Analysis Of Indicators And Parameters

Published Date: 02 Nov 2017

An analysis of indicators and parameters of ratings and downgrading’s of countries vis-à-vis corporate firm

Under the guidance of:

Faculty Guide

Prof. Meena Barot

Submitted By

Anil Kumar Soni

For Completion of

PGDM (International Business) – 2011-13

Institute for Technology and Management

Khargar, Navi Mumbai

March 2013

CERTIFICATE

This is to certify that the study presented by (Anil Kr. Soni) to the ITM Business School , in part completion of the Capstone Project under the title "An analysis of indicators and parameters of ratings and downgrading’s of countries vis-à-vis corporate firm" had been done under the guidance of Prof. Meena Barot .

The project is in the nature of original work that has not so far been submitted for any Degree of Institute for Technology and Management or any other University/ Institute. References of work and related sources of information have been given at the end of the project.

Signature of the Guide

Prof. Meena Barot

ITM Business School

STUDENT DECLARATION

I, Anil Kumar Soni to the best of my knowledge & belief, hereby declare that the project report entitled: "An analysis of indicators and parameters of ratings and downgrading’s of countries vis-à-vis corporate firm" is the study of my own work in the fulfilment of academic requirement. This Capstone project work is submitted to Institute for Technology and Management, Kharghar-Navi Mumbai as my Capstone Report which is done under the guidance of Prof. Meena Barot.

Anil Kr Soni

PGDM (International Business)

KHR2011PGDMIB10F032

Institute for Technology and Management

Kharghar- Navi Mumbai

ACKNOWLEDGEMENT

As a Master program student, I feel privileged and grateful in taking this opportunity to express my gratitude to many people who have contributed to the completion of this project.

I would like to express my deep gratitude and sincere thanks to my project guide Prof. Meena Barot (Sr. Lecturer, ITM Business School) for his valuable guidance and unparalleled support during the progress of this project. Without his encouragement & crucial inputs, this project would not have been possible.

Apart From that I would like to thanks Dr. Ganesh Raja (Director, ITM Business School)) for his leadership and guidance through the course of the curriculum. I also like to thanks Dr. C.S Adhikari (Dean-Academics, ITM Business School)) for giving us opportunity to work in this project.

At last, I would like to thank my parents for their love and unconditional support that they gave it to me, not only during academic education but also throughout my life, who have been the most important reason for where I am today. Apart from that I would like to thank all my friends, who directly or indirectly, contributed to the successful completion of this project. I sincerely thank everyone who was a part of this and helped me in completing this project successfully.

Anil Kumar Soni

Executive Summary

This report provides the findings from a research project on the analysis of indicators and parameters of ratings and downgrading’s of countries vis-à-vis corporate firm. The information contained in this report is primarily based upon the secondary research. Secondary research included an exhaustive search of relevant publications like newspapers, website white papers, industry journals, magazines and proprietary databases.

Credit rating agencies (CRAs) play a key role in financial markets by helping to reduce the informative asymmetry between lenders and investors, on one side, and issuers on the other side, about the creditworthiness of companies or countries. CRAs' role has expanded with financial globalization and has received an additional boost from Basel II which incorporates the ratings of CRAs into the rules for setting weights for credit risk. Ratings tend to be sticky, lagging markets, and overreact when they do change. This overreaction may have aggravated

financial crises in the recent past, contributing to financial instability and cross-country contagion.

The banking sector in India underwent an unprecedented transformation in the 1990s with the emergence of a large number of private as well as foreign multinational banks entering the country increasing rapidly the number of banks in India due to the economic reforms. So the banking activities increased manifold and affected a large number of areas of operation of banks, particularly in the field of bank lending. Banks operate on the pattern of extending credit against security given by its customers associated with the bank. The facility of extending credit agencies are recognition of the changing times in which banks have to operate in a changing and ever evolving economic scenario. Growing needs and realization of higher rate of investments is giving birth to bank credit in India.

