IRJMST Volume 4 Issue 3 Online ISSN 2250 - 1959
Efficacy of Credit Rating and Credit Rating Agencies in India
Dr M.M.Goyal
OSD-Principal
PGDAV College
Nehru Nagar-110065
Abstract
Credit Rating Agencys (CRA) plays a key role in the financial markets by helping reduce
information asymmetry between lenders and investors regarding the credit worthiness of the
latter. The role of CRAs been scrutinized under lenses post sub prime crisis, though Indian
subcontinent was not much affected by the repercussions of the crisis, still there were
questions about the efficacy of the information provided by the CRAs. The paper captures
the role of credit rating and CRAs especially in perspective of Indian economy and the
issues limiting its efficacy.
Keywords: Credit Rating, Credit Rating Agency(CRA), Default Rate, Credit Ratio
Defining Credit Rating and the Credit Rating Agency
According to Standards & Poors(S&P) Ratings express the agencys opinion about the
ability and willingness of an issuer to meet its financial obligation in full and on time.
the above definition highlights the following aspect:
Credit ratings are not a guarantee that investment will pay out and not default, it is an
opinion expressed by the agency based on the information available and factoring in
the foreseeable future events
It also assesses the full and timely repayment i.e with respect to repayment amount
and repayment date
Credit ratings do not indicate investment merit; it only talk about the Credit Quality
Credit ratings are forward looking wherein the current and historical information is
ascertained and the potential impact of foreseeable future event is evaluated
A credit rating does not reflect other types of risk, such as market or liquidity risks, which
may also affect the value of a security nor does a credit rating consider the price at which an
investor purchased a security, or the price at which the security may be sold. It is neither an
investment advice nor any recommendation to buy, sell, or hold securities. Investor need to
perform its own analysis regarding such investment decisions. The role of rating agencies is
essentially to reduce information asymmetry between borrower (issuers) and lenders
(investors). The essential subject matter of this information asymmetry is a borrower's
creditworthiness and because creditworthiness is not a directly observable attribute, a lender
generally has to estimate it from attributes that are observable, using various approaches.
Thus , Credit Ratings play a useful role in corporations and governments to raise debt in the
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capital markets. However , Credit ratings are not absolute measure of default probability
instead ratings express relative opinion about creditworthiness of an issuer or credit quality of
an individual debt issue, from strongest to weakest within the universe of credit risk for eg:
a corporate bond that is rated AA is viewed by the rating agency as having a higher credit
quality than a corporate bond with a BBB rating. But the AA rating isnt a guarantee that
it will not default, only that, in the agencys opinion, it is less likely to default than the BBB
bond.
A credit rating agency (CRA) is a commercial concern engaged in the business of credit
rating of any debt obligation or of any project or program requiring finance in the form of
debt or otherwise. It is
also different from a credit bureau, which collates information on credit record of corporates
or even individuals. CRAs have been operating in India since 1988.
The Reserve Bank of India has so far accredited six credit rating agencies viz., Crisil, ICRA,
CARE, India Ratings, Brickwork Ratings and SMERA Ratings. In India where financial
literacy is still at the nascent stage the opinion provided by the CRAs help investors make
better informed investment decision.
Role of Credit Rating and Credit Rating Agencys
This section highlights the role and function of Credit Rating and the credit rating agencys
for eg: in deepening the financial markets, pricing the debt instruments, capital adequacy
framework for banks, its relation with the economic indicators
Pricing of Debt
Credit ratings facilitate the process of issuing and purchasing bonds and other debt issues by
providing an efficient, widely recognized, and long-standing measure of relative credit risk.
The primary purpose of obtaining a rating is to enhance access to capital markets and lower
debt issuance and interest costs. Issuers with lower credit ratings pay higher interest rates
embodying larger risk premiums than higher rated issuers. CRAs, in their role as information
gatherers and processors, can reduce a firm's capital costs by certifying its value in a market,
thus solving or reducing the informative asymmetries between purchasers and issuers.
Credit Ratings and Economic Indicators Gross Domestic Product(GDP) and Index of
Industrial Production(IIP)
Ratings do not come out of a pre-determined mathematical formula, which fixes the relevant
variables as well as the weights attached to factors affecting the rating. 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
etc. However the criteria and methodology of determining the rating differs across the rating
agencies and also the type of instrument being rated.
