Credit Rating Meaning, Origin, Features, Advantages of Rating, Regulatory Framework

7th December 2021 0 By indiafreenotes

A credit rating is an evaluation of the credit risk of a prospective debtor (an individual, a business, company or a government), predicting their ability to pay back the debt, and an implicit forecast of the likelihood of the debtor defaulting. The credit rating represents an evaluation of a credit rating agency of the qualitative and quantitative information for the prospective debtor, including information provided by the prospective debtor and other non-public information obtained by the credit rating agency’s analysts.

Credit reporting (or credit score) is a subset of credit rating it is a numeric evaluation of an individual’s credit worthiness, which is done by a credit bureau or consumer credit reporting agency.

A credit agency evaluates the credit rating of a debtor by analyzing the qualitative and quantitative attributes of the entity in question. The information may be sourced from internal information provided by the entity, such as audited financial statements, annual reports, as well as external information such as analyst reports, published news articles, overall industry analysis, and projections.

A credit agency is not involved in the transaction of the deal and, therefore, is deemed to provide an independent and impartial opinion of the credit risk carried by a particular entity seeking to raise money through loans or bond issuance.

Origin:

Mercantile credit agencies the precursors of today’s rating agencies were established in the wake of the financial crisis of 1837. These agencies rated the ability of merchants to pay their debts and consolidated these ratings in published guides. The first such agency was established in 1841 by Lewis Tappan in New York City. It was subsequently acquired by Robert Dun, who published its first ratings guide in 1859. Another early agency, John Bradstreet, formed in 1849 and published a ratings guide in 1857.

Credit rating agencies originated in the United States in the early 1900s, when ratings began to be applied to securities, specifically those related to the railroad bond market. In the United States, the construction of extensive railroad systems had led to the development of corporate bond issues to finance them, and therefore a bond market several times larger than in other countries. The bond markets in the Netherlands and Britain had been established longer but tended to be small, and revolved around sovereign governments that were trusted to honor their debts. Companies were founded to provide investors with financial information on the growing railroad industry, including Henry Varnum Poor’s publishing company, which produced a publication compiling financial data about the railroad and canal industries. Following the 1907 financial crisis, demand rose for such independent market information, in particular for independent analyses of bond creditworthiness. In 1909, financial analyst John Moody issued a publication focused solely on railroad bonds. His ratings became the first to be published widely in an accessible format, and his company was the first to charge subscription fees to investors.

In 1913, the ratings publication by Moody’s underwent two significant changes: it expanded its focus to include industrial firms and utilities, and it began to use a letter-rating system. For the first time, public securities were rated using a system borrowed from the mercantile credit rating agencies, using letters to indicate their creditworthiness. In the next few years, antecedents of the “Big Three” credit rating agencies were established. Poor’s Publishing Company began issuing ratings in 1916, Standard Statistics Company in 1922, and the Fitch Publishing Company in 1924.

A market for low-rated, high-yield “junk” bonds blossomed in the late 1970s, expanding securities financing to firms other than a few large, established blue chip corporations. Rating agencies also began to apply their ratings beyond bonds to counterparty risks, the performance risk of mortgage servicers, and the price volatility of mutual funds and mortgage-backed securities. Ratings were increasingly used in most developed countries’ financial markets and in the “emerging markets” of the developing world. Moody’s and S&P opened offices Europe, Japan, and particularly emerging markets. Non-American agencies also developed outside of the United States. Along with the largest US raters, one British, two Canadian and three Japanese firms were listed among the world’s “most influential” rating agencies in the early 1990s by the Financial Times publication Credit Ratings International.

Structured finance was another growth area of growth. The “financial engineering” of the new “private-label” asset-backed securities such as subprime mortgage-backed securities (MBS), collateralized debt obligations (CDO), “CDO-Squared”, and “synthetic CDOs” made them “harder to understand and to price” and became a profit center for rating agencies. By 2006, Moody’s earned $881 million in revenue from structured finance. By December 2008, there were over $11 trillion structured finance debt securities outstanding in the US bond market.

