit Rating Agencies
function, how they rate the instruments. The factors, which matter in the rating
process is also included in this study.

The secondary objective of this study is to find out the challenges being faced by
the rating agencies and what is being done to face it.

Research Design:

Descriptive Research is used in this study. The nature of this study is such that it
eradicates the necessary of doing primary research. Research has been done from
secondary sources of information.

Secondary sources of information:

 Credit Rating manuals from ICRA

 ICRA Information brochures

 Chartered Financial Analyst magazines

 ICFAI Reader magazine

 www.icraindia.com

 www.crisil.com

 www.businessstandard.com

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CREDIT RATING AGENCIES IN INDIA

The rating coverage in India is not too old, beginning 1987 when the first rating
agency, CRISIL was established. At present there are three main rating agencies –
CRISIL(Credit Rating and Information Services of India Ltd.),ICRA Ltd.
(Investment Information and Credit Rating Agency of India Limited) and
CARE(Credit Analysis and Research). The fourth rating agency is a JV between
Duff & Phelps, US and Alliance Capital Limited , Calcutta.

CRISIL:

It was promoted by ICICI, nationalized and foreign banks and insurance

companies in 1987. it went public in 1992 and is the only listed credit rating
agency in India. In 1996 it entered into a strategic alliance with Standard & Poor’s
to extend its credit rating services to borrowers from the overseas market. The
services offered are broadly classified as Rating, Information services ,
Infrastructure services and consulting.

Rating services cover rating of Debt instruments-long, medium and short term,
securitised assets and builders. Information services offer corporate research
reports and the CRISIL 500 index. The Infrastructure and consultancy division
provide assistance on specific sectors such as power, telecom and infrastructure
financing.

ICRA:

It was promoted by IFCI and 21 other shareholders comprising nationalized and

foreign banks and insurance companies. Established in 1991 , it is the second
rating agency in India. The services offered can be broadly classified as Rating
services , Advisory services and Investment Information services. The rating
services comprise rating of debt instruments and credit assessment. The Advisory
services include strategic counseling, general assessment such as restructuring
exercise and sector specific services such as for power, telecom, ports, municipal

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ratings , etc. The information or the research desk provides research reports on
specific industries, sectors and corporates. The Information services also include
equity related services, viz, Equity Grading and Equity Assessment. In 1996,
ICRA entered into a strategic alliance with Financial Proforma Inc. , a Moody’s
subsidiary to offer services on Risk

Management Training and software: Moody’s and ICRA has entered into a
memorandum, of understanding to support these efforts.

CARE:

It was set up in 1992, promoted by IDBI jointly with other financial institutions,
nationalized and private sector finance companies. The services offered cover
rating of Debt instruments and sector specific industry reports from the research
desk and equity research.

Market share

Marketshare of the different Credit Rating Agencies

in India

11% 2%
CRISIL
48% ICRA
CARE
39%
Duff& Phelps

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ICRA - A Detailed Study

Ministry of Finance, Department of Economic Affairs , vide its letter No. 1(120)
SE/89, dated the 19th Sept. 1990 accorded approval for the establishment of a
second Credit Rating and Information Agency in the country to meet the
requirements of companies based in North.

The approval was granted subject to the following conditions viz .

(1) The Agency shall be self-supporting after a maximum period of 2

years and accordingly shall not require any subvention thereafter from
IFCI;

(2) The agency should be managerially independent.

The major shareholders are:- Moody’s Investment Company India private Ltd.,
IFCI Ltd., SBI, LIC, UTI, PNB, GIC, Central Bank of India, Union Bank of India,
Allahabad Bank, United Bank of India, Indian Bank, Canara Bank, Andhra Bank ,
Export-Import Bank of India, UCO Bank HDFC Ltd., Infrastructure Leasing and
Financial Services Ltd., Vysya Bank.

The main objective of ICRA like any other Credit Rating Agency is to assess the
credit instrument and award it a grade consonant to the risk associated with such
instrument. ICRA’s main objectives include providing guidance to the
investors/creditors in determining the credit risk associated with a particular debt
instrument or credit obligation and reflecting independent, professional and
impartial assessment of such instruments/obligations. The ratings done by ICRA
are not recommendations to buy or sell securities but culminate symbolic indicator
of the current opinion of the relative capability of timely servicing of the debts and
obligations.

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RANGE OF SERVICES

The services offered by Credit Rating Agencies are as follows:-

1. Rating service—rating of bonds, debentures, Commercial Paper(CP),

certificates of deposit(CD), claim paying ability of insurance companies,
corporate governance, structured obligations.

2. Information service—provides sector/industry specific

studies/publications, corporate reports and mandate based studies
customized research.

3. Grading services—includes grading of Construction Entities, Real Estate

Developers & Projects and Mutual Fund schemes.

4. Advisory services—it offers wide ranging management advisory services

covering the areas of Strategy practice, Risk Management practice,
Regulatory practice and Transaction practice.

RATING SERVICE

Credit Rating

The ICRA rating is a symbolic indicator of the current and prospective opinion on
the relative capability of the corporate entity concerned to timely service debts and
obligations with reference to the instrument rated. The rating is based on an
analysis of the information and clarifications obtained from the entity , as also
other sources considered reliable by ICRA. The independence and professional
approach of ICRA ensure reliable, consistent and unbiased ratings. Ratings
facilitate investors to factor credit risk in their investment decisions. ICRA rates
long-term, medium-term and short-term debt instruments. ICRA offers its rating
services to a wide range of issuers including:

 Manufacturing companies

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 Banks and financial institutions

 Power companies

 Service companies

 Municipal and other local bodies

 Non-banking financial service companies.

Structured Finance Rating

Structured finance ratings (SFRs) are based on the estimation of the expected loss
to the investor on the rated instrument, under various possible scenarios. The
expected loss is defined as the product of probability of default and severity of
loss, once the default has occurred. An SFR symbol indicates the relative level of
expected loss for that instrument, with the risk of loss being similar as in the case
of a corporate credit rating of the same level. However, an SFR may be different
from the credit rating of the issuer as in many cases the transaction is structured as
an off-balance sheet item. ICRA’s four major SFR products are listed below. ICRA
employs a specific methodology for each of its SFR products. The methodology is
based on ICRA’s understanding of that particular asset class and the structured and
legal issues associated with the transaction involved.

 Asset Backed Securitization(ABS) - ABS refers to the securitisation of a

diversified pool of assets, which may include financial assets like automobile
loans, commercial vehicle loans, consumer durable loans or any other non-
financial class of assets that are identifiable and separable from the operations
of the issuer and whose risk of loss is measurable.

 Mortgage Backed Securitisation (MBS) An MBS has diversified

housing loans as the underlying asset for the transaction.

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 Collateralised Debt Obligation (CDO) A CDO transaction has a

pool of corporate loans, bonds or any other debt security, including
structured debt, as the underlying asset.

 Future Flow Transaction (FFT) FFTs involve devising a structure

where specified sources of future cash flows are identified are earmarked
for servicing investors. Some examples of such sources are property tax
revenues of municipal corporations, power receivables of bulk consumers
and property lease rentals. FFTs are not completed de-linked from the
credit risk of the issuer, but the structure, through preferential tapping of
cash flows of the issuer can achieve a rating that is higher than the issuer’s
credit rating.

The Benefits

An issuer can derive multiple advantages from structured finance products like
lowering the cost of funds, accessing new markets and investors on the
strength of a higher rating vis-à-vis a stand-alone corporate credit rating,
improving capital adequacy, reducing asset-liability mismatches and
increasing specialization.

