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INTRODUCTION

The removal of strict regulatory framework in recent years. has led to a spurt in the number of companies borrowing directly from the capital markets. There have been several instances in the recent past where the "fly-by-nightn operators have cheated unwary investors. In such a situation, it has become increasingly difficult for an ordinary investor to distinguish between 'safe and good investment opportunities' and 'unsafe and bad investments'. Investors find that a borrower's size or name are no longer a sufficient guarantee of timely payment of interest and principal. Investors perceive the need of an independent and credible agency, which judges impartially and in a professional manner, the credit quality of different companies and assist investors in making their investment decisions. Credit Rating Agencies, by providing a simple system of gradation of corporate debt instruments, assist lenders to form an opinion on -the relative capacities of the borrowers to meet their 5 I Financial and Investment obligations. These Credit Rating Agencies, thus, assist and Institutions in India form an integral part of a broader programme of financial disintermediation and broadening and deepening of the debt market. Credit rating is used' extensively fqr evaluating debt instruments. These include long-term instruments, like bonds and debentures as will as short-term obligations, like Commercial Paper. In addition, fured deposits, certificates of deposits, inter-corporate deposits, structured obligations including non-convertible portion of partly Convertible Debentures (PCDs) and preferences shares are also rated. The Securities and Exchange Board of India (SEBI), the regulator of Indian Capital Market, has now decided to enforce mandatory rating of all debt instruments irrespective of their maturity. Let us recall that earlier only debt issues " of over 18 months maturity had to be compulsorily rated.

Credit rating agency


A Credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings. In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued. The value of such security ratings has been widely questioned after the 2007-09 financial crisis. In 2003 the U.S. Securities and Exchange Commission submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.[1] More recently, ratings downgrades during the European sovereign debt crisis of 2010-11 have drawn criticism from the EU and individual countries. A company that issues credit scores for individual credit-worthiness is generally called a credit bureau (US) or consumer credit reporting agency (UK).

Uses of ratings
Credit ratings are used by investors, issuers, investment banks, broker-dealers, and 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.
[edit] Ratings use by bond issuers

Issuers rely on credit ratings as an independent verification of their own credit-worthiness and the resultant value of the instruments they issue. 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). Studies by the Bond Market Association note that many 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.
[edit] Ratings use by government regulators

Regulators use credit ratings as well, or permit 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" (NRSRO) for similar purposes. The idea is that banks and other financial institutions should not need 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). CRA ratings are also used for other regulatory purposes as well. The US SEC, for example, permits certain bond issuers to use a shortened 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 Federal Deposit Insurance Corporation insurance) comprise only securities with a very high NRSRO rating. Likewise, insurance regulators use credit ratings to ascertain the strength of the reserves held by insurance companies.

In 2008, the US SEC voted unanimously to propose amendments to its rules[2] that would remove credit ratings as one of the conditions for companies seeking to use short-form registration when registering securities for public sale. This marks the first in a series of upcoming SEC proposals in accordance with Dodd-Frank to remove references to credit ratings contained within existing Commission rules and replace them with alternative criteria. Under both Basel II and SEC regulations, not just any CRA's ratings can be used for regulatory purposes. (If this were the case, it would present a moral hazard).[citation needed] Rather, there is a vetting process of varying sorts. The Basel II guidelines[3] (paragraph 91, et al.), for example, describe certain criteria that bank regulators should look to when permitting the ratings from a particular CRA to be used. These include "objectivity," "independence," "transparency," and others. Banking regulators from a number of jurisdictions have since issued their own discussion papers on this subject, to further define how these terms will be used in practice. (See The Committee of European Banking Supervisors Discussion Paper,[4] or the State Bank of Pakistan ECAI Criteria).[5] In the United States, since 1975, NRSRO recognition has been granted through a "No Action Letter" sent by the SEC staff. Following this approach, if a CRA (or investment bank or brokerdealer) were interested in using the ratings from a particular CRA for regulatory purposes, the SEC staff would research the market to determine whether ratings from that particular CRA are widely used and considered "reliable and credible." If the SEC staff determines that this is the case, it sends a letter to the CRA indicating that if a regulated entity were to rely on the CRA's ratings, the SEC staff will not recommend enforcement action against that entity. These "No Action" letters are made public and can be relied upon by other regulated entities, not just the entity making the original request. The SEC has since sought to further define the criteria it uses when making this assessment, and in March 2005 published a proposed regulation to this effect. On September 29, 2006, US President George W. Bush signed into law the "Credit Rating Reform Act of 2006".[6] This law requires the US Securities and Exchange Commission to clarify how NRSRO recognition is granted, eliminates the "No Action Letter" approach and makes NRSRO recognition a Commission (rather than SEC staff) decision, and requires NRSROs to register with, and be regulated by, the SEC. S & P protested the Act on the grounds that it is an unconstitutional violation of freedom of speech.[6] In the Summer of 2007 the SEC issued regulations implementing the act, requiring rating agencies to have policies to prevent misuse of nonpublic information, disclosure of conflicts of interest and prohibitions against "unfair practices".[7] Recognizing CRAs' role in capital formation, some governments have attempted to jump-start their domestic rating-agency businesses with various kinds of regulatory relief or encouragement. This may, however, be counterproductive, if it dulls the market mechanism by which agencies compete, subsidizing less-capable agencies and penalizing agencies that devote resources to higher-quality opinions.