The Big Three issued 97%–98% of all credit ratings in the United States and roughly 95% worldwide, giving them considerable pricing power. This and credit market expansion brought them profit margins of around 50% from 2004 through 2009.

As the influence and profitability of CRAs expanded, so did scrutiny and concern about their performance and alleged illegal practices. In 1996 the US Department of Justice launched an investigation into possible improper pressuring of issuers by Moody’s in order to win business. Agencies were subjected to dozens of lawsuits by investors complaining of inaccurate ratings following the collapse of Enron,[ and especially after the US subprime mortgage crisis and subsequent financial crisis of 2007–2008. During that debacle, 73% over $800 billion worth of all mortgage-backed securities that one credit rating agency (Moody’s) had rated triple-A in 2006 were downgraded to junk status two years later. In July 2008, SIFMA formed a global task force with members drawn from a cross-section of the financial services industry, including asset managers, underwriters, and issuers, and provided industry input to lawmakers and regulators in Europe and Asia, and was designated by the U.S. President’s Working Group on Financial Markets as the private-sector group to provide the PWG with industry recommendations on credit rating matters. It published the “Recommendations of the Securities Industry and Financial Markets Association Credit Rating Agency Task Force”, which included a dozen recommendations to change the credit rating agency process.

Features

Provides superior Information:

Provides superior information on credit risk for three reasons:

(i) An independent rating agency, unlike brokers, financial intermediaries, underwriters who have vested interest in an issue, is likely to provide an unbiased opinion.

(ii) Due to professional and highly trained staff, their ability to assess risk is better, and finally.

(iii) The rating firm has access to a lot of information which may not be publicly available.

Basis for a proper risk and return:

If an instrument is rated by a credit rating agency, then such instrument enjoys higher confidence from investors. Investors have some idea as to what is the risk associated with the instrument in which he/she is likely to take, if investment is done in that security.

Low cost information:

Rating firm gathers, analyses, interprets and summarises complex information in a simple and readily understood formal manner. It is highly welcome by most investors who find it prohibitively expensive and simply impossible to do such credit evaluation of their own.

Healthy discipline on corporate borrowers:

Higher credit rating to any credit investment tends to enhance the corporate image and visibility and hence it induces a healthy discipline on corporate.

Formation of public policy:

Public policy guidelines on what kinds of securities are eligible for inclusions in different kinds of institutional portfolios can be developed with greater confidence if debt securities are rated professionally.

Greater credence to financial and other representation:

When credit rating agency rates a security, its own reputation is at stake. So it seeks financial and other information, the quality of which is acceptable to it. As the issue complies with the demands of a credit rating agency on a continuing basis, its financial and other representations acquire greater credibility.

Advantages of Rating

Benefits to Investors

Safe Investment Environment

Credit Ratings provide a prior approach to understanding the instrument and issuer company. Based on the advance information and ratings, investors invest on the desired instrument which qualifies their expectation. High rated instruments assure investors the instrument to be safe but return on investment is low and vice versa.

Recognition of Risk and Return

Credit rating is also the reflection of risk factors associated with the instrument. Higher rating signifies low risk of default and low rating reflects high chance of default. Credit ratings make work easier for investors to understand the worth of the instrument and issuer. Similarly, investors can assign and evaluate the risk-return factors associated with the instruments.

Freedom of Investment Decision

Credit Ratings is a publicly published document which reflects the potential of the instrument. Investors can rely upon these ratings for making their investment decision. Investors do not need to consider stock brokers, merchant bankers, portfolio managers, independent advisors etc. about the creditworthiness of the debt instrument with credit ratings. This is the freedom for investors in their investment decision.

Wider Choice of Investment

It is very essential for the issuer company to rate their debt instrument to increase the confidence of investors for their high rating issues. Similarly, there are multiple issues from multiple organizations and credit rating defines each issue and investors can choose the needed investment from this available variety of rated debt instruments.

Easy understanding of investment proposals

Credit rating agencies publish the final rating after considering various factors related to the particular instruments. The final rating published is denoted by alphabetical or alphanumeric symbols. Each symbol has some significance. Therefore, looking at these symbols, investors can easily understand the worth of the instruments.