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The general state of economy affecting the industry forecast is also reflected in the rating
exercise. The movement capturing the trend of ratings in India, can be compared with the
economic indicators of the economy.
Credit ratio is the proportion of upgrades to the downgrades some agencies also come with
the reverse credit ratio which is the proportion of downgrades to upgrades, reflects the
trend ratings are driven towards upward or downward. This movement of credit ratio can be
compared with the economys health parameter for eg: GDP or IIP to recognise the
correlation in the movement of ratings trend along with these economic indicators.
CRISILs credit ratio frequently exhibits correlation with economic indicators such as IIP
and GDP(Refer Figure I) . Slow growth in GDP and IIP led the credit ratio below 1 over two
and a half years ended March 31, 2014, it soared in HI 2014-15 with an improvement in the
IIP and GDP growth. Figure 1 reflects this movement in the credit ratio in tandem with IIP
and GDP growth rates from H1, 2009 to H1, 2014-15.Thus movement along credit rating
reflects the state of the economy
Figure 1.
Credit ratio trends with IIP and GDP growth rates
The figure captures CRISILs credit ratio exhibits correlation with the economic indicators
GDP and IIP
Rating Penetration and Basel II
Regulatory changes in banks capital requirements under Basel II have resulted in a new role
to credit ratings. Post 2008, RBIs directive on Bank Loan Ratings spurred the rating
business and the regulation has brought many smaller firms within the fold of credit rating.
For eg: CRISIL has 13000 outstanding long term ratings as on March 31, 2014. CARE
completed over 30,000 rating assignments since inception to reach 31,381 as of March 2014.
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(Data inconsistency as to the number of ratings outstanding at the year end doesnt
warrant comparison amongst the rating agencies)
Data available that gives an insight about the rating penetration is tabulated
Number of
Outstanding long
ratings 2008 2009 2010 2011 2012 2013 2014
CRISIL 400 1400 3700 6200 9000 11500 13000
(Source: CRISIL Ratings Round Up)
Number of
assignments
complete 2008 2009 2010 2011 2012 2013 2014
CARE Data not available 2187 5980 7439 7865
(Source: Annual Report)
Number of entities rated as 2008 2009 2010 2011 2012 2013 2014
part of
Basel II ratings
Data not
ICRA available 1843 2289 3054 3933 3392
(Source: Annual Report)
According the companys annual reports it is the rating business especially that has lead to
increase in the top line(Operating Revenue) and the bottom line(Profit).
Borrowers can benefit from the rating exercise as this can help them tone up their
management systems and business models. Banks also provide loans as social obligation to
institutions
with a weak balance sheet like such as state electricity boards, etc. The credit risk on the
balance sheet of the lending banks and institutions could be far higher than what is declared,
considering the weak financials of those companies. The capital adequacy norms help bank
capital saving as they have to provide for the capital on the basis of the risk weight attached
with such portfolios which is measured by the credit rating. Figure2. Exhibits the scenario of
capital savings across different rating levels . It is also expected that the proposed Basel III
guidelines proposed to be implemented in a phased manner between 2013 to 2019. The
guidelines require to maintain higher liquidity to improve their ability to withstand tough
liquidity scenarios will put more resilience on the credit ratings.
Figure 2.
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Report card of rating agency performance
The best report card of a rating agencys performance is its published default and transition
rates. SEBI has made this publication mandatory.
The default rate for a specified period is the number of defaults among the rated firms
during the period expressed as a percentage of the total number of rated firms whose rating
are outstanding throughout the period. Default rate can be calculated at each rating level and
can be calculated over multiple periods.
Transition rate measures the instance of a change in credit rating over a specified period .
Transition rates can be calculated for entire rated population.
For all debt market participants , accurate and reliable default and transition rates are critical
inputs in formulating following decisions:
Pricing Debt: Default and transition rates are critical inputs for pricing a debt
instrument or loan exposure . Default probabilities associated with ratings help
investors and lender quantify credit risk in their debt exposure and provide input on
whether and how much to lend and at what price
Structuring and pricing credit enhanced instruments: the structuring, rating and
pricing of credit enhanced instruments depend heavily on default and transition rates
of underlying borrowers and securities.