Ratings use in structured finance

Credit rating agencies may also play a key role in structured financial transactions. Unlike a "typical" loan or bond issuance, where a borrower offers to pay a certain return on a loan, structured financial transactions may be viewed as either a series of loans with different characteristics, or else a number of small loans of a similar type packaged together into a series of "buckets" (with the "buckets" or different loans called "tranches"). Credit ratings often determine the interest rate or price ascribed to a particular tranche, based on the quality of loans or quality of assets contained within that grouping. Companies involved in structured financing arrangements often consult with credit rating agencies to help them determine how to structure the individual tranches so that each receives a desired credit rating. For example, a firm may wish to borrow a large sum of money by issuing debt securities. However, the amount is so large that the return investors may demand on a single issuance would be prohibitive. Instead, it decides to issue three separate bonds, with three separate credit ratingsA (medium low risk), BBB (medium risk), and BB (speculative) (using Standard & Poor's rating system). The firm expects that the effective interest rate it pays on the A-rated bonds will be much less than the rate it must pay on the BB-rated bonds, but that, overall, the amount it must pay for the total capital it raises will be less than it would pay if the entire amount were raised from a single bond offering. As this transaction is devised, the firm may consult with a credit rating agency to see how it must structure each tranchein other words, what types of assets must be used to secure the debt in each tranchein order for that tranche to receive the desired rating when it is issued. There has been criticism in the wake of large losses in the collateralized debt obligation (CDO) market that occurred despite being assigned top ratings by the CRAs. For instance, losses on $340.7 million worth of CDOs issued by Credit Suisse Group added up to about $125 million, despite being rated AAA or Aaa by Standard & Poor's, Moody's Investors Service and Fitch Group.[8] The rating agencies respond that their advice constitutes only a "point in time" analysis, that they make clear that they never promise or guarantee a certain rating to a tranche, and that they also make clear that any change in circumstance regarding the risk factors of a particular tranche will invalidate their analysis and result in a different credit rating. In addition, some CRAs do not rate bond issuances upon which they have offered such advice. Complicating matters, particularly where structured finance transactions are concerned, the rating agencies state that their ratings are opinions (and as such, are protected free speech, granted to them by the "personhood" of corporations) regarding the likelihood that a given debt security will fail to be serviced over a given period of time, and not an opinion on the volatility of that security and certainly not the wisdom of investing in that security. In the past, most highly rated (AAA or Aaa) debt securities were characterized by low volatility and high liquidityin other words, the price of a highly rated bond did not fluctuate greatly day-to-day, and sellers of such securities could easily find buyers.

However, structured transactions that involve the bundling of hundreds or thousands of similar (and similarly rated) securities tend to concentrate similar risk in such a way that even a slight change on a chance of default can have an enormous effect on the price of the bundled security. This means that even though a rating agency could be correct in its opinion that the chance of default of a structured product is very low, even a slight change in the market's perception of the risk of that product can have a disproportionate effect on the product's market price, with the result that an ostensibly AAA or Aaa-rated security can collapse in price even without there being any default (or significant chance of default). This possibility raises significant regulatory issues because the use of ratings in securities and banking regulation (as noted above) assumes that high ratings correspond with low volatility and high liquidity.

List of credit rating agencies


Agencies that assign credit ratings for corporations include:
y y y y y y y y y y y y y y y y y

A. M. Best (U.S.) Baycorp Advantage (Australia) Capital Intelligence (Cyprus)[34] Capital Standards Rating (Kuwait)[35] Credo line (Ukraine) CTRISKS (Hong Kong )[36] Dagong Global (People's Republic of China) Dominion Bond Rating Service (Canada) Egan-Jones Rating Company (U.S.) Fitch Ratings (Dual-headquartered U.S./UK) CIBIL (India) Japan Credit Rating Agency, Ltd. (Japan)[37] Moody's Investors Service (U.S.) Muros Ratings[38] (Russia alternative rating agency) Rapid Ratings International (U.S.) Standard & Poor's (U.S.) Weiss Ratings (U.S.)