TABLE OF CONTENT

SR NO

CONTENT

PAGE NO

1

Title Page

1

2

Certificate

2

3

Declaration

3

4

Acknowledgement

4

5

Executive Summary

5

6

Table of Content

6

7

Introduction

7

8

Objective of Research

9

Methodology

10

CRA in the International Financial System

11

Process and Methods of Ratings by CRA

12

Rating agencies in India

13

Comparison of credit rating agencies in India

14

Comparison of credit rating agencies in other countries

15

Impact of Ratings

16

RBI draft and SEBI rules and regulations

17

Critical Proposition Of The Credit Information Companies

18

Public Policy Concerns

19

Conclusion

20

Limitations

21

References

INTRODUCTION

Credit Rating is the symbolic indication of the current opinion regarding the relative capability of a corporate entity to service its debt obligations in time with reference to the instrument being rated.

Credit Rating is an alphabetical or alphanumerical representation of the credit worthiness of the individual, business or instrument of a business. However Ratings merely express an opinion on the credibility of the entity and cannot be considered to be a recommendation. The evaluation of the credit worthiness of the anything is based on several premises, most important of them being:

• Ability to pay

• Willingness to pay

History:

First Credit Rating Agency was the Mercantile Credit Rating Agency, established in 1841 in New York. First rating guide was published by Robert Dun in 1859 and another rating agency was set up by John Bradstreet, which is popularly known as Dun & Bradstreet today. Some of the renowned rating agencies are:

• Standard & Poor’s

• Moody’s Investor Service

• Fitch Rating Agency

In India

• CRISIL (Credit Rating and Information Services (India) Limited) – first in India

• ICRA Limited (Investment information and Credit Rating Agency of India Limited)

• CARE (Credit Analysis and Research Limited)

• Fitch Rating India Pvt Ltd

Credit rating agencies (subsequently denoted CRAs) specialize in analyzing and evaluating

the creditworthiness of corporate and sovereign issuers of debt securities. In the new financial architecture, CRAs are expected to become more important in the management of both corporate and sovereign credit risk. Their role has recently received a boost from the revision by the Basel Committee on Banking Supervision (BCBS) of capital standards for banks culminating in Basel II.

The logic underlying the existence of CRAs is to solve the problem of the informative asymmetry between lenders and borrowers regarding the creditworthiness of the latter. Issuers with lower credit ratings pay higher interest rates embodying larger risk premiums than higher rated issuers. Moreover, ratings determine the eligibility of debt and other financial instruments for the portfolios of certain institutional investors due to national regulations that restrict investment in speculative-grade bonds.

The rating agencies fall into two categories: (i) recognized; and (ii) non-recognized. The former are recognized by supervisors in each country for regulatory purposes. In the United States, only five CRAs of which the best known are Moody’s and Standard and Poor’s (S&P) are recognized by the Security and Exchange Commission (SEC). The majority of CRAs such as the Economist Intelligence Unit (EIU), Institutional Investor (II), and Euro money are "non-recognized". There is a wide disparity among CRAs. They may differ in size and scope (Geographical and sectorial) of coverage. There are also wide differences in their methodologies and definitions of the default risk, which renders comparison between them difficult.

Regarding their role vis-à-vis developing countries, the rating of country and sovereign is particularly important. As defined by Nagy (1984), "Country risk is the exposure to a loss in cross-border lending, caused by events in a particular country which are – at least to some extent – under the control of the government but definitely not under the control of a private enterprise or individual". Under this definition, all forms of cross-border lending in a country – whether to the government, a bank, a private enterprise or an individual – are included. Country risk is therefore a broader concept than sovereign risk. The latter is restricted to the risk of lending to the government of a sovereign nation. However, sovereign and country risks are highly correlated as the government is the major actor affecting both. Rare exceptions to the principle of the sovereign ceiling – that the debt rating of a company or bank based in a country cannot exceed the country’s sovereign rating – do occur.

The failure of big CRAs to predict the 1997–1998 Asian crisis and the recent bankruptcies of

Enron, WorldCom and Parmalat has raised questions concerning the rating process and the

Accountability of CRAs and has prompted legislators to scrutinize rating agencies. This report

gives an overview of the sovereign credit rating industry: (i) analyses its impact on developing countries; and (ii) assesses some of the CRAs' shortcomings in the context of concerns that have recently been raised.

What can be rated?

• Financial Instruments

• Customer Rating

• Sovereign Rating

• Borrower Rating

Benefits of Credit Rating:

• Numerical indicator of the ability of an entity to meet its financial obligations

• Establishes a link between risk and return

• Helps in making investment decision

• Plays an investor protection role and acts like a marketing tool on behalf of the company

• Encourages corporates to maintain discipline, improve their financial structure and operating risks to get a better rating

• Credit rating is important from the regulatory point of view as well, for determining the margin requirements, entry levels, category of investors etc.