Credit Risk Measurement: Default and transition rates are key inputs for many
quantitative risk assessment models . Investors in rated instruments can manage their
risk exposure effectively if they access to reliable default and transition rates.
Transition rates are also important for debt funds that need to maintain certain
threshold or credit quality in their portfolios and for investors who are because of
regulation or otherwise mandated to invest only in securities that are rated at a certain
level or above.
Indicating efficacy of rating scale: If ratings are reliable , the default rate should
decrease as one moves up the rating scale . Thus default and transition rates can be
used to validate rating scales and quantify rating stability.
For instance CRISILs average one year transition rate for long term ratings, exhibited in
Figure 3
Figure 3.CRISILs one year transition rates between 2003 and 2013
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As can be seen, between 2003 and 2013, around 94.94% per cent of the instruments rated in
the CRISIL AA category remained in that category at the end of one year; around 1.07 per
cent was upgraded to a higher rating (CRISIL AAA),and around 3.2 per cent was
downgraded to a lower rating(CRISIL A). The highlighted diagonal of Figure 3. indicates the
stability rates of various rating categories. Thus the probability of CRISIL AAA rating
remaining stable over the period is 98.03%. The stability of CRISILs ratings increases with
movement up the rating scale; in other words, CRISILs stability rates are also ordinal which
highlight the strength of the rating assigned and the effectiveness of rating agency
The default rate across the Indian CRAs reflects increasing trend because of the significant
increase in the number of ratings in the sub investment grade category which also resulted in
the shift of median rating of the agency for instance the median rating of CRISIL and ICRA
is highlighted in the following table.(Figure 4)
Figure 4 Median Rating
median rating HI
g 2008 2009 2010 2011 2012 2013 2014 2014-15
CRISIL CRISIL CRISIL CRISIL CRISIL CRISIL CRISIL CRISIL
CRISIL AA BBB BB BB BB BB BB BB
(Source: CRISILs Rating Round Up)
median rating 2008 2009 2010 2011 2012 2013 2014
ICRA ICRA ICRA ICRA
ICRA N.A BBB- N.A BB B+ B+ N.A
(Source: ICRA Default and Transition Study)
N.A: Not Available
Standardised Default recognition policy and Impact of Default on credit rating
Default should be recognised as soon as the rating agency become aware of defaults to serve
the best interest of investors , an early recognition of default will support higher post default
recoveries for the investors which drives their preference to have default recognised as soon
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as debt servicing payment is missed . Securities and Exchange Board of India (SEBI) in its
guidelines for credit rating agencies (CRAs) computation of default statistics has specified
that default be recognised at the first instance of delayed payment ( circular:
CIR/MIRSD/CRA/6/2010 dated May 3, 2010). RBI in its guidelines on new capital
adequacy framework also states that ratings on bank facilities should reflect timely payment
of principal and interest (circular: DBOD.No.BP.BC.15 / 21.06.001 / 2010-11/section 6.2.3
dated July 1, 2012). Both SEBI as well as RBI require CRAs to recognise default on the first
instance of missed payment.
CRISIL defines default as any missed payment on a rated instrument. In other words, it
recognises
even 'a single rupee of missed payment, or delay by a single day'as default
Impact of Default on Credit Rating
For instance, On noting default, ICRA downgrades the rating outstanding to ICRAD
regardless of the magnitude or duration of default , in case default is on other debt obligations
not rated by it then if default is on account of liquidity crunch or any other credit related
issues , then it is considered that default is likely to be extended to the instrument being rated
, the rating is revised to ICRA D however if strong reasons exist from differentiating the rated
instrument and other instruments , protective factors or clauses then the rating is not straight
away moved to default category but to a low sub investment grade depending upon the credit
profile of the issuer and the seniority of the issue. In case issuer applies for restructuring and
starts delaying on repayments, the event is considered as default even if the lender
subsequently approves the restructuring package with retrospective effect.