Claims Paying Ability Rating (for Insurance companies)

ICRA’s claims paying ability ratings (CPRs) for insurance companies are an
opinion on the ability of the insurers concerned to honour policy-holder claims and
obligations on time. In other words a CPR is ICRA’s opinion on the financial
strength of the insurer, from a policy-holder’s perspective. Following deregulation,
a paradigm shift is expected in the domestic insurance sector as newer players and
products enter the market. Given this scenario, ICRA expects its CPRs to be an
important input influencing the customer’s choice of insurance companies and
products. ICRA’s rating process involves analysis of an insurer’s business
fundamentals and its competitive position and focuses primarily on the insurer’s
franchise value, its management, organizational structure/ownership and
underwriting and investment strategies. Besides, the analysis includes an

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assessment of an insurance company’s profitability, liquidity, operational and

financial leverage, capital adequacy and asset / liability management method.

Corporate Governance Rating

ICRA’s Corporate Governance Rating(CGR) provides a current opinion on the

level to which an organization accepts and agrees to codes and guidelines of
corporate governance practices that serve the interests of stakeholders such as
shareholders, customers, creditors, bankers, employees, government and society at
large. The aspects examined during a CGR exercise include: ownership structure;
financial stakeholder relation; financial transparency & information disclosure; and
Board structure & process. A CGR , carrying the ICRA stamp, helps the corporate
entity concerned in raising funds; listing on stock exchanges; dealings with third
parties like creditors; providing comfort to regulators; improving
image/credibility; improving its valuation; and bettering its corporate governance
practices through benchmarking.

GRADING SERVICES
The grading services of ICRA include

---Grading of Construction Entities

---Grading of Mutual Fund Schemes

Grading of Construction Entities

The unique grading methodology developed by ICRA, along with the

Construction Development Industry Council(CIDC) encompasses all the entities
in a construction project, the contractor, the consultant, the project owner and the
project itself. The service of grading, by providing an independent opinion on the
quality of the entity graded , is designed to enhance the lender’s confidence in
financing construction sector participants.

Grading of Mutual Fund Schemes

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ICRA’s grading of Mutual Funds seeks to address the perceived need among
investors and intermediaries for an informed, reliable and independent opinion on
the performance and risks associated with investing in individual Mutual Fund
Schemes. Specifically the gradings are opinions on the relative past-performance
of Mutual-Fund schemes and the various factors that can influence their future
performance.

ICRA Mutual Fund Grading services include:

 Performance Grading
 Credit Risk Grading
 Market Risk Grading

ADVISORY SERVICES

RISK MANAGEMENT PRACTICE

The Risk Management Practice advises clients on efficient management of credit

risks, market risks, and operational risks. ICRA’s clients include commercial
banks, financial institutions, multi-lateral agencies, non-banking finance
companies, project financiers, equity investors, venture capital firms, insurance
firms and manufacturing firms. For manufacturing and service companies, ICRA
Advisory offers consultancy in risk management, planning and control.

Counterparty risk assessment: ICRA Advisory has developed “Counterparty Risk

Assessment”(CPRA) to assess risks that counterparties are exposed to in the course
of buying and selling of goods and services in all kinds of marketplaces. CPRA is a
relative measure of counterparty’s ability to honour the terms of trade. ICRA
Advisory offers CPRA as an on-line plug and play model for e-
marketplaces/Virtual Private networks, and as an off-line facility for organizations
desiring to assess counter party risks of buyers/dealers and suppliers.

Credit Risk

 Regulatory compliance

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 Processes/systems for credit risk management

 Internal risk rating systems

 Credit monitoring systems(including MIS)

 Moody’s software for credit risk management

 Organization design for risk management

 Portfolio management

 Industry and corporate reports

 Credit risk culture assessment

Market risk

 Regulatory compliance

 Asset-liability management

 Interest rate/liquidity/currency risks

 Hedging strategies

 Transfer pricing

 Software for ALM

 Integrating ALM with overall planning

Training for Risk management

 Analyzing financial statements-basic/advanced

 Credit risk management-middle/senior executives

 Understanding ALM

 Customized training for bankers

Operating Risk

 Diagnostic analysis of risk for a company

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 Systems for risk measurement

 Risk mitigation strategies

 Internal control and corporate governance

REGULATORY PRACTICE

ICRA advisory Services focuses on issues concerned with economic aspects of

regulation. Instances of the regulatory practice would be assisting in policy
formulation with regard to pricing of public goods, competition, efficient market
making mechanisms, consumer protection and fair trade practices , subsidies and
public-private partnership structures. Clients of regulatory practice are
Governments, regulatory authorities and municipalities who formulate economic
and financial policies. ICRA also work with corporate entities in formulating their
strategies in dealing with regulatory issues.

ICRA advisory Services has worked on several consulting projects concerning

regulatory issues in the areas of power, water, public sector, banking
and urban infrastructure.

Functional Areas

 Tariff setting for public goods and services

 Economic development

 Development of regulations

 Fiscal management policies

 Privatization policies

 Institutional strengthening

 Determining of subsidies

 Evaluation of contracts & agreements

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RATING PROCESS

Rating is an interactive process with a prospective approach. It involves series of

steps. The main points are described below:

(a) Rating request: Ratings in India are initiated by a formal request

(or mandate) from the prospective issuer. This mandate spells out the
terms of the rating assignment. Important issues that are covered include:
binding the credit rating agency to maintain confidentiality, the right to the
issuer to accept or not to accept the rating and binds the issuer to provide
information required by the credit rating agency for rating and subsequent
surveillance.

(b) Rating team: The team usually comprises two members. The
composition of the team is based on the expertise and skills required for
evaluating the business of the issuer.

(c )Information requirements: Issuers are provided a list of information

requirements and the broad framework for discussions. The requirements are
derived from the experience of the issuers business and broadly conform to all
the aspects which have a bearing on the rating.

(d)Secondary information: The credit rating agency also draws on the

secondary sources of information including its own research division.

The credit rating agency also has a panel of industry experts who provide
guidance on specific issues to the rating team. The secondary sources generally
provide data and trends including policies about the industry.

(e)Management meetings and plant visits: Rating involves assessment of

number of qualitative factors with a view to estimate the future earnings of the
issuer. This requires intensive interactions with issuers’ management
specifically relating to plans, future outlook, competitive position and funding
policies.

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Plant visits facilitate understanding of the production process, assess the state
of equipment and main facilitates, evaluate the quality of technical personnel
and form and opinion on the key variables that influence level, quality and cost
of production. These visits also help in assessing the progress of projects under
implementations.

(f)Preview meeting: After completing the analysis, the findings are discussed
at length in the internal committee, comprising senior analysts of the credit
rating agency. All the issues having a bearing on the rating are identified. At
this stage, an opinion on the rating is also formed.

(g)Rating committee meeting: This is the final authority for assigning ratings.
A brief presentation about the issuers business and the management is made
by the rating team. All the issues identified during discussions in the internal
committee are discussed. The rating committee also considers the
recommendations of the internal committee for the rating. Finally a rating is
assigned and all the issues, which influence the rating, are clearly spelt out.

(h)Rating communication: The assigned rating along with the key issues is
communicated to the issuer’s top management for acceptance.

The ratings which are not accepted are either rejected or reviewed. The rejected
ratings are not disclosed and complete confidentiality is maintained.

(i)Rating reviews: If the rating is not accepted to the issuer , he has a right to
appeal for a review of the rating. These reviews are usually taken up only if
the issuer provides fresh inputs on the issues that were considered for assigning
the rating. Issuers response is presented to the Rating Committee. If the inputs
are convincing, the Committee can revise the initial rating decision.

(j)Surveillance: It is obligatory on the part of the credit rating agency to

monitor the accepted ratings over the tenure of the rated instrument. As has
been mentioned earlier, the issuer is bound by the mandate letter to provide
information to the credit rating agency. The ratings are generally reviewed
every year, unless the circumstances of the case warrant an early review. In a

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surveillance review the initial rating could be retained or revised(upgrade or

downgrade) . The various factors that are evaluated in assigning the ratings
have been explained under rating framework.