Factors for successful credit rating systems:

• Credible and independently determined

• Independence and unbiased opinion

• Analytical research, consistency is crucial

• Industry related expertise

• Confidentiality

• Timeliness of ratings and changes in ratings

• Wide reach and coverage

Objectives of this Research

Objective to choose this topic is to understand the Rating and downgrading system of the agencies like Standard & Poor, Moody, Fitch how they rate the countries and what are the parameters they consider while rating the countries. Also what are the impacts of those ratings in terms of economically and politically on the countries.

METHODOLOGY

The information contained in this report is primarily based upon the secondary research. Secondary research included an exhaustive search of relevant publications like newspapers, website white papers, industry journals, magazines and proprietary databases.

Tools for Data collection

Secondary Data:

The information will be collected from Internet, White papers, Industry Journals and Magazines. Secondary research included an exhaustive search of relevant publications like newspapers, website white papers, industry journals, magazines and proprietary databases.

Credit Rating Agencies in the International Financial System

A. Asymmetry of information and CRAs as "opinion" makers

A credit rating compresses a large variety of information that needs to be known about the credit worthiness of the issuer of bonds and certain other financial instruments. The CRAs thus contribute to solving principal agent problems by helping lenders "pierce the fog of asymmetric information that surrounds lending relationships and help borrowers emerge from that same fog.

CRAs stress that their ratings constitute opinions. They are not a recommendation to buy, sell or hold a security and do not address the suitability of an investment for an investor. Ratings have an impact on issuers via various regulatory schemes by determining the conditions and the costs under which they access debt markets. Regulators have outsourced to CRAs much of the responsibility for assessing debt risk. For investors, ratings are a screening tool that influences the composition of their portfolios as well as their investment decisions.

B. Credit ratings and Basel II

Regulatory changes in banks’ capital requirements under Basel II have resulted in a new role to credit ratings. Ratings can be used to assign the risk weights determining minimum capital charges for different categories of borrower. Under the Standardized Approach to credit risk, Basel II establishes credit risk weights for each supervisory category which rely on "external credit assessments". Moreover, credit ratings are also used for assessing risks in some of the other rules of Basel II.

Basel II

The major objective of Basel II is to revise the rules of the 1988 Basel Capital Accord in such a way as to align banks’ regulatory capital more closely with their risks, taking account of progress in the measurement and management of these risks and the opportunities which these provide for strengthened supervision. Under Pillar 1 of Basel II, regulatory capital requirements for credit risk are calculated according to two alternative approaches: (i) the Standardized Approach; and (ii) the Internal Ratings-Based Approach. Under the Standardized Approach (SA) the measurement of credit risk is based on external credit assessments provided by External Credit Assessment Institutions (ECAIs) such as credit rating agencies or export credit agencies. Under the Internal Ratings-Based Approach (IRBA), subject to supervisory approval as to the satisfaction of certain conditions, banks use their own rating systems to measure some or all of the determinants of credit risk. Under the Foundation Version (FV), banks calculate the Probability of Default (PD) on the basis of their own ratings but rely on their supervisors for measures of the other determinants of credit risk. Under the Advanced Version (AV), banks also estimate their own measures of all the determinants of credit risk, including Loss Given Default (LGD) and Exposure at Default (EAD). Under the regulatory capital requirements for operational risk, there are three options of progressively greater sophistication: (i) under the Basic Indicator Approach (BIA), the capital charge is a percentage of banks' gross income; (ii) under the Standardized Approach (SA), the capital charge is the sum of specified percentages of banks' gross income from eight business lines (or alternatively for two of these business lines, retail and commercial banking, of different percentages of loans and advances) and (iii) under the Advanced Measurement Approach (AMA), subject to the satisfaction of more stringent supervisory criteria, banks estimate the required capital with their own internal systems for measuring operational risk.

The importance of ratings-based regulations is particularly visible in the United States, where it can be traced back to the 1930s. These regulations not only affect banks but also insurers, pension funds, mutual funds and brokers by restricting or prohibiting the purchase of bonds with "low" ratings. Examples are: (i) non-investment grade or speculative-grade ratings easing the issuance conditions or disclosure requirements for securities carrying a "satisfactory" rating; and (ii) an investment-grade rating.2 While ratings-based regulations are less common in Europe, they are part of the new Capital Requirements Directive through the EU that will implement Basel II.

