Credit Rating

Need, Process and Limitations

Snehal Khetan | Rupam Bora | Tilak Sondagar

Gaurav Jagetia | Shubham Patle | Shashank Chavali
What is Credit Rating?
A credit rating is a quantified
assessment of the creditworthiness of
a borrower in general terms or with
respect to a particular debt or financial
obligation. A credit rating can be
assigned to any entity that seeks to
borrow money—an individual,
corporation, state or provincial
authority, or sovereign government.
Credit Ratings and 2008
Financial Crisis
The role of the credit ratings agencies
during the financial crisis remains highly
criticized and mostly unaccountable.
The agencies have been blamed for
exaggerated ratings of risky mortgage-
backed securities, giving investors false
confidence that they were safe for
investing.

During the 2008 financial crisis, a lot of worthless mortgage-related securities

were given AAA ratings: the highest and safest investment grade.
 Objectives
The main objective is to provide superior and low cost information to
investors for taking a decision regarding risk return trade off, but it also
helps to market participants in the following ways:

★ Improves a healthy discipline on borrowers

★ Lends greater credence to financial representations
★ Encourages greater information disclosure, better
accounting standards and improved financial information
★ Helps merchant bankers, brokers, regulatory authorities in
discharging their functions related to debt issues,
★ Acts as a marketing tool
 Types of Ratings
SOVEREIGN SHORT TERM CORPORATE
CREDIT RATING RATING CREDIT RATINGS
Indicates the risk level of Probability factor of an Financial indicator to
the investing environment individual going into default
potential investors of debt
of a country and is used by within a year
securities such as bonds
investors looking to invest
abroad.

Apart from these we have Equity rating, Preference share rating, Commercial paper rating, Bond rating, Fixed deposit
rating, borrowers rating, Individual rating.
 Credit Rating Agencies
Standard & Poor’s
(S&P)
S&P Corporation was
formed in 1941 merging
Standard Statistics and
Poor’s Publishing. S&P
ratings ranges from AAA to
D.
Headquarter: New York
Moody’s Investor
Service
Created in 1914 and initially
provided ratings for
government bonds.
Moody’s ratings system
ranges from Aaa to Caa3.
Headquarter: New York
Fitch ratings
John Knowles Fitch started
Fitch ratings in 1924. Fitch
ratings system ranges from
symbol AAA to D.
Headquarter: NY & London

These Big Three CRAs account for 95% market share, with S&P and Moody’s sharing 80% of it. Other CRAs of the world
are Dun & Bradstreet, A.M.Best, Baycorp Advantage,etc
Similarly major CRAs of India are: CRISIL, ICRA, CARE and Fitch India
 Grades of Ratings
INVESTMENT SPECULATIVE
GRADE RATING GRADE RATING
Investment is considered Investment is considered of
solid by the rating agency lower safety and higher risk
and the issuer is likely to and the issuer is likely to
honor the terms of default on the investment
repayment. in future.

Typically ranges from AAA Typically ranges from BB to

to BBB (S&P) D(S&P)

These symbols of ratings are different for different credit rating agencies and are also different with respect to
debentures, fixed deposits, short term instruments, bond funds, bank loans,etc .
A typical Credit Rating Scale
 Why Credit Ratings are needed
❖ Better Investment Decision : In view of the growing number of cases of
defaults, lenders are worried about the borrowers. With credit rating, they
get an idea about the creditworthiness of the entity and the risk factor
associated with them.
❖ Safety assurance: High credit ratings means that the issuer is very likely to
pay back the money on time with interest which gives an assurance to the
lender.
❖ Easy Loan Approval: For the borrower, a high credit rating helps in easy
approval of the loan as it is viewed as a low/no risk entity.
❖ Considerate Rate of Interest : Borrowers with good repayment history and
higher credit ratings are offered lower interest on loans as they are viewed
as low/no risk entity.
The Process involved in credit rating
Step 1: Request from issuer and analysis

Step 2: Rating committee

Step 3: Communication to management and appeal

Step 4: Pronouncement of rating

Step 5: Monitoring of the assigned rating

Step 6: Rating Watch

Step 7: Rating Coverage

Step 8: Rating Scores

 Rating Process
Issuer Rating Agency

Request for a rating

Rating team assigned. Team collates
Signs rating agreement, provides information, conducts preliminary analysis
information and rating fees

Management meetings within the Team conducts site visits and perform analysis
rating team

Analysis presented to rating committee

Accepts the rating or Appeal Rating assigned and communicated to issuer

Rating disseminated and carried in

www.crisil.com

All ratings kept under continuous surveillance

throughout validity
 Credit Rating Methodology
Consists of 4 areas:

➔ Business Analysis
Covers an analysis of industry risk, market position in the
country, operating efficiency and legal position

➔ Financial Analysis
Analysis of accounting quality, earnings protection, cash flow
adequacy and financial flexibility

➔ Management Evaluation
Study of track record of management’s capacity to overcome
adverse situations, goals, philosophies and strategies.