ICRA’s Rating Process

An Overview

Mandate

Initial Stage
Assign Rating Team

Receive initial information

Conduct basic research

Fact findings and

analysis
Meetings and visits

Analysis and Preparation of Report

Purview Meeting Rating Finalisation

Rating Meeting Fresh inputs/Clarifications

Assign Rating

Communicate the rating and Request for Review

rationale

Acceptance Non Acceptance

Surveillance

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BUSINESS STUDIES

RATING FRAMEWORK

The basic objective of rating is to provide an opinion on the relative credit risk (or
default risk) associated with the instrument being rated. This in a nutshell includes,
estimating the cash generation capacity of the issuer through operations (primary
cash flows) vis-à-vis its requirements for servicing obligations over the tenure of
the instrument. Additionally , an assessment is also made of the available
marketable securities(secondary cash flows) which can be liquidated if require d,
to supplement the primary cash flow may be noted that secondary cash flows have
a greater bearing in the short term ratings , while the long term ratings are
generally entirely based on the adequacy of primary cash flows.

All the factors whish have a bearing on future cash generation and claims that
require servicing are considered to assign ratings. These factors can be
conceptually classified into business risk and financial risk drivers.

Business risk drivers

• Industry characteristic

• Market position

• Operational efficiency

• New projects

• Management quality

Financial risk drivers

• Funding policies

• Financial flexibility

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Industry characteristics: This is the most important factor in credit risk

assessment. It is a key determinant of the level and volatility in earnings of
any business. Other factors remaining the same , industry risk determines the
cap for ratings. Some of the factors that are analyzed include:

Demand factors

• Drivers & potential

• Nature of product

• Nature of demand-seasonal, cyclical

• Bargaining position of customers

State of competition

• Existing & expected capacities

• Intensity of competition

• Entry barriers for new entrants

• Exit barriers

• Threat of substitutes

Environmental factors

• Role of the industry in the economy

• Extent of government regulation

• Government policies-current and future direction

Bargaining position of suppliers

• Availability of raw material

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• Dependence on a particular supplier

• Threat of forward integration

• Switching costs

For credit risk evaluation , stable businesses(low industry risk) with lower level of
cash generation are viewed more favorably compared to business with higher cash
generation potential but relatively higher degree of volatility.

It needs to be mentioned that with the opening up of the Indian economy, it is also
critical to establish international competitiveness both at the industry and unit
level.

Market position : All the factors influencing the relative competitive position of
the issuer are examined in detail. Some of these factors include positioning of the
products , perceived quality of products or brand equity, proximity to the markets,
distribution network and relationship with the customers. In markets where
competiveness is largely determined by costs, the market position is determined
by the unit’s operational efficiency. The result of these factors is reflected in the
ability of the issuer to maintain/ improve its market share and command
differential in pricing. It may be mentioned that the issuers whose market share is
declining, generally do not get favourable long term ratings.

Operational efficiency : In a competitive market , it is critical for any business

unit to control its costs at all levels. This assumes greater importance in commodity
or “ me too” businesses, where low cost producers almost always have an edge.
Cost of production to a large extent is influenced by:

• Location of the production units

• Access to raw materials

• Scale of operations

• Quality of technology

• Level of integration

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• Experience

• Ability of the unit to efficiently use of its resources

A comparison with the peers is done to determine the relative efficiency of the
unit. Some of the indicators for measuring production efficiency are:- resource
productivity, material usage and energy consumption. Collection efficiency and
inventory levels are important indicators of both the market position and
operational efficiency.

New project risks : The scale and nature of new projects can significantly
influence the risk profile of any issuer. Unrelated diversifications into new
products are invariably assessed in greater detail.

The main risks from new projects are:-Time and cost overruns, even non-
completion in an extreme case, during construction phase; financing tie-up;
operational risks; and market risk.

Besides clearly establishing the rationale of new projects, the protective factors
that are assessed include: track record of the management in project
implementation, experience and quality of the project implementation team,
experience and track record of technology supplier, implementation schedule,
status of the project, project cost comparisons, financing arrangements, tie-up of
raw material sources , composition of operations team and market outlook and
plans.

Management quality : The importance of this factor can not be overemphasized.

When the business conditions are adverse , it is the strength of management that
provides resilience. A detailed discussion is held with the management to
understand its objectives, plans & strategies, competitive position and views about
the past performance and future outlook of the business.

These discussions provide insights into the quality of the management. It also
helps in establishing management’s priorities. A review of the organization

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structure and information system is done to assess whether it aligns with the
management’s plans and priorities. The interactions with key operating personnel
help in determining the quality of the management. Issues like dependence on a
particular individual and succession planning are also addressed.

Funding policies :This determines the level of financial risk. Management’s views
on its funding policies are discussed in detail. These discussions are generally
focused on the following issues:

• Future funding requirements

• Level of leveraging

• Views on retaining shareholding control

• Target returns for shareholders

• Views on interest rates

• Currency exposures including policies to control the currency risk

• Asset-liability tenure matching

Financial flexibility : While the primary source for servicing obligations is the
cash generated from operations, an assessment is also made of the ability of the
issuer to draw on other sources, both internal(secondary cash flows) and external,
during periods of stress.

These sources include: availability of liquid investments, unutilized lines of credit,

financial strength of group companies, market reputation, relationship with
financial institutions and banks, investor’s perceptions and experience of tapping
funds from different sources.

Past financial performance : The impact of the various drivers is reflected in the
actual performance of the issuer. Thus , while the focus of rating exercise is to
determine the future cash flow adequacy for servicing debt obligations, a detailed
review of the past financial statements is critical for better understanding of the
influence of all the business and financial risk factors.

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Evaluation of the existing financial position is also important for determining the
sources of secondary cash flows and claims that may have to be serviced in future.

Accounting quality : Consistent and fair accounting policies are a pre-requisite

for financial evaluation and peer group comparisons. It may be mentioned that
accounting quality is also an important indicator of the management quality.
Rating analysts review the accounting policies, notes to accounts and auditors
comments in detail. Wherever necessary, rating analysts adjust the financial
statements to reflect the correct position. Over a period of time the focus of
financial analysis at the credit rating agency has shifted towards evaluation of cash
flow statements as cash flows to a large extent offset the impact of “financial
engineering”.

Indicators of financial performance: Financial indicators over the last few years
are analyzed and performance of the issuer is compared with its peers.
Comparison with peers is important for better understanding of the industry
trends and determining the relative position of the issuer. Some of the
important indicators that are analyzed are presented below:

Profitability : A traditional indicator of success or failure of any business

endeavor has been its ability to add to its wealth or generate profits. A few
important indicators are trends in:

• Return on capital employed

• Return on net worth

• Gross operating margins

Higher profitability implies greater cushion to debt holders. Profitability also

determines the market perception which has a bearing on the support of share
holders and other lenders. This support can be an important factor during stress.

Gearing or level of leveraging : This is an important determinant of the financial

risk. Some important indicators are:

• Total debt as a % of net worth

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• Long term debt as a % of net worth

• Total outside liabilities as a% of total assets

It needs to be emphasized that business risk is a prime driver, while gearing has a
secondary role in determining the overall rating.

Coverage ratios : Considered to be of primary importance to the debt holders. The

important ratios are:

• Interest coverage ratio(OPBIT/Interest)

• Debt service coverage ratio

• Net cash accruals as a % of total debt

The level of these ratios reflects the result of business risk drivers and the funding
policies. Generally speaking, higher the level of coverage, higher is the rating.
However as mentioned earlier , business with lower level of coverage can get
higher ratings if the earnings are steady.

Liquidity position : The indicators of liquidity positions are , the levels of:

• Inventory

• Receivables

• Payables

The state of competition , issuer’s market position & policies , relationship with
customers and suppliers arte the important factors that impact the above levels.

Comparison with peers on these indicators helps to determine the relative position
of the issuer in the industry. The funding profile with respect to matching of asset –
liability tenures also has an important bearing on the liquidity position.