Process of rating:

Credit Rating Agency enters into an agreement with the client whose securities are to be rated

a. Rights and liabilities of the parties are defined

b. Fees charged is specified

c. Tenure for periodic review of the rating is specified

d. The client shall disclose the credit rating received for its listed securities and disclosed the same in its offer document whether or not it is accepted by him

e. Ensure confidentiality of all the information disseminated by the client

f. The rating agency shall exercise due diligence to ensure that the rating assigned is fair and appropriate

Rating agencies on the basis of several premises assign the credit rating and communicate to the client/ issuer.

The issuer can make one request for review of the rating based on fresh facts and clarifications.

Then the final rating is assigned and the same is published along with the definition of the concerned rating along with the symbol.

A copy of the rating is filed with the Board along with any modifications and additions made thereafter.

The rating agency will also publish the rationale behind the rating assigned and the justification to the premises considered, favorable assessment and factors constituting risk.

Once accepted, it is disclosed and put in the surveillance process thereafter.

Surveillance: Continuous review of the ratings assigned to the rating agency. Frequency of the reviews may vary from quarterly to annually as per the agreement.

Credit Watch: In case of any event taking place, that may result in major deviations from the expected trends and which are likely to impact the credibility, rating of the entity, such instruments are put on credit watch, until the impact of the event is not evident or clear.

Investments in investment grade: Investors are advised to invest in securities upto investment grade level, which is BBB (S&P) and Baa (Moody’s). Securities rated below the investment grade are referred to as speculative grade or junk bonds.

Setting up a Credit Rating Agency: As per the SEBI (Credit Rating Agencies) Regulations, 1999

Application for grant of certificate of registration:

• Application is to be made to SEBI in Form A along with non-refundable application fee for grant of certificate of registration to carry out activity of credit rating agency and shall be granted certificate of registration in Form B by the Board.

• The Applicant must comply with the Eligibility Criteria laid down by SEBI

• Credit Rating Agency must be promoted only by persons belonging to the following categories:

Public Financial Institution, as defined in Section 4A of the Companies Act, 1956

Scheduled Commercial Bank

Foreign Bank operating in India with the approval of Reserve Bank

Foreign credit rating agency having 5 years’ experience in rating securities

Company/ Body Corporate having continuous net worth of Rupees 100 crore as per the annual audited accounts for the previous 5 years

• Credit Rating Agency would appoint a compliance officer who shall be responsible for compliances with the various acts, rules, regulations, notifications, circulars and guidelines concerning them as may be issued by the Board or Central Government

• Credit Rating Agency shall maintain its books of accounts and records for a minimum period of 5

Years

Obligations of Credit Rating Agencies: Code of Conduct

• They shall observe high standards of integrity and fairness in all their dealings

• Fulfill all its obligations in a prompt, ethical and professional manner

• Protect the interest of the investors

• Render at all times

High standards of service

Exercise due diligence

Exercise independent professional judgment

Provide unbiased services

• Any conflict of interest in the rating analysis shall be avoided and disclosed if any

• Shall NOT indulge in unfair competition

• Shall maintain confidentiality of the information disclosed by the client during the process of rating or pass any price sensitive information

• Shall not make false statements about its capability to render services or its qualifications and achievements

• Shall NOT make an untrue statement or suppress material facts while rating a security

Credit Rating Agencies’ Procedures and Methods

There are different types of methods used for ratings by the different agencies which are:

Quantitative and qualitative methods

Empirical assessments of credit rating determinants

Rating differences, notching, solicited and unsolicited ratings

A. Quantitative and qualitative methods:

The processes and methods used to establish credit ratings vary widely among CRAs. Traditionally, CRAs have relied on a process based on a quantitative and qualitative assessment reviewed and finalized by a rating committee. More recently, there has been increased reliance on quantitative statistical models based on publicly available data with the result that the assessment process is more mechanical and involves less reliance on confidential information. No single model outperforms all the others. Performance is heavily influenced by circumstances.