When the CRISIL-rated instrument is in default , the outstanding rating is revised to CRISIL
D. This is regardless of the extent of default (what portion of the debt service obligation is
not met) or the period of default (for how many days has the debt service obligation) When
issuers with outstanding CRISIL-rated instruments default on external debt/loan facilities not
rated by, it is very likely that the outstanding CRISIL rating will be lowered to near-default
status.
This warrants comparability across the rating agencies . Prior to this notification default
definition and default recognition practices was left to the discretion of individual rating
agencies , thus the ratings assigned by the rating agencies were not comparable.
Issues limiting the Efficacy of Credit Rating and Credit Rating Agencys
This section highlights the concerns that limit the effectiveness of credit rating and the credit
rating agencys .
Information Availability
Information availability- a key risk factor in credit rating. Credit rating reflects an opinion on
the relative likelihood of the timely payment of interest and principal on the rated obligation.
It is an unbiased, objective and an independent opinion as to the issuers capacity to meet its
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financial obligations. Ratings are determined by assessing the relative credit worthiness of the
issuer within the clearly defined framework of rating criteria encompassing evaluation of
different types of risks such as business, financial, management, project risk etc.
Ratings are assigned to debt instruments or facilities availed by the cross section of entities
ranging from public listed companies ,private limited companies , partnerships firms ,
proprietorship firms, societies , trusts etc. Listed companies by virtue of listing regulations
need to disclose their financial performance in the public domain. On the other hand
information availability can be the key risk factor in assessing credit worthiness of unlisted
entities, which are not bounded by any law or regulation to disclose their financial
performance in the public domain. The RBIs implementation of new capital adequacy
framework for branks had bring in more unlisted entities within the ambit of credit rating. As
on March 2012 about 95 percent of CRISILs rated portfolio consist of entities that are not
listed.
Also once the entity accepts the rating and it is put forth in the public domain , rating
agencies are required to keep the ratings updated and current at all times to continually serve
the interest of investors and rating users , even regulations require credit rating to be current
and updated ; SEBI requires rating agency to continuously monitor the rating assigned over
the life time of the security; RBI guidelines also require that to be eligible for risk weighting
purpose , the rating should be reviewed . Hence it is imperative for the rated entities to extend
their cooperation with the rating agencies by regularly sharing financial and other relevant
information. However it has been observed that some rated entities choose to become non
cooperative after accepting the rating, in many cases such non cooperation is also
accompanied by financial stress leading to deterioration of the financial risk profile , in such
scenarios different rating agencies have different approaches and methodologies to deal for
eg: CRISIL continues to engage non cooperating clients for seeking information , even after
sending in reminders the entity refuse to cooperate , it suspends the rating , considering lack
of information availability as a deterrent to keep the rating updated or affirmed.
Information availability risks and its linkage to other risk elements
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Management
Risk
Information
Business Project
Risk Availability Risk
Risk
Financial
Risk
Difference in rating symbols
Although all the Indian Credit rating agencies use the same rating symbols in keeping with
the guidelines of the Securities and Exchange Board of India(SEBI) , credit risks conveyed
by the same rating symbol tend to differ from one CRA to another . However the difference
in the quality of risk conveyed by ratings depend on the degree to which the CRAs adhere to
the best practices in criteria , methodologies, policies, processes and analytical standards . For
example AA ratings of all raters are not equal, since their methodologies and analytical
standards differ, hence there is a strong case for investors not to automatically equate the
ratings of all agencies, the investors need to distinguish between CRAs and not equate
ratings of all agencies with a reductionist approach.
Business Model of Rating agencies
Issuer Pays model wherein the issuer pays to get its securities rated , creates conflict of
interest and the rating agency may be influenced to determine more favourable or higher
rating than warranted to retain the issuer . This encourage rating shopping or chooses the
rating agency that will assign the highest rating or that has the most lax criteria for achieving
a desired rating. Rating shopping hinders the ability of ratings to fulfil their role of reducing
information asymmetry
Post financial crisis, research has highlighted the weaknesses of the issuer pays model. On
balance, when the economy is on the upturn, rating agencies may rate bad projects as good
risks. If the overall market for rating does not grow, market shares of CRAs decline and
hence there is trade off between reputation and revenue to retain market share and that may
lead to inflating ratings.