Cash flow analysis : Cash is required to service obligations. Thus, any financial
evaluation would be incomplete if cash flow analysis is not carried out.

Cash flows reflect the sources from which cash is generated and it is deployed.

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Cash flows offset the impact of diverse accounting policies and hence facilitate
peer comparison.

Future cash flow adequacy : The ultimate objective of the rating is to determine
the adequacy of cash generation to service obligations. Number of assumptions
based on the future outlook of the business is made to draw projections of financial
statements. Invariably, the financial projections are carried out for a number of
scenarios incorporating a range of possibilities in the set of assumptions for the key
cash flow drivers. A few important drivers are expectations of growth , selling
prices, input costs, working capital requirements, value of currencies.

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Rating Scale by ICRA

Long-Term –including Debentures

LAAA : Highest safety. Indicates fundamentally strong

position. Risk factors are negligible. There may
be circumstances adversely affecting the degree
of safety but such circumstances, as may be
visualized are not likely to affect the timely
payment of principal and interest as per terms.

LAA+ High safety. Risk factors are modest and may vary
slightly. the protective factors are strong and the
LAA
prospect of timely Payment of principal and interest

LAA - as per terms under adverse circumstances, as may be

visualized, differs from LAAA only marginally.

LA+ Adequate safety. Risk factors are more variable

and greater in periods of economic stress. The
LA
protective factors are average and any adverse

LA- change in circumstances, as may be visualized,

may alter the fundamental strength and affect the
timely payment of principal and interest as per
terms

LBBB+ : Moderate safety. Considerable variability in risk

factors. The protective factors are below average.
LBBB
Adverse changes in business /economic

LBBB- circumstances are likely to affect the timely

payment of principal and interest as per terms

LBB+ Inadequate safety. The timely payment of interest

and principal is more likely to be affected by present
LBB
or prospective changes in business/economic

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LBB- circumstances. The protective factors fluctuate in

case of changes in economy/business conditions.

LB+ : Risk-prone. Risk factors indicate that obligations

may not be met when due. The protective Factors
LB
are narrow. Adverse changes in business/ economic

LB- conditions could result in inability/unwillingness to

service debts on time as per terms.

LC+ : Substantial risk. There are inherent elements of risk

and timely servicing of debts/obligations could be
LC
possible only in case of continued existence of

LC- favourable Circumstances.

LD : Default. Extremely speculative. Either already in

default in Payment of interest and/or principal as per
terms or expected to default. Recovery is likely only
on liquidation or re-organisation.

Medium-Term –including Fixed Deposit Programmes

MAAA : Highest Safety. The prospect of timely servicing of

the Interest and principal as per terms is the best.

MAA+ : High safety. The prospect of timely servicing of the

interest and principal as per terms is high, but not as
MAA
high as in ‘MAAA’ rating.

MAA-

MA+ : Adequate safety. The prospect of timely servicing of

the interest and principal as per terms is adequate.
MA
However, debt servicing may be affected by adverse

MA- changes in the business/economic conditions.

MB+ : Inadequate safety. The timely payment of interest

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MB and principal is more likely to be affected by future

uncertainties.
MB-

MC+ : Risk prone. Susceptibility to default is high. Adverse

changes in business/economic conditions could
MC
result in inability/unwillingness to service debts on

MC- time and as per terms.

MD : Default. Either already in default or expected to

default.

Short-Term –Commercial Paper

A1+ : Highest safety. The prospect of timely payment of

debt/ obligation is the best.
A1

A2+ : High safety. The relative safety is marginally lower

than in A1 rating.
A2

A3+ : Adequate safety. The prospect of timely payment of

interest and installment is adequate, but any adverse
A3
change in business/economic conditions may affect
the fundamental strength.

A4+ : Risk prone. The degree of safety is low . likely to

default in case of adverse changes in
A4
business/economic conditions.

A5 : Default. Either already in default or expected to

default.

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RATING OF STRUCTURED OBLIGATION

Structured Obligation (SO) or Structured Finance is a term that is applied to a

wider variety of debt instruments wherein the repayment of principal and interest is
backed by:

• Cash flows from sense • Credit enhancement from a

financial assets and/or third party.

The process of converting financial assets (loans, receivables, etc.) into tradable
securities is generally referred to as ‘securitization’ and the securities thus created
are referred to as ‘asset backed securities’(AIS).

A cash flow structure is the one in which some or all of the cash flows generated
by the identified assets are dedicated for the payment of principal and interest. The
cash flows to the investors are secured primarily by cash flows from the specific
pool of assets.

Credit Enhancement’ is a form of protection against collateral losses. Examples

include-letter of credit, guarantee, cash reserve account, over collateralization, etc.

A structured obligation can be considered as variation of conventional secured debt

instrument wherein the credit quality of debt obligation is backed by a lien on
identified assets or credit support from third party. In conventional debt
instruments the income/profits made by the company remain the primary source of
debt servicing. However, in the case of structured obligations, a repayment
mechanism is devised in such a way that the debt servicing is taken over by a
specific pool of assets or by a third party which acts as a credit support provider.

Advantages of securitisation

The main advantages of securitisation for companies holding financial assets are
listed below:

(a) Increased Liquidity: relatively illiquid assets are converted into tradable
securities.

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(b) Risk Diversification: securitisation allows the issuer to manage its credit
exposure to a particular borrower/sectors and thus helps in risk diversification
of asset portfolios.

(c) Higher Credit Quality: the structure of the instrument can be tailored in such a
manner that a desired credit rating, which is higher than the rating of
company holding the assets is achieved.

(d) Asset Liability Management: securitisation offers an efficient way of tenure

matching of assets and liabilities.

(e) Funding Sources: securitisation allows the issuer to find alternate sources of
funding and also raise funds at low costs with improved credit rating.

CASH FLOW STRUCTURE

Borrower of Company holding

assets financial assets
LENDER
loan
repayments Transfer of Payment for
assets assets

loan
Servicer repayments Issuer Spl Credit
Purpose Support
Vehicle
Principal &
Issues Interest Payment
Securities payments for
Securities

Investors

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The Steps in Securitisation Transaction

Step1: Origination-Lender (Banks, NBFCs, etc.) makes a loan to a

borrower for purchase of an asset(car, property, etc.)

Step2: Pooling-Large number of homogenous loans are aggregated or

packaged into a pool. The maturities and interest rates of pooled loans are
generally the same.

Step3: Sales/Transfer –Sale (or transfer ) of assets from originator to an entity that
is generically referred to as a ‘Special Purpose Vehicle” or SPV. An SPV may be a
trust, a special purpose bankruptcy remote company or a public sector entity.

Step4: Credit Enhancement-Protection against the failure of borrower to make

interest and principal payments on the loans. Examples include letter of credit,
financial guarantee from a third party, cash collateral or over-collateralisation.

Step5: Issue of ABS –SPV issues securities to investors and the proceeds from the
issuance are used to pay the originator for the pool of loans.

Some Conditions for Securitisation

A structured obligation is highly beneficial for issuers who are in a position to

’structure’ appropriate levels of credit protection so that they achieve the desired
credit rating. The conditions under which a securitisation transaction is highly
suited for issuers are:

• the availability of clearly identifiable and homogenous pool of assets;

• relatively predictable stream of cash flows from the identified assets;

• a positive interest rate spread which is defined as the difference between

interest earned on the assets and the interest plus servicing costs of security;

• the presence of full credit support in the structure.

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Rating Methodology

Credit ratings plays a very important role in the issuance of structured debt
instruments. The structure of the instruments is generally quite complex which
makes the task of assigning the credit risk extremely difficult for lay investors.