A sovereign rating is aimed at "measuring the risk that a government may default on its own obligations in either local or foreign currency. It takes into account both the ability and willingness of a government to repay its debt in a timely manner.3" The key measure in credit risk models is the measure of the Probability of Default (PD) but exposure is also determined by the expected timing of default and by the Recovery Rate (RE) after default has occurred:

• Standard and Poor's ratings seek to capture only the forward-looking probability of the occurrence of default. They provide no assessment of the expected time of default or mode of default resolution and recovery values;

• By contrast, Moody's ratings focus on the Expected Loss (EL) which is a function of both Probability of Default (PD) and the expected Recovery Rate (RE). Thus EL = PD (1- RE); and

• Fitch's ratings also focus on both PD and RE (Bhatia, 2002). They have a more explicitly hybrid character in that analysts are also reminded to be forward-looking and to be alert to possible discontinuities between past track records and future trends. The credit ratings of Moody's and Standard and Poor's are assigned by rating committees and not by individual analysts. There is a large dose of judgment in the committees’ final ratings.

CRAs provide little guidance as to how they assign relative weights to each factor, though they do provide information on what variables they consider in determining sovereign ratings. Identifying the relationship between the CRAs' criteria and actual ratings is difficult, in part because some of the criteria used are neither quantitative nor quantifiable but qualitative. The analytical variables are interrelated and the weights are not fixed either across sovereigns or over time. Even for quantifiable factors, determining relative weights is difficult because the agencies rely on a large number of criteria and there is no formula for combining the scores to determine ratings.

In assessing sovereign risk, CRAs highlight several risk parameters of varying importance:

(i) Economic; (ii) Political; (iii) Fiscal and monetary flexibility; (iv) the debt burden.

Economic risk addresses the ability to repay its obligations on time and is a function of both quantitative and qualitative factors. Political risk addresses the sovereign's willingness to repay debt. Willingness to pay is a qualitative issue that distinguishes sovereigns from most other types of issuers. Partly because creditors have only limited legal redress, a government can (and sometimes does) default selectively on its obligations, even when it possesses the financial capacity for debt service. In practice, political risk and economic risk are related. A government that is unwilling to repay debt is usually pursuing economic policies that weaken its ability to do so. Willingness to pay, therefore, encompasses the range of economic and political factors influencing government policy.

The economic variables aim at measuring three types of performance:

(i) measures of domestic economic performance; (ii) measures of a country's external position and its ability to service its external obligations; and (iii) the influence of external developments. Bhatia (2002), notes that CRAs’ analyses prior to the Asian financial crisis focused on traditional macroeconomic indicators with limited emphasis on contingent liability and international liquidity considerations. Moreover, private sector weaknesses were not included in the analyses of sovereign rating.

In practice, a small number of variables such as:

(i) GDP per capita; (ii) real GDP growth per capita; (iii) the Consumer Price Index (CPI); (iv) the ratio of government fiscal balance to GDP; and (v) government debt to GDP have a large impact on credit ratings. The relationship between these indicators and Standard and Poor's ratings are illustrated in figures 1-5 of Annex 1. By and large: (i) higher GDP per capita leads to higher ratings; higher CPI inflation to lower ratings, the lower the rating, the lower the government balance as a ratio to GDP; and (ii) higher fiscal deficits and government debt in relation to GDP to lower ratings.

Standard and Poor's sovereign ratings methodology profile

Political risk

• Stability and legitimacy of political institutions;

• Popular participation in political processes;

• Orderliness of leadership successions;

• Transparency in economic policy decisions and objectives;

• Public security; and

• Geopolitical risk.

Income and economic structure

• Prosperity, diversity and degree to which economy is market-oriented;

• Income disparities;

• Effectiveness of financial sector in intermediating funs availability of credit;

• Competitiveness and profitability of non-financial private sector;

• Efficiency of public sector;

• Protectionism and other non-market influences; and

• Labor flexibility.

Economic growth prospects

• Size and composition of savings and investment; and

• Rate and pattern of economic growth.

Fiscal flexibility

• General government revenue, expenditure, and surplus/deficit trends;

• Revenue-raising flexibility and efficiency;

• Expenditure effectiveness and pressures;

• Timeliness, coverage and transparency in reporting; and

• Pension obligations.

General government burden

• General government gross and net (of assets) debt as a per cent of GDP;

• Share of revenue devoted to interest;

• Currency composition and maturity profile; and

• Depth and breadth of local capital markets.