Relief from botheration to know company

Credit rating is the final valuation of the debt instruments. The credit rating is alone capable of reflecting various information from its alphanumeric and alphabetic representation. Credit rating saves investors from hectic work company analysis and other valuations.

Advantages of continuous monitoring

Credit Rating is a continuous approach until the instrument is available in the market. Unlike other valuation. Credit rating is a continuous  approach where the rating of instruments upgrade and downgrade subject to market factors.

Benefits to the Company

Easy to raise resources

Credit ratings measure multiple aspects of an instrument. A company with highly rated debt has probably the higher chances to raise funds  from the market. The ratings of different instruments attract different sets of investors i.e. investment decision is informed and hence matching instruments with investors is easier.

Reduce the cost of borrowing

Credit Rating allows a match of risk-return factor associated with the instruments. Higher rated instruments means the chance of default is low or is secure investment and hence the return i.e interest on such instrument is lower. The issuer company will have enough ground to define market value of their instrument. A higher rated debt will have lower cost of borrowing.

Reduce the cost of public issues

A high rated instrument will have to face less challenges in attracting investors for raising funds. Also, credit rating will attract only those investors who are interested hece cost will be reduced as unwanted subscription while raising funds is minimized.

Rating reflects image

Credit rating is done for instruments but ratings can influence the image of the issuer as well. An issuer with high rated debt in its portfolio will definitely enjoy the goodwill and corporate image. The investors, customers, shareholders and creditors are assured about the issuers as the debt issued is highly rated. Everyone feels safe with their association with such an issuer.

Rating facilitates growth

Ratings attract the desired investors. A high rate debt instrument will have desired investors and raising of funds will not be an issue. This provides companies with an expansion strategy diversifying their business and operations. Highly rated companies will never feel shortage of funds as there are investors ready to invest on their highly rated goodwill.

Recognition of new/unknown companies

Rating is not preferred by all the issuers. As rating involves disclosure of information, many new issuers prefer not giving this. A-rated issue in the market will have more credentials than a normal public issue. Investors are sure about the credit rating as someone has conducted an analysis for such issues. Similarly, an unknown company gets some recognition in public issues due to credit rating.

Regulatory Framework

Registration: Broadly, the CRA Regulations require that CRAs should be companies promoted by persons who have experience in the field of credit rating i.e., by financial institutions or by persons who have a net-worth of more than 100 crore rupees. CRAs need to have a minimum net-worth of 5 crore rupees, and adequate infrastructure, professionals and employees to carry on the activity of issuing credit ratings. Additionally, registration would only be granted if it registering the applicant is in the interest of investors and the securities market.

Obligations: The CRA Regulations envisage that CRAs need to carry out their activities in accordance with the terms of their engagement with the issuer,35 and the baseline principles in the Regulations. CRAs have to comply with the Code of Conduct prescribed by SEBI, which requires that they discharge their duties with integrity, professional competence, independence and confidentiality. In addition, CRAs are required to monitor their rating throughout the lifetime of the securities rated and carry on periodic reviews of their rating as well.

Disclosure: The CRA Regulations require CRAs to maintain and disclose their ratings in a specified manner. They require that CRAs should maintain copies of their rating notes, ratings issued, terms of engagement, records of decisions of rating committees and fees charged for ratings for at least five years.

Conflict of interest: The Regulations attempt to reduce conflicts of interest. They require that CRAs may not rate securities that are issued by their promoters or their associates. In addition, CRAs must also maintain an arm’s length relationship between credit rating activities and other activities.

Accountability and Enforcement: The Regulations require that CRAs should have an internal audit, submit information to SEBI whenever required, and be open to inspection and investigation by SEBI.44 They also specify that CRAs may be held liable for any contravention under the SEBI Act, or any of the Rules or Regulations as specified in them. Alternatively, they may be held liable under Chapter V of the Securities and Exchange Board of India (Intermediaries) Regulations, 2008.