Credit ratings provide a simple and objective assessment of default risk in the form
of a symbolic indicator which is easy to comprehend. The framework used for
assessing the risk of default involves assessment of three types of risk-credit risk,
structured risk and legal risk.

a) Credit Risk: It is the risk of default by the borrower. It refers to the

uncertainty regarding the extent to which the borrowers of underlying
assets backing the security will pay as per terms of contract. The factors
considered in assessment of credit risk are:

• credit risk characteristics of the underlying pool of assets;

• key factors that influence the incentive and ability of borrowing to

pay off their loans;

• pool selection process;

• future performance of the selected pool;

b) Structured Risk: It refers to the manner in which the transaction is

structured to direct the payment stream from the collateral or support
provides to the investors. Assessment of structural risk includes the
following factors:

• analysis of credit support provider;

• evaluation of the size of enhancement and the change in size over time,
trigger events;

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• analysis of liquidity facilitates in structures wherein cash inflows do not

match the payments to the investors;

• third party risk which is the risk of non-performance of the various parties
such as receiving and paying agent, trustees, etc who are involved in the
transaction;

c) Legal Risk: It refers to the risk of potential insolvency of the issuer or

other parties involved in securitisation transaction. Assessment of legal risk
includes:

• Evaluation of the manner in which the rights of the assets are

transferred to investors.

• Legal enforceability of cash flows structure under various Scenarios

• Compliance with various laws and regulations

Thus credit rating of a structured obligation is a forward-looking measure of

relative safety level of the structural transaction against credit loss that may occur
over the life of the instrument.

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RATING INADEQUACIES
Rating agencies by making information widely available at a low cost have
increased market efficiency radically over the last few decades. However, in the
credit rating business, unlike any other business, the issuers of information do not
pay for it. It is so because though investors, financial intermediaries and other end
–users use the results of the rating agencies, they actually do not pay for it. The
issuer of the financial instruments whose information is disclosed by the rating
agency actually pays it . this is the basic source of revenue of the rating agencies.
This aspect makes the rating business a different animal. The potential for conflict
of interest facing rating agencies is thus inherent.

Diversification:

Traditionally, the agencies used to gather and analyse all sorts of pertinent
financial and non-financial information. Then they used to utilize it to provide
a rating of the intrinsic value or quality of a security. This was considered as a
convenient way for investors to judge quality and make investment decisions.
However, they were not the only source of information. Market based ratings
provided by market analysts outside the purview of the rating agencies, also
performed about as well as the agency ratings. This eventually posed
challenges to the rating agencies and emerged as a potential threat.

Rating agencies sell information and survive, based on their ability to accumulate
and retain reputation capital. However , once regulation is passed that makes it
mandatory for a company to incorporate ratings, rating agencies begin to sell
not only information but also valuable property rights associated with
compliance of regulation. This again accentuates the possibility of the rating
agencies to exploit the regulation. Though the rating agencies will never
force any company to buy their information, the companies will always try to
oblige the rating agencies by buying them. As the sale of these products
generates revenues the rating agencies will not be willing to lose them. There
lies the potential conflict of interest. If the companies buy the services of the

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rating agencies , irrespective of the quality aspect, then the reward they expect
is definitely a better rating.

Both CRISIL, ICRA have diversified into the consultancy business, after
perceiving the potential threat and partly foreseeing the saturation of the
market for new rating business. Presently both the rating giants provide a well
– diversified portfolio of risk-consultancy services. Over the past two
decades. The risk –consultancy services of Moody’s has become a leading
provider to investors, financial analysts and other end-users in managing the
risk in portfolios of credit exposures to both private and public companies. It
allows credit risk professionals to employ Moody’s ratings and credit history
experience to better measure and manage credit risk, to price credit risk, to
identify industry and geographic concentrations , and to measure the impact of
the prospective purchases or sale of debt within a portfolio context. The
international practice is being replicated in India on an increasing basis by
ICRA and CRISIL given the fact that Moody’s and S&P hold stakes in each
of them respectively.

In the aftermath of the Enron debacle , allegations have been raised against the
rating agencies for not being prompt in identifying the Enron debacle. It has been
opined by various people that had the rating agencies been quick in envisaging the
company’s bankruptcy, many investors would have saved themselves from burning
their hands.

Holier than thou approach

The rating agencies defending themselves, say that their job is to portray the true
picture of the riskiness associated with a bond and its likelihood of default in the
long run. The possibility of the rating agencies being jittery of revealing shoddy
financial statements hiding actual transaction cannot be ruled out. With Enron , it
is possible that they thought it better to think twice before having the courage to
say that the emperor is not wearing any clothes. And that took time to downgrade
the company.

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CONCLUSION

Credit Rating in India is a concept with not too long a history. Given its
significance as an information provider and facilitator for the efficient allocation of
resources by the financial market, credit rating services will continue to occupy a
place of significance in our growing economy. The success of the system will
ultimately hinge on the presentation of credibility and integrity by the concerned
agencies.

The rating agencies faces a lot of challenges specially after the Enron debacle.
Allegations have already been raised against the rating agencies for not doing
their job. As the credit rating agencies have to maintain their own reputation for
their survival, it becomes imperative to them to remain extremely alert to the
developments both in the market and within companies.

Mr. Clifford Griep, Chief Credit Officer, S&P says “ Many changes are underway,
including publishing commentary more frequently so that the markets hear from
us after routine events such as earning calls and management changes.” According
to him , the forward looking commentary will enable the investor to identify “
credit cliff situations” and the change in the credit worthiness of companies over a
period of time. The fast changing economic scenario, increased global competition,
high volatility among investment grade credits and securities price behavior has
fueled the demand for a more complete and rigorous surveillance and commentary
from rating agencies.

However , the flipside of prompt down(or up) gradation by the rating agencies
henceforth , will increase the volatility in the stock prices, to a grate extent. It may
also lead to a loss of long-term focus of credit rating.

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Another issue that asks for introspection is how the credit rating agencies account
for off-balance sheet deals and the degree of financial disclosure of the company
they rate.

The rating agencies must put more focus on the information related to the off-
balance sheet transactions. Clearly, lesser the transparency in financial disclosure,
more is the possibility of surprises to investors. The rating agencies should more
promptly identify companies trying to suppress financial information.

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BIBLIOGRAPHY

1. Verma J.C/ Credit Rating(Practice & Procedure), New Delhi, Bharat

Publishing House.

2. SEBI Manual, Taxmann

3. Credit Rating, ICRA ,

4. “Risky Conflicts,” Chartered Financial Analyst,

5. “Rating-Knotty issues,” Chartered Financial Analyst,

6. www. icraindia.com

7. www.crisil.com

8. www.businessstandard.com

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PREFACE

This study was undertaken to understand the functioning of credit rating agencies,
their role and impact in the capital market in India. Credit Rating agencies ,
worldwide has evolved over the years. It was started by rating the ability of
merchants to pay their financial obligations and that of Railroad Securities.
Nowadays the items that are rated include debt, instruments issued by
manufacturing companies, commercial banks, NBFC’s, FI’s, PSU’s and
municipalities; structured obligation; Corporate Governance; Claim paying ability
of Insurance Companies; Construction Entities; Real Estate Developers & Projects;
and Mutual Fund Schemes.

Credit Rating is a boon for the common investors in terms of information which
are not always accessible to them and also for the issuers as it helps them to build a
credibility and helps them to raise funds from the market at a cheaper rate.

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CONTENTS

Introduction
--Objective
--Historical Origin
--Concept of Credit Rating
--Use
--SEBI Regulations
Methodology
Credit Rating Agencies in India
ICRA
-Range of services
Rating Process
Rating Framework
Rating of Structured obligations
Rating Inadequacies
Conclusion
Annexure
Bibliography

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ANNEXURE
Source: Internet

Credit Ratings and Analysis

A credit rating is an assessment by a third party of the creditworthiness of an issuer
of financial securities. It tells investors the likelihood of default, or non-
payment, by the issuer of its financial obligations.