Offshore and contingent liabilities

• Size and health of NFPEs; and

• Robustness of financial sector.

Monetary flexibility

• Price behavior in economic cycles;

• Money and credit expansion;

• Compatibility of exchange rate regime and monetary goals;

• Institutional factors such as central bank independence; and

• Range and efficiency of monetary goals.

External liquidity

• Impact of fiscal and monetary policies on external accounts;

• Structure of the current account;

• Composition of capital flows; and

• Reserve adequacy.

External debt burden

• Gross and net external debt, including deposits and structured debt;

• Maturity profile, currency composition, and sensitivity to interest rate changes;

• Access to concessional lending; and

• Debt service burden.

B. Empirical assessments of credit rating determinants

A number of economists have estimated econometrically the determinants of credit ratings for both mature and emerging markets (Cantor and Packer, 1995, 1996; Haque et al., 1996, 1997; Reisen and von Maltzan 1999; Juttner and McCarthy, 2000; and Bhatia, 2002). In these studies, a small number of variables explain 90 per cent of the variation in the ratings:

• GDP per capita;

• GDP Growth;

• Inflation;

• The ratio of non-gold foreign exchange reserves to imports;

• The ratio of the current account balance to GDP; and

• Default history and the level of economic development.

Indeed, a single variable GDP per capita, explains about 80 per cent of the variation in ratings Borenszstein and Panizza, 2006). It is worth noting that the fiscal position, measured by the average annual central government budget deficit/surplus ratio to GDP, in the three years before the rating year and the external position measured by the average annual current account deficit/surplus in relation to GDP, in the three years before the rating year, were found to be statistically insignificant. While including political events can improve the explanatory power of the regressions, the exclusion of political variables does not bias the parameter estimates. In addition, for developing country ratings, two other variables adversely affected ratings independently of domestic economic fundamentals.

• Increases in international interest rates; and

• The structure of its exports and its concentration.

Econometric estimates may convey wrong or meaningless signals to investors during a rating crisis, there is no set model or framework for judgment which are capable of explaining the variations in assignment of sovereign ratings over time. Ina global financial system crisis ratings, models might become completely obsolete since a stable relationship between rating and their determinants might be impossible to identify. The following variables are very significant in the analysis of the determinant of ratings

• The CPI;

• The ratio of external debt to exports;

• A dummy default history;

• The interest rate differential; and

• The real exchange rate.

Neither the interest rate differential nor the real exchange rate were found to be significant determinants prior to the Asian crisis thus indicating that these variables may have been overlooked by the agencies before the crisis. Variables denoting financial strength were not found to be significant determinants of sovereign ratings even one year after the Asian crisis. However, these variables were subsequently included in ratings assessments by the major CRAs following their unsatisfactory performance during Asian crisis.

C. Rating differences, notching, solicited and unsolicited ratings

Although CRAs have different concepts and measurements of the probability of default, various studies which have compared Moody's and Standard and Poor's ratings, have found a great similarity for investment grade ratings (Cantor and Packer, 1996; Ammer and Packer, 2000). In the case of speculative-grade issues, Moody's and Standard and Poor's assign divergent ratings much more frequently to sovereign bonds than to corporate bonds. The literature also finds clear evidence of differences in rating scales once we move beyond the two largest agencies. For example, ratings for the same issuer tend to be lower for the two largest agencies than for other agencies such as Fitch, Duff and Phelps.

Some of these differences can be explained by sample selection bias. The analysis of (Cantor and Packer, 1997) points to only limited evidence of significant selection bias and significant evidence for differences in rating scales between larger and small CRAs. Regardless of rating differences, the market appears to reward issuers with a lower interest costs when a third rating is assigned, especially when the rating is higher (BCBS, 2000).

Fitch and the Egan-Jones Rating Companies have accused the big two CRAs of practising the "notching", a practice whereby Moody's and Standard and Poor's would initiate an automatic downward of structured securities, if the two agencies were not hired to rate them (Egan-

Jones Ratings Company, 2002). Moody's response to Fitch's accusations is that unsolicited ratings usually result in a lower rating for debt securities because of either lack of information or the use of different methodologies to determine the probability of default.