Credit Report
A credit report is important for everyone. When you make purchases by credit, your payment history is reported to the three major credit reporting agencies. Many companies will review your credit history to determine if they want to do business with you or give you a loan or credit

Types of Credit Reports:


y y y

Annual credit report Business credit report and Consumer credit report

The Annual credit report is prepared by each of the 3 US credit reporting agencies, which are Experian, TransUnion and Exuifax. The credit report comprises US consumer credit history. The 'Fair Accurate Credit Transaction' alternatively known as FACT states that, all US consumers can avail a free transcript of credit report yearly from any of the above mentioned national bureaus on request. Any subsequent requests for credit reports will entail payment to these US credit bureaus. Business credit report essentially documents the credit history of business organizations. This report also comes for free. Consumer credit report involves consumer credit history as documented by US credit reporting agencies. Its primary difference with the annual credit report lies in the fact that consumers can place a demand for it at any point of time in a year. It is not free. Consumers can access online consumer credit reports, which are instant on the payment of the requisite fees.

Functions of Credit Rating Agencies The primary function of the credit rating agencies is to provide credit ratings to the service providers of various forms of debt products and services. They are also meant to provide ratings to the debt instruments being provided by these service providers. The clients of the credit rating agencies are those entities that deal in the provision of debt products and services. At times, it has been observed that the companies that provide debt products and services are rating the debt instruments by themselves.

THE DETERMINANTS OF RATINGS

The default-risk assessment and quality rating assigned to Issuers are primarily determined by three factors i) The issuer's ability to pay,

ii) ' The strength of the security owner's claim on the issue, and

iii) The economic significance of the industry and market place Of the issuer... Ratio analysis is used to analyse the present and future Earning power of the issuing corporation and to get insight Into the strengths and weaknesses of the firm. Bond rating Agencies have suggested guidelines about what value each Ratio should have within a particular quality rating. Different Ratios are favoured by rating agencies.

RATING METHODOLOGY
kating is a search for long-term fundamentals and the pr,obabilities for changes in the fundamentals. Each agency's rating process usually includes fundamental analysis of public and private issuer-specific data, 'industry analysis
Financial and Investment presentations by the issuer's senior Institutions 'in India classification models, and judgments . .

executives, statistical . ..

Key areas considered in a rating include the following: i) Business Risk: To ascertain business risk, the rating Agency considers Industry's characteristics, performance And outlook, operating position (capacity, market share, distribution system, marketing network, etc.), technological Aspects, business cycles, size and capital intensity.

ii) Financial Risk : To assess financial risk, the rating agency Takes into account various aspects of its Financial Management (e.g. capital structure, liquidity position, financial flexibility and cash flow adequacy, profitability, leverage, interest coverage), projections with particular emphasis on the components of cash flow and claims thereon, accounting policies and practices with particular reference to practices of providing depieciation, income recognition, inventory valuation, off-balance sheet claims and liabilities, amortization of intangible assets, foreign currency transactions, etc. iii) Management Evaluation : Management evaluation includes consideration of the background and history of the issuer, corporate strategy and philosophy, organisational structure, quality of management and management capabilities under stress, personnel policies etc.

CREDIT RATING AGENCIES IN INDIA


In India, at present, there are four credit Rating Agencies: i) Credit Rating and Information Services of India Limited (CRISIL). ii) Investment Information and Credit Rating Agency of India Limited (ICRA) . iii) Credit Analysis and Research Limited (CARE). iv) Duff and Phelps Credit Rating of India (Pvt.) Ltd.
I

CRISIL: This was set-up by ICICI and UTI in 1988, and rates debt instruments. Nearly half of its ratings on the Instruments are being used. CRISIL's market share is Around 75%. It has launched innovative products for credit risks assessment viz., counter party ratings and bank loan ratings. CRISIL rates debentures, fixed deposits, commercial papers, preference shares and structured obligations. Of the total value of instruments rated, debentures' accounted for 3 1.196, fmed deposits for 42.3% and commercial paper 6.6%. CRISIL publishes CRISIL rating in SCAN that is a quarterly publication in Hindi and Gujarati, besides English. CRISIL evaluation is carried out by professionally qualified persons and includes data collection, analysis and meeting with key personnel in the company to discuss strategies, plans and other issues that may effect ,evaluation of the company. The rating ,process ensures confidentiality. Once . the company decides to use rating, CRISIL is obligated to monitor the rating over the life of the debt instrument.
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ii) ICRA : ICRA was promoted by IFCI in 1991. During the year 1996-97, ICRA rated 261 debt instruments of manufacturing companies, finance companies and financial institutions equivalent to Rs. 12,850 crore as compared to 293 instruments covering debt volume of Rs. 75,742 crore in 1995-96. This showed a decline of 83.0% over the year in the volume of rated debt instruments. Of the total amount rated cumulatively until March-end 1997, the share in terms of number of instruments was 28.5% for debentures (including long ternr'instruments), 49.4% for Fixed Deposit programme (including medium- term instruments), and