____________________________________________
What is credit rating??? How is it generally done?

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

a country. Credit ratings are calculated from financial history and current assets
and liabilities. Typically, a credit rating tells a lender or investor the probability of
the subject being able to pay back a loan. However, in recent years, credit ratings
have also been used to adjust insurance premiums, determine employment
eligibility, and establish the amount of a utility or leasing deposit.

A poor credit rating indicates a high risk of defaulting on a loan, and thus leads to
high interest rates, or the refusal of a loan by the creditor.
Personal credit ratings

In countries such as the United States, an individual's credit history is compiled

and maintained by companies called credit bureaus. In the United States, credit
worthiness is usually determined through a statistical analysis of the available
credit data. A common form of this analysis is a 3-digit credit score provided by
independent financial service companies such as the FICO credit score. (The term,
a registered trademark, comes from Fair Isaac Corporation, which pioneered the
credit rating concept in the late 1950s.)

An individual's credit score, along with his or her credit report, affects his or her
ability to borrow money through financial institutions such as banks.

In Canada, the most common ratings are the North American Standard Account
Ratings, also known as the "R" ratings, which have a range between R0 and R9.
R0 refers to a new account; R1 refers to on-time payments; R9 refers to bad debt.

The factors which may influence a person's credit rating are:

* ability to pay a loan

* interest
* amount of credit used
* saving patterns

Corporate credit rating or

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Bond credit rating

The credit rating of a corporation is a financial indicator to potential investors of

debt securities such as bonds. These are assigned by credit rating agencies such as
Standard & Poor's or Fitch Ratings and have letter designations such as AAA, B,
CC.

Credit rating is done by a credit rating agency..check out info about that also

A credit rating agency (CRA) is a company that assigns credit ratings for issuers of
certain types of debt obligations. In most cases, these issuers are companies, cities,
non-profit organizations, or national governments issuing debt-like securities that
can be traded on a secondary market. A credit rating measures credit worthiness,
the ability to pay back a loan, and affects the interest rate applied to loans. (A
company that issues credit scores for individual credit-worthiness is generally
called a credit bureau or consumer credit reporting agency.)

Interest rates are not the same for everyone, but instead are based on risk-based
pricing, a form of price discrimination based on the different expected costs of
different borrowers, as set out in their credit rating. There exist more than 100
rating agencies worldwide.
Credit rating agencies for corporations
* A. M. Best (U.S.)
* Baycorp Advantage (Australia)
* Dominion Bond Rating Service (Canada)
* Fitch Ratings (U.S.)
* Moody's (U.S.)
* Standard & Poor's (U.S.)
* Pacific Credit Rating (Peru)

Uses of ratings by credit rating agencies

Credit ratings are used by investors, issuers, investment banks, broker-dealers, and
by governments. For investors, credit rating agencies increase the range of
investment alternatives and provide independent, easy-to-use measurements of
relative credit risk; this generally increases the efficiency of the market, lowering
costs for both borrowers and lenders. This in turn increases the total supply of risk
capital in the economy, leading to stronger growth. It also opens the capital
markets to categories of borrower who might otherwise be shut out altogether:
small governments, startup companies, hospitals and universities.

Ratings use by bond issuers

Issuers rely on credit ratings as an independent verification of their own credit-

worthiness. In most cases, a significant bond issuance must have at least one rating
from a respected CRA for the issuance to be successful (without such a rating, the
issuance may be undersubscribed or the price offered by investors too low for the
issuer's purposes). Recent studies by the Bond Market Association note that many

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institutional investors now prefer that a debt issuance have at least three ratings.
Issuers also use credit ratings in certain structured finance transactions. For
example, a company with a very high credit rating wishing to undertake a
particularly risky research project could create a legally separate entity with certain
assets that would own and conduct the research work. This "special purpose entity"
would then assume all of the research risk and issue its own debt securities to
finance the research. The SPE's credit rating likely would be very low and the
issuer would have to pay a high rate of return on the bonds issued. However, this
risk would not lower the parent company's overall credit rating because the SPE
would be a legally separate entity. Conversely, a company with a low credit rating
might be able to borrow on better terms if it were to form an SPE and transfer
significant assets to that subsidiary and issue secured debt securities. That way, if
the venture were to fail, the lenders would have recourse to the assets owned by the
SPE. This would lower the interest rate the SPE would need to pay as part of the
debt offering.

The same issuer also may have different credit ratings for different bonds. This
difference results from the bond's structure, how it is secured, and the degree to
which the bond is subordinated to other debt. Many larger CRAs offer "credit
rating advisory services" that essentially advise an issuer on how to structure its
bond offerings and SPEs so as to achieve a given credit rating for a certain debt
tranche. This creates a potential conflict of interest, of course, as the CRA may feel
obligated to provide the issuer with that given rating if the issuer followed its
advice on structuring the offering. Some CRAs avoid this conflict by refusing to
rate debt offerings for which its advisory services were sought.

Ratings use by investment banks and broker-dealers

Investment banks and broker-dealers also use credit ratings in calculating their
own risk portfolios (i.e., the collective risk of all of their investments). Larger
banks and broker-dealers conduct their own risk calculations, but rely on CRA
ratings as a "check" (and double-check or triple-check) against their own analyses.

Ratings use by government regulators

Regulators use credit ratings as well, or permit these ratings to be used for
regulatory purposes. For example, under the Basel II agreement of the Basel
Committee on Banking Supervision, banking regulators can allow banks to use
credit ratings from certain approved CRAs (called "ECAIs" or "External Credit
Assessment Institutions") when calculating their net capital reserve requirements.
In the United States, the Securities and Exchange Commission (SEC) permits
investment banks and broker-dealers to use credit ratings from "Nationally
Recognized Statistical Rating Organizations" (or "NRSROs") for similar purposes.
The idea is that banks and other financial institutions should not need to keep in
reserve the same amount of capital to protect the institution against (for example) a
run on the bank, if the financial institution is heavily invested in highly liquid and
very "safe" securities (such as U.S. government bonds or short-term commercial
paper from very stable companies).

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CRA ratings are also used for other regulatory purposes as well. The U.S. SEC, for
example, permits certain bond issuers to use a shorten prospectus form when
issuing bonds if the issuer is older, has issued bonds before, and has a credit rating
above a certain level. SEC regulations also require that money market funds
(mutual funds that mimic the safety and liquidity of a bank savings deposit, but
without FDIC insurance) comprise only securities with a very high rating from an
NRSRO. Likewise, insurance regulators use credit ratings to ascertain the strength
of the reserves held by insurance companies.

_________________________________________________________
What Is A Corporate Credit Rating?
by Reem Heakal

Before you decide whether to invest into a debt security from a company or foreign
country, you must determine whether the prospective entity will be able to meet its
obligations. A ratings company can help you do this. Providing independent objective
assessments of the credit worthiness of companies and countries, a credit ratings company
helps investors decide how risky it is to invest money in a certain country and/or security.

Credit in the Investment World

As investment opportunities become more global and diverse, it is difficult to decide not
only which companies but also which countries are good investment opportunities. There
are advantages to investing in foreign markets, but the risks associated with sending
money abroad are considerably higher than those associated with investing in your own
domestic market. It is important to gain insight into different investment environments but
also to understand the risks and advantages these environments pose. Measuring the ability
and willingness of an entity - which could be a person, a corporation, a security or a
country - to keep its financial commitments or its debt, credit ratings are essential tools for
helping you make some investment decisions.

The Raters
There are three top agencies that deal in credit ratings for the investment world. These are:
Moody's, Standard and Poor's (S&P's) and Fitch IBCA. Each of these agencies aim to
provide a rating system to help investors determine the risk associated with investing in a
specific company, investing instrument or market.

Ratings can be assigned to short-term and long-term debt obligations as well as securities,
loans, preferred stock and insurance companies. Long-term credit ratings tend to be more
indicative of a country's investment surroundings and/or a company's ability to honor its
debt responsibilities.

