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Credit rating

Introduction

It is the effort of investors in financial instruments to minimize or eliminate default risk. Credit rating (CR) service is useful to them in designing strategies for this purpose. It can be defined as an act of assigning values to credit instruments by estimating or assessing the solvency, i.e. the ability of the borrower to reimburse debt, and expressing them through predetermined symbols. It is an assessment of the credit quality or investment quality of a particular credit instrument issued by a given business unit. The following definitions of CR indicate towards the same meaning of CR:

Credit rating is designed exclusively for the purpose of grading bonds according to their investment quality.?

Corporate or municipal debt rating is a current assessment of the credit worthiness of the obligator with respect to a specific obligation.?

A corporate Credit rating provides lenders with a simple system of gradation by which the relative capacities of companies to make timely repayment of interest and principal on a particular type of debt can be noted. The higher the rating, the greater the likelihood that the borrower will fulfill his obligations towards the creditors.?

In order to know the meaning of CR, it is useful to know what it is not. CR is not a recommendation to purchase, sell, or hold security. It is not a general-purpose evaluation of the company. It does not create a fiduciary relationship between the credit rating agency (CRA) and the rating users. It does not imply that the CRA performs an audit function or attests the veracity of information provided by the borrowers. It is not a one-time evaluation of risk, which remains valid for the entire life of the society.

Credit rating is done by specialized, expert, reputed, accredited institutions. It is mostly confined to debt instruments, but efforts are made to rate equity shares also. In CR, though the whole organization is not graded, it does reflect the issuer?s strength, soundness of operations, quality of management, organizational behavior, and composite performance. CR may differ for different instruments issued by the same organization because of the different nature of obligations each instrument contains. The CRA undertakes the job of rating an instrument on a request by the organization issuing that instrument. However, once it gives a rating for an instrument, it becomes its obligation towards investors to announce the deterioration/improvement in the grade of that instrument, whether the issuer wants it or not. Unsolicited CR also exists abroad. While assigning ratings, CRAs take into account factors such as industry risk, market position, operating efficiency, track record, planning and control systems, accounting quality, financial flexibility, profitability, liquidity, and asset quality of the borrower. CR is based on information provided by the borrower and the one obtained by CRA independently. After they are assigned, ratings are continuously monitored by CRA, and they can be changed, suspended, and withdrawn by it at any time because of new information or other circumstances.

The practice of ?country rating? or ?sovereign rating? as well as debt instruments? rating is becoming more common in the recent past. It is worth noting that while in the case of domestic borrowers only the instruments are rated. In the case of country ratings, the whole country or nation is rated which is against the basic tenet of CR.

Though the basic objective of CR is to provide superior and low-cost information to investors for taking a decision regarding risk-return trade-off, it helps other market participants in many ways:

ğIt imposes a healthy discipline on borrowers.

ğIt lends greater credence to financial and other representations.

ğIt facilitates formulation of public guidelines on institutional investment.

ğIt helps merchant bankers, brokers, regulatory authorities, etc. in discouraging their functions related to debt issues.

ğIt encourages greater information disclosure; better accounting standards, and improved financial information, which help in investor protection.

ğIt may reduce interest costs for highly rated companies.

ğAs a marketing tool, it is of great help to the issuer.

Credit rating guide the investors, but they may also misguide them, which depends on both the expertise and honesty of CRAs. Credit rating is a science as well as an art. It is rightly pointed out that rating will never be a precise science. There are too many variables or a tremendous variety and combination of business conditions to be judged. Therefore, there is no magic formula for arriving at CR. It involves matters of judgment, not merely an analysis of statistics. Subject to this, the usefulness of CR depends upon the quality of CRA, its independence from industrial concerns, absence of its vested interest in or linkages with the issuer of securities, its objectivity, the quality of its staff, and so on.

The CR in India began in 1988. At present, the following four CRAs are at work in India:

Credit Rating Information Services of India Ltd. (CRISIL)

It was set up in January 1988 jointly by ICICI, UTI, LIC, GIC, Asian Development Bank as the first CRA in India. Its objective is to rate, on request from companies, their debentures, fixed deposit programmes, short-term borrowing instruments, and preference shares. The CRISIL ratings are required by the authorities, banks, UTI, merchant bankers, etc. when they assist companies. CRISIL also provides corporate reports on a regular basis on public sector and private sector companies, containing information on their financial, business, and technical aspects. It also undertakes industry studies on requests covering topics such as structure of industry, basis of competition, and demand/supply estimates.

Investment Information and Credit Rating Agency of India Ltd. (ICRA)

It was established in 1991. It rates short, medium and long-term debt instruments. However, since1995, it is also doing equity rating to some extent. Its Earnings Prospects and Risk Analysis Group grades equities for the primary market, and assess them for the secondary market. While the former is undertaken at the instance of the issuer, the latter is done at the instance of the investor.

Credit Analysis and Research Ltd. (CARE)

It commenced operations in November 1993. It is set up by the IDBI in collaboration with some banks and financial service companies.

ONIDA Individual Credit Rating Agency of India Ltd. (ONICRA)

It was launched in November 1993. Its objective is to assess creditworthiness of individuals seeking finance for purchases of consumer durables or trade credit.

The RBI and SEBI made credit rating mandatory in respect of all non-government debt securities where the maturities exceed 18 months or the conversion takes place after 18 months.

The credit rating activity in India suffers from certain weaknesses. The CRAs in India do not do unsolicited rating, and the firms, which are not happy with their rating, are free not to use it, and go elsewhere in search of a better rating. It is estimated that about a third of the ratings done by CRAs are not accepted by their clients. It is feared that this will lead to a competitive relaxation of rating standards by CRAs. The institutions whose instruments were given the highest rating performed badly. Ratings in India do not often communicate much objective information in financial terms, that they display poor discriminating ability.

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