➔ Fundamental Analysis
Analysis of liquidity management, asset quality, profitability and
interest and tax sensitivity
 Business Risk Analysis
It begins with an assessment of
company’s environment focussing on
the strength of industry prospects,
business cycle as well as competitive
Tip
factors affecting the industry.
Tell the audience about
the problem through a If the company is involved in more
story , ideally a person. than one business , each segment is
analyzed separately.
Financial Risk Analysis
Is analyzed mainly through financial
ratios. Emphasis is placed on the
ability of the company to
maintain/improve its future financial
performances.
 Management Risk
The analyst compares company’s
business strategies and financial plans
Tip
to provide insights into a
Show how your solution
management’s ability to forecast and
helps the person in implement plans.
the story reach his or
her goals.
Fundamental Analysis
Includes an analysis of liquidity
management, profitability and
financial position, interests and tax
sensitivity of the company.

Fundamental analysis is undertaken

for rating debt instruments of financial
institutions, banks and NBFC’s.
Factors involved in credit rating

❖ Overall fundamental and earning capacity of the company and the volatility
of the same.
❖ Overall macroeconomic and business environment
❖ Liquidity position of the company (as distinguished from the profits)
❖ Requirements of funds to meet irrevocable commitments.
❖ Financial flexibility of the company to raise funds from outside sources to
meet temporary financial needs
❖ Guarantee/support from financially strong external bodies
❖ Level of existing leverage(borrowings) and financial risk
 Benefits of Credit Rating
BENEFITS TO INVESTOR
➔ Safeguard against Bankruptcy : Credit rating gives assurance to the investors
against any bankruptcy and provide safety of their investment.
➔ Recognition of Risk : The various symbols help the investors to carry the
information in easily recognizable manner.
➔ Credibility of Issuer : Rating symbols also give an idea about the credibility of the
issuer.
➔ Rating Facilities Quick Investment Decisions : This includes that the investors can
take up quick decisions about the investments to be made in various instruments.
➔ No need to depend on Investment Advisors or Professionals : This includes no
dependence on investment advisors as the rating symbol suggest the credit
worthiness of the instruments.
➔ Choice of Investment : This includes making choice from various instruments
depending upon the risk profile and the diversification plan.
➔ Benefits of Rating Surveillance : This includes benefit of credit rating agencies of
on going rating surveillance of different companies.
Benefits of Credit Rating to Issuer Company .

➔ Lowers Cost of Borrowing : Com p a nie s tha t ha ve hig h c re d it ra ting for the ir d e b t instrum e nts will g e t fund s a t
lowe r c osts from the m a rke t. Hig h ra ting will e na b le the c om p a ny, to offe r low inte re st ra te s on fixe d d e p osits,
d e b e nture s a nd othe r d e b t se c uritie s.
➔ Wider Audience for Borrowing : A c om p a ny with hig h ra ting for its instrum e nts c a n g e t a wid e r a ud ie nc e for
b orrowing . It c a n a p p roa c h fina nc ia l institutions, b a nks, inve sting c om p a nie s.
➔ Self Discipline by Companies : Cre d it ra ting is b e ne fic ia l to the non-p op ula r c om p a nie s, suc h a s c lose ly-he ld
c om p a nie s. If the c re d it ra ting is g ood , the p ub lic will inve st in the se c om p a nie s, e ve n if the y d o not know the se
c om p a nie s.
➔ Rating as a Marketing Tool : Cre d it ra ting not only he lp s to d e ve lop a g ood im a g e of the c om p a ny a m ong the
inve stors, b ut a lso a m ong the c ustom e rs, d e a le rs, sup p lie rs, e tc . Hig h c re d it ra ting c a n a c t a s a m a rke ting tool to
d e ve lop c onfid e nc e in the m ind s of c ustom e rs, d e a le r, sup p lie rs, e tc .

➔ Motivation for Growth : Cre d it ra ting e na b le s a c om p a ny to g row a nd e xp a nd . This is b e c a use b e tte r c re d it ra ting
will e na b le a c om p a ny to g e t fina nc e e a sily for g rowth a nd e xp a nsion.
Benefits to financial Intermediaries
The rated instruments speak themselves about the financial soundness and strength
of a company. Because of this the financial intermediaries and the brokers are able to
save their time, cost and energy in convincing the client to invest in that company.