22.1% for Commercial Paper Programme (including shortterm instmments). The corresponding figures of amount involved for these three broad rated categories was 23.8% trends in cash flows and potential liquidity, financial flexibility, asset quality and past record of servicing of debt as well as government policies affecting the industry are examined. Besides determining the credit risk associated with a debt instrument, ICRA has also formed a group under Earnings Prospects and Risk Analysis (EPRA). Its goal is to provide authentic information on the relative quality of the equity.

BENEFITS OF CREDIT RATING

Rating serves as a useful tool for different constituents of the capital market. For different classes of persons, different benefits accrue from the use of rated instruments. 1) Investors : Rating safeguards against bankruptcy through recognition of risk. It gives an idea of the risk involved in the investment. It gives a clue to the credibility of the issuer company. Rating symbols give information on the quality of instrument in a simpler way that can be understood by lay investor and help him in taking decision on investment without the help from broker. Both individuals and institutions can draw up their credit risk policies and assess the adequacy or otherwise of the risk premium offered by the market on the basis of credit ratings. 2) Issuers of Debt Instruments : A company whose instruments are highly rated has the opportunity to have a wider access to capital, at lower cost of borrowing. Rating also facilitates the best pricing and timing of issues and provides financing flexibility. Companies with rated instruments can use the rating as a marketing tool to create a better image in dealing with its customers, lenders and creditors. Ratings encourage the companies to come out with more disclosures about their accounting systems, financial reporting and management pattern. It also makes it possible for some categoiy of investors who require mandated rating from

reputed rating agencies to make investments.

3) Financial Intermediaries : Financial intermediaries like

banks, merchant bankers, and investment advisers find rating as a very useful input in the decisions relating to lending and investments. For instance, kith high credit rating, the brokers can convince their clients to select a particular investment proposal Inore easily thereby saving on time, cost and manpower ill convincing their clients.
4) Business Counter-parties : The credit rating helps business

counter-parties in establishing business relationships particularly for opening letters of credit, awarding contracts, entering into collaboration agreements, etc.

RATING AND DEFAULT RISK


Most investors prefer to use credit ratings to assess default risk. Internationally acclaimed credit rating agencies such as Moody's, Standard and Poor's and Duff and Phelps have been offering rating services to bond issuers over a very long time. The bond issuers pay the rating agency to evaluate the quality of the bond issue in order to increase the information flow to investors and hopefully increase the demand for their bonds. The rating agency determines the appropriate bond rating by assessing various factors. For example, Standard and Poor's judges the credit quality of corporate bonds largely by looking at the bond indenture, asset protection, financial resources, future earning power, and management. More specifically, Standard and Poor's focuses on cash flows to judge a firm's financial viability.

LIMITATIONS OF CREDIT RATINGS


There are several limitations of credit ratings. First, credit ratings are changed when the agencies feel that sufficient changes have occurred. The rating agencies are physically unable to constantly monitor all the firms in the market. The opinions of rating agencies may turn wrong in the context of subsequent events that may have an adverse impact on asset quality of the issuer. Second, the use of credit ratings imposes discrete categories on default risk, while, in reality default risk is a continuous phenomenon. Moody's recognised this way back in 1982 by adding numbers to the letter system, thereby increasing its number of rating categories from 9 to 19. Nevertheless, this limitation still pertains. The letter grades assigned by rating agencies serve only as a gcneral, somewhat coarse form of discrimination.

Conclusion: The agencies proved that they are poor at rating complex structured finance products. Their approach to rating sub-prime mortgage backed securities was not sufficiently rigorous and their models for assessing other more complex products were inadequate. By virtue of this, their opinions on these products should now be viewed as being of little value and the market should effectively withdraw the agencies licence to rate such products. This will open the door for new specialist structured finance ratings agencies to enter the market. This seems a better approach than more regulation and the unintended consequences that could result.