All ratings are not public
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Once the rating is accepted by the client only then it is put in the public domain, CRAs
disseminate plenty of information on their website as well as in print about the rated entity
with the detailed press release and the rating rationale, available freely to the general public
or investor ;but this process also provide loophole for issuers shop for informal ratings and
get the final rating done by the most favourable CRA. Thus the tendering process for getting
the most favourable rating or Rating Shopping
Conflict of Interest
In India, most of the credit rating agencies have rating and non-rating businesses. Apart from
their core business of ratings, the CRAs have diversified in other the areas like:
Research: Some Indian CRAs have set up research arms to complement their rating activities
and carry out research on the economy, industries and specific companies, and make the same
available to external subscribers for a fee
Consulting and advisory: The CRAs, by virtue of assessing credit risk has expertise in risk
consulting which they carry out separately. They offer various kinds of advisory services,
usually through dedicated advisory arms
Knowledge process outsourcing: Some Indian CRAs have KPO arms that leverage their
analytical skills and other process capabilities to serve clients outside India. Most of the
CRAs in India are subsidiaries of the International CRAs
Funds research: Some CRAs have diversified from mutual fund ratings into mutual fund
research
The advisory and consulting practices provide an inherent area of conflict of interest.
However, CRAs have often argued that advisory or consulting services are offered by
different legal entities with whom physical, organisational and functional separation is
maintained
Conclusion
Rating penetration has increased and has received an additional boost from Basel II ,while
the CRAs have been staed with very competent personnel, it is also felt that there is room
for improvement in the work systems, to address the problem of asymmetric information.
The quality of the rating depends on the quality of financial statements. This, in turn, depends
on the quality of the audits and the governance standards of the managements of issuing
companies.
Ab initio, there is asymmetric information between the management of rated companies and
their auditors. In turn, the CRAs depend on auditors. Further information is obtained from the
bankers. The CRAs also rely on projections made by the company managements. Due to this
over-reliance on information from the company and the auditors, other formal and informal
sources of information are not utilized It is strongly suggested that the Due Diligence Review
Process (DDR) goes beyond Financial Statement Analysis to assess the credit worthiness of
the entity and improve the eciency of CRAs.
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For the benet of the public, it is necessary to display the various rating symbols of various
CRAs on a common website (say of regulators), on a comparable scale to help retail investors
Issuers attempt to seek informal ratings from various CRAs and pass the final rating mandate
to the agency that could potentially offer the highest rating. To curb this unhealthy practice, it
is necessary to come to a stage where all ratings, including unaccepted ratings, are published
There is no mechanism to protect investors and/or borrowers from mistakes made by CRAs
or
any abuse of power on their part. This is true even if reputable interests and competition
provide incentives for generating quality financial information. There remains the need for
more formal regulation to address market failures in the form of imperfect competition and
principal-agent problems in the credit rating industry
It has been argued that there is a inherent conflict of interest in the Issuer Pay model.
However, globally the same model is currently followed, though greater transparency is
needed. CRAs need to disclose any existing conflict of interest and process audit should be
mandated so that strict guidelines are followed with Chinese walls being effected between the
sales and ratings divisions.
References
http://www.standardandpoors.com/products-services/RatingsDirect-Global-Credit-
Portal/en/us
https://www.globalcreditportal.com/ratingsdirect/Login.do
http://www.sebi.gov.in/commreport/nismreport.pdf
http://www.sebi.gov.in/cms/sebi_data/attachdocs/1288588001441.pdf
http://www.crisil.com/Ratings/Brochureware/RR_ASSES/CRISIL-ratings_default-
definition-credit%20rating_mar09.pdf
http://www.crisil.com/downloads/publications.jsp
http://www.crisil.com/ratings/publications.jsp?selTab=latest_posts&secID=4
http://www.icra.in/Content.aspx?cid=N0KQ9Q666WJDF5QO905CVQMTP6QKX57
2FTL1RM4CE80AJ6T8HG
http://www.careratings.com/pdf/annual-report/CARE-ANNUAL-REPORT-2014.pdf
http://www.pwc.in/en_IN/in/assets/pdfs/publications/2014/growing-npas-in-banks.pdf
http://businesstoday.intoday.in/story/basel-iii-deferral-to-ease-pressure-on-banks-
india-ratings/1/204694.html
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