Other Benefits

➔ Id e ntific a tion of Stre ng th a nd W e a kne ss of the Issue r Com p a ny

➔ Liq uid ity a nd Ma rke ta b ility of De b t Se c uritie s
➔ Positive Im p a c t on Ca p ita l Ma rke t
 Case of IL&FS
➔ IL&FS Group is a vast conglomerate with a complex corporate structure that funds
infra struc ture p roje c ts a c ross the world ’s fa ste s t-g rowing m a jor e c onom y. The fina nc ie r, se t
up in 1987, a nd its liste d sub sid ia rie s ha ve p owe re d Ind ia ’s infra struc ture b oom - inc lud ing the
Che na ni-Na shri roa d tunne l, Ind ia ’s long e st - a nd ra ise d b illions of d olla rs from the c ountry’s
c orp ora te d e b t m a rke t.
➔ IL&FS is a hug e b orrowe r, a c c ounting for 2% of outs ta nd ing c om m e rc ia l p a p e r, 1% of
d e b e nture s a nd a s m uc h a s 0 .7% of b a nking syste m loa ns. The g roup itse lf in turn a c ts a s a
ke y sourc e of c a p ita l to non-b a nk le nd e rs.
➔ Until July 20 18, Ind ia ’s c re d it ra ting c om p a nie s ha d inve stm e nt g ra d e ra ting s on b illions of
d olla rs of c orp ora te d e b t ra ise d b y the IL&FS Group a nd its sub sid ia rie s. The first sig ns of
troub le c a m e in June , whe n the sp e c ia l p urp ose ve hic le s tie d to IL&FS Tra nsp orta tion
Ne tworks Ltd ., a g roup sub sid ia ry, d e fa ulte d on its d e b t ob lig a tions. More d e fa ults in othe r
p a rts of the e m p ire followe d in Aug us t a nd Se p te m b e r.
➔ In Aug us t 20 18, m a jor c re d it ra ting c om p a nie s suc h a s ICRA, a unit of Mood y’s, Fitc h-owne d
Ind ia Ra ting s & Re se a rc h a nd CARE b e g a n to c ut the ir ra ting for the g roup ’s p a re nt c om p a ny,
Infra struc ture Le a sing & Fina nc ia l Se rvic e s
➔ The “issuer-p a ys " m od e l a fford s the ra ting c om p a nie s a c c e ss to the b orrowe r’s m a na g e m e nt
a nd he lp s to fa c tor in re g ula r inp uts a b out the issue r, a c c ord ing to S&P’s Ind ia unit, whic h sa id
it c olle c ts fe e s up front a nd ha sn’t a sse s s e d IL&FS. Othe r m od e ls suc h a s “inve stor-p a ys" a nd
“re g ula tor or g ove rnm e nt p a ys" ha ve n’t b e e n te ste d , it sa id in a e m a ile d sta te m e nt.
➔ IL&FS g roup ’s inve stm e nt g ra d e ra ting wa s b a se d on the stre ng th of the inve stors in the
p a re nt c om p a ny, a c c ord ing to a n offic ia l a t a ra ting c om p a ny. The le nd e r’s inve stors inc lud e
Life Insura nc e Corp ., Ind ia ’s la rg e st life insure r; Sta te Ba nk of Ind ia , its la rg e st b a nk; a nd
Housing De ve lop m e nt Fina nc e Corp , its la rg e st m ortg a g e le nd e r. Ja p a n’s Orix Corp . is the
c om p a ny’s se c ond -la rg e st sha re hold e r
➔ For IL&FS, ra ting c om p a ny ICRA, fla g g e d the g roup ’s “e le va te d le ve ra g e " in Ma rc h b ut ke p t its
inve stm e nt g ra d e ra ting b e c a use of “e xp e rie nc e d se nior m a na g e m e nt te a m a nd its sig nific a nt
tra c k re c ord of op e ra tions in the infra struc ture d om a in.
Limitations
➔ Biased rating and misrepresentations
➔ Concealment of material information
➔ Rating is no guarantee for soundness of
company
➔ Human bias
➔ Reflection of temporary adverse
conditions
➔ Difference in rating of two agencies
Possible solutions
➔ The regulators should seriously consider
mandatory rotation of the rating agency of
an issuer just like the rotation of auditors
➔ This will allay the concern that a very long
association between issuer and rating
agency may allow scope for complacency
➔ We should look at alternative models like
investors or regulator paying to rate
issuances of a company
➔ Another model proposed to prevent ‘rating
shopping’ is that regulators create a
centralised clearing platform for rating
agencies. While issuers still pay the rating
fee, the centralised clearing platform would
assign a rating firm for an issue using its
discretion.