For a government or company it is sometimes easier to pay back local-currency

obligations than it is to pay foreign-currency obligations. The ratings therefore assess an
entity's ability to pay debts in both foreign and local currencies. A lack of foreign reserves,
for example, may warrant a lower rating for those obligations a country made in foreign
currency.

It is important to note that ratings are not equal to or the same as buy, sell or hold

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recommendations. Ratings are rather a measure of an entity's ability and willingness to

repay debt.

The Ratings Are In

The ratings lie on a spectrum ranging between highest credit quality on one end and
default or "junk" on the other. Long–term credit ratings are denoted with a letter: a triple A
(AAA) is the highest credit quality, and C or D (depending on the agency issuing the
rating) is the lowest or junk quality. Within this spectrum there are different degrees of
each rating, which are, depending on the agency, sometimes denoted by a plus or negative
sign or a number.

Thus, for Fitch IBCA, a "AAA" rating signifies the highest investment grade and means
that there is very low credit risk. "AA" represents very high credit quality; "A" means high
credit quality, and "BBB" is good credit quality. These ratings are considered to be
investment grade, which means that the security or the entity being rated carries a level of
quality that many institutions require when considering overseas investments.

Ratings that fall under "BBB" are considered to be speculative or junk. Thus for Moody's a
Ba2 would be a speculative grade rating while for S&P's, a "D" denotes default of junk
bond status.

Here is a chart that gives an overview of the different ratings symbols that Moody's and
Standard and Poor's issue:
Bond Rating
Grade Risk
Moody's Standard & Poor's
Aaa AAA Investment Lowest Risk
Aa AA Investment Low Risk
A A Investment Low Risk
Baa BBB Investment Medium Risk
Ba, B BB, B Junk High Risk
Caa/Ca/C CCC/CC/C Junk Highest Risk
C D Junk In Default

Sovereign Credit Ratings

As previously mentioned, a rating can refer to an entity's specific financial obligation or to
its general creditworthiness. A sovereign credit rating provides the latter as it signifies a
country's overall ability to provide a secure investment environment. This rating reflects
factors such as a country's economic status, transparency in the capital market, levels of
public and private investment flows, foreign direct investment, foreign currency reserves,
political stability, or the ability for a country's economy to remain stable despite political
change.

Because it is the doorway into a country's investment atmosphere, the sovereign rating is
the first thing most institutional investors will look at when making a decision to invest
money abroad. This rating gives the investor an immediate understanding of the level of
risk associated with investing in the country. A country with a sovereign rating will
therefore get more attention than one without. So to attract foreign money, most countries
will strive to obtain a sovereign rating and they will strive even more so to reach
investment grade. In most circumstances, a country's sovereign credit rating will be its
upper limit of credit ratings.

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Conclusion
A credit rating is a useful tool not only for the investor, but also for the entities looking for
investors. An investment grade rating can put a security, company or country on the global
radar, attracting foreign money and boosting a nation's economy. Indeed, for emerging
market economies, the credit rating is key to showing their worthiness of money from
foreign investors. And because the credit rating acts to facilitate investments, many
countries and companies will strive to maintain and improve their ratings, hence ensuring
a stable political environment and a more transparent capital market.
by Reem Heakal

Some FAQs about Credit Rating

What is credit rating?
Credit rating is, essentially, the opinion of the rating agency on the relative ability and
willingness of the issuer of a debt instrument to meet the debt service obligations as and
when they arise.

Why do rating agencies use symbols like AAA, AA, rather than give marks or
descriptive credit opinion?
The great advantage of rating symbols is their simplicity, which facilitates universal
understanding. Rating companies also publish explanations for their symbols used as well
as the rationale for the ratings assigned by them, to facilitate deeper understanding.

Why is credit rating necessary at all?

Credit rating is an opinion expressed by an independent professional organisation, after
making a detailed study of all relevant factors. Such an opinion will be of great assistance
to investors in making investment decisions. It also helps the issuers of debt instruments to
price their issues correctly and to reach out to new investors. Regulators like Reserve
Bank of India (RBI) and Securities & Exchange Board of India (SEBI) often 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.

Does credit rating constitute an advice to the investors to buy?

It does not. The reason is that some factors, which are of significance to an investor in
arriving at an investment decision, are not taken into account by rating agencies. These
include reasonableness of the issue price or the coupon rate, secondary market liquidity
and pre-payment risk. Further, different investors have different views regarding the level
of risk to be taken and rating agencies can only express their views on the relative credit
risk.

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What kind of responsibility or accountability will attach to a rating agency if an

investor, who makes his investment decision on the basis of its rating, incurs a loss
on the investment?
A credit rating is a professional opinion given after studying all available information at a
particular point of time. Nevertheless, such opinions may prove wrong in the context of
subsequent events. Further, there is no privity of contract between an investor and a rating
agency and the investor is free to accept or reject the opinion of the agency. Nevertheless,
rating is essentially 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 a rating agency has to be built, brick by brick, on the quality of its services.

Do rating companies undertake unsolicited ratings?

Not in India, at least not yet. There is however, a good case for undertaking unsolicited
ratings. It will be relevant to mention here that 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. Co-operation from the issuers
as well as their willingness to share even confidential information are important pre-
requisites. On its part, the rating agency has a great responsibility to ensure confidentiality
of the sensitive information that comes into its possession during the rating process.

How reliable and consistent is the rating process? How do rating agencies eliminate
the subjective element in rating?
To answer the second question first, it is neither possible nor even desirable, to totally
eliminate the subjective element. Rating does not come out of a pre-determined
mathematical formula, which fixes the relevant variables as well as the weights attached to
each one of them. Rating agencies do a great amount of number crunching, but the final
outcome also takes into account factors like 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 professionals with impeccable
credentials. Rating agencies also ensure that the rating process is insulated from any
possible conflicts of interest.

Is it customary to have the same issue rated by more than one rating agency? Do
the ratings for the same instrument vary from agency to agency?
The answer to both the questions is yes. 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 the
opinions given by two or more agencies will vary, in some cases. But it will be very unusual
if such differences are very wide. For example, a debt issue may be rated DOUBLE A
PLUS by one agency and DOUBLE A or DOUBLE A MINUS by another. It will indeed be
unusual if one agency assigns a rating of DOUBLE A while another gives a TRIPLE B.

Why do rating agencies monitor the issues already rated?

A rating is an opinion given on the basis of information available at a particular point of
time. As time goes by, many things change, affecting the debt servicing capabilities of the
issuer, one way or the other. It is, therefore, essential that as a part of their investor
service, rating agencies monitor all outstanding debt issues rated by them. In the context of
emerging developments, the rating agencies often put issues under credit watch and
upgrade or downgrade the ratings as and when necessary. Normally, such action is taken
after intensive interaction with the issuers.

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Do issuers have a right of appeal against a rating assigned?

Yes. In a situation where an issuer is unhappy with the rating assigned, he may request for
a review, furnishing additional information, if any, considered relevant. The rating agency
will, then, undertake a review and thereafter indicate its final decision. Unless the rating
agency had overlooked critical information at the first stage, (which is unlikely), chances of
the rating being changed on appeal are rare.

How much time does rating take?

The rating process is a fairly detailed exercise. It involves, among other things, analysis of
published financial information, visits to the issuer’s office and works, intensive discussion
with the senior executives of issuer, discussions with auditors, bankers, etc. It also involves
an in-depth study of the industry itself and a degree of environment scanning. All this takes
time and a rating agency may take three to four weeks or more to arrive at a decision,
subject to availability of all the solicited information. It is of paramount importance to rating
companies to ensure that they do not, in any way, compromise on the quality of their
analysis, under pressure from issuers for quick results. Issuers would also be well advised
to approach the rating agencies sufficiently in advance so that issue schedules can be
adhered to.

Is it possible that not satisfied with the rating assigned by one rating agency, an
issuer approaches another, in the hope of getting a better result?
It is possible, but rating companies do not and should not indulge in competitive
generosity. Any attempt by issuers to play one agency against another will have to be
discouraged by all the rating companies. It may, however, be pointed out here that two
rating companies may, and often do, arrive at different conclusions on the same issue.
This is only natural, as perceptions differ.

Who rates the rating companies?

Informed public opinion will be the touchstone on which the rating companies have to be
assessed and the success of a rating agency should be measured by the quality of the
services offered, consistency and integrity.

Is the rating assigned for an instrument or for the Issuer Company?

Both. Rating of instruments would consider instruments’ specific characteristics like
maturity, credit reinforcements specific to the issue etc. Issuer ratings consider the overall
debt management capability of an issuer on a medium term perspective, typically three to
five years. While issuer ratings are more often than not, one time assessments of credit
quality, instrument ratings are monitored over the life of the instrument.

Why are equity shares not rated?

By definition, credit rating is an opinion on the issuers capacity to service debt. In the case
of equity, there is no pre-determined servicing obligation, as equity is in the nature of
venture capital. So, credit rating in the conventional sense does not apply to equity shares.
However, of late, credit rating agencies offer grading of IPOs which take into account the
fundamentals of the issuer.

If a rating is downgraded, how would it "benefit" (or compensate ) the investor?

A credit rating is a professional opinion on the ability and willingness of an issuer to meet
debt-servicing obligations. It is an opinion on future debt servicing capabilities given on the

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basis, inter-alia, of past performance and all available information (from audited financial
statements, interaction with company management, banks and financial institutions,
statutory auditors, etc.) at a particular time. While rating agencies make all possible efforts
to project corporate business prospects, industry trends and management capabilities,
many events are unpredictable. Hence, such opinions may prove wrong in the context of
subsequent events. On the occurrence of such an event, a rating agency can only review
and make appropriate changes in the rating. Moreover, when there are recessionary
trends in certain segments of the economy, companies in such segments or with large
exposures to such segments are adversely affected and their credit ratings get
downgraded. Such downgradations are a natural consequence of the recessionary trends.
In other words, credit quality (and credit rating) is dynamic, not static and all rating
agencies review their ratings periodically and make changes, wherever considered
appropriate. Such changes are reported widely through the media. It is the experience of
all rating agencies that some instruments initially rated as investment grade fall below
investment grade or go into default, over a period of time.

Further, it must be noted that there is no privity of contract between an investor or a lender
and a rating agency and the investor is free to accept or reject the opinion of the agency. A
credit rating is not an advice to buy, sell or hold securities or investments and investors are
expected to take their investment decisions after considering all relevant factors and their
own policies and priorities. A credit rating is not a guarantee against future losses. Please
also note that credit ratings do not take into account many aspects which influence
investment decisions. They do not, for example, evaluate the reasonableness of the issue
price, possibilities for capital gains or take into account the liquidity in the secondary
market. Ratings also do not take into account the risk of prepayment by issuer, or interest
or exchange risks. Although these are often related to the credit risk, the rating essentially
is an opinion on the relative quality of the credit risk, based on the information available at
a given point of time.

GLOSSSARY

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§ Intermediator:institution that provide the

market function of matching borrowers and lenders or
traders
§ Disintermediation: Withdrawal of funds from a
financial_institution in order to invest them directly
§ Moodyʼs investor service:performs financial
research and analysis on commercial and government
entities. The company also ranks the credit-worthiness
of borrowers using a standardized ratings scale. The
company has a 40% share in the world credit rating
market.
§ Standard & Poorʼs: a division of McGraw-Hill
that publishes financial research and analysis on
stocks and bonds. It is one of the top three companies
in this business
§ Audit : An examination of a company's accounting
records and books conducted by an outside professional
in order to determine whether the company is
maintaining records according to generally accepted
accounting principles
§ Underwriting: To guarantee, as to guarantee the
issuer of securities a specified price by entering into
a purchase and sale agreement. To bring securities to
market
§ RBI: Reserve bank of India
§ SEBI: Securities and exchange board of India
§ CRISIL: Credit Rating and Information Services
of India Ltd.
§ ICRA Ltd: Investment Information and Credit
Rating Agency of India Limited.
§ CARE: Credit Analysis and Research Ltd.
§ FITCH: JV between Duff & Phelps, US and Alliance
Capital Limited , Calcutta.
§ Equity Grading : A service offered by the credit
rating agency, ICRA Limited, under which the agency
assigns a grade to an equity issue, at the request of
the prospective is

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§ IFCI Ltd.: The Industrial Finance Corporation of

India, the first Development Financial Institution in
the country to cater to the long-term finance needs of
the industrial sector.
§ SBI: State bank of India,the biggest PSU bank in
India.
§ LIC: Life Insurance corp. of India, the biggest
life insurer in India and under control of govt of
India.
§ UTI: Unit trust of India
§ PNB: Punjab National Bank
§ GIC: General insurance corp. a psu and biggest
insurer in india,formed for the purpose of
superintending,controlling and carrying on the
business of general insurance
§ Forward integration: The expansion of a
business' products and/or services to related areas in
order to more directly fulfill the customer's needs.
§ Switching costs: cost of Liquidating a position
and simultaneously reinstating a position in another
futures contract of the same type
§ Leveraging :Use of debt to increase the expected
return on equity. Financial leverage is measured by the
ratio of debt to debt plus equity.
§ Currency exposures: The part of a portfolio that
is denominated in a currency (or currencies) other than
the base currency and is not hedged. Currency risk
arises from a combination of currency exposure and
currency volatility. Currency hedges reduce (direct)
currency exposure
§ Gross operating margin What remains from sales
after a company pays out the cost of goods sold. To
obtain this margin, divide gross profit by sales. Gross
operating margin is expressed as a percentage.
§ Interest coverage ratio(OPBIT/Interest) :The
ratio of earnings before interest and taxes to annual
interest expense. This ratio measures a firm's ability
to pay interest

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§ Debt service coverage ratio: Earnings before

interest and income taxes, divided by interest expense
plus the quantity of principal repayments divided by
one minus the tax rate
§ Net cash accruals:???
§ Equity assessment:???
§ Great depression: The Great Depression (also
known in the U.K. as the Great Slump) was a dramatic,
worldwide economic downturn beginning in some countries
as early as 1928.
§ Lien :A security interest in one or more assets
that lenders hold in exchange for secured debt
financing
§ Collateral : In the context of project
financing, additional security pledged to support the
project financing
§ Securitization: the process of conversion of
financial assets into tradable securities.
§ Franchise value: franchise value refers to the
popularity of a particular brand or product with
consumers.
§ Capital adequacy : A measure of the financial
strength of a bank or securities firm, usually
expressed as a ratio of its capital to its assets.
§ Enron debacle: After a series of revelations
involving irregular accounting procedures bordering on
fraud perpetrated throughout the 1990s involving Enron
and its accounting firm Arthur Andersen, Enron stood on
the verge of undergoing the largest bankruptcy in
history by mid-November 2001. Enron filed for
bankruptcy on December 2, 2001. In addition, the
scandal caused the dissolution of Arthur Andersen,
which at the time was one of the world's top accounting
firms.
§ Volatility: A measure of risk based on the
standard deviation of the asset return. Volatility is a
variable that appears in option pricing formulas, where
it denotes the volatility of the underlying asset
return from now to the expiration of the option
§ Financial disclosure: A company's release of all
information pertaining to the company's business

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activity, regardless of how that information may

influence investors
§ Differential: A small charge added to the
purchase price and subtracted from the selling pr
§ Liquidation Occurs when a firm's business is
terminated. Assets are sold, proceeds are used to pay
creditors, and any leftovers are distributed to
shareholders. Any transaction that offsets or closes
out a long or short position
§ Financial engineering: Combining or carving up
existing instruments to create new financial products

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