Unsolicited ratings raise potential conflict of interests. Both Moody's and Standard and Poor's state that they reserve the right to rate and make public ratings for United States SEC registered corporate bonds, whether or not requested by an issuer. If the issuer does not request the rating, the rating will simply be based on publicly available information. If the issuer requests the rating, then it provides information to the rating agency and pays the fees. Many new entrants in the credit rating industry issue unsolicited ratings to gain credibility in the market. Some issuers have accused CRAs of using unsolicited ratings and the threat of lower ratings to induce issuers to cooperate in the rating process and pay the fees of solicited ratings.

Since 2001, Moody's claims that it has not done any unsolicited rating in Europe. Standard and Poor's also claims not to do any unsolicited rating outside the United States. As unsolicited ratings are based on public information and thus lack issuer input, the issue of unsolicited ratings could be addressed by requiring CRAs to disclose whether it has been solicited or not. Both Moody's and Standard and Poor's already specify in their ratings whether the ratings have been solicited and give issuers the opportunity to participate at any stage of the process, if they wish.

Rating agencies in India

There are five Credit rating agencies in India, namely

Credit Rating Information Services of India Limited (CRISIL)

Investment Information and Credit Rating Agency of India (ICRA)

Credit Analysis & Research Limited (CARE)

Duff & Phelps Credit Rating India Private Ltd. (DCR India)

ONICRA Credit Rating Agency of India Ltd.

CRISIL:

The concept of credit rating in India was initiated by the Credit Rating Information Services of India Limited (CRISIL). CRISIL was established in 1987 and started operations in January 1998. Currently, five rating agencies are in operation in India, rating bonds, time deposits, CP (Commercial Paper) and structured obligations. All the four Indian rating agencies have tie ups/alliances with international rating agencies.10 CRISIL is India's leading rating agency, and is the fourth largest in the world. Its business model comprises of three divisions - Debt Rating, Crisil Research and Information Services (CRIS) and CRISIL Advisory Services (CAS). Standard and Poor`s (S&P), which holds a 9.6 per cent stake in the company, assists it on developing new rating methodologies for newer securities.

With over a 70% share of the Indian Ratings market, CRISIL Ratings is the agency of choice for issuers and investors. It is a full service rating agency that offers a comprehensive range of rating services and it also provides the most reliable opinions on risk by combining its understanding of risk and the science of building risk frameworks, with a contextual understanding of business.

CRISIL has rated over 6,797 debt instruments worth Rs.13.53 trillion (over USD343 billion)11 issued by over 4,600 debt issuers, including manufacturing companies, banks, financial institutions (FIs), state governments and municipal corporations. It is the only rating agency to operate on the basis of a sectorial specialization, which underpins the sharpness of analysis, responsiveness of the process and large-scale dissemination of opinion pieces. CRISIL Ratings also offers technical know-how overseas. For instance, it has provided assistance and up ratings agencies in Malaysia (RAM) and Israel and in the Caribbean. In March 2004, CRISIL took up an equity stake of about 9% in the share capital of the Caribbean Information & Credit Rating Services Limited (CariCRIS), with an investment of US $ 300,000.

ICRA:

ICRA Limited (formerly, Investment Information and Credit Rating Agency of India Limited) was incorporated on January 16, 1991 and launched its services on August 31, 1991, by leading financial/investment institutions, commercial banks and financial services companies as an independent and professional investment information and credit rating agency. ICRA is a public limited company with its shares listed on the Bombay Stock Exchange and National Stock Exchange. It is an independent and professional company providing investment information and credit rating services. ICRA’s major shareholders include Moody's Investors Service and leading Indian financial institutions and banks. As the growth and globalization of Indian Capital markets have led to an exponential surge in demand for professional credit risk analysis, ICRA has actively responded to this need by executing assignments including credit ratings, equity grading’s, and mandated studies spanning diverse industrial sectors. In addition to being a leading credit rating agency with expertise in virtually every sector of the Indian economy, ICRA has broad-based its services to the corporate and financial sectors, both in India and overseas, and presently offers its services under three banners namely:

1. Rating services

2. Information services

3. Advisory service

CARE:

Credit Analysis & Research Ltd. (CARE Ratings) is a full service rating company that offers a wide range of rating and grading services across sectors. It was established in 1993. CARE has an unparalleled depth of expertise. CARE Ratings methodologies are in line with the best international practices. It has completed over 3850 rating assignments having aggregate value of about Rs 8071 billion (as at December 2007), since its inception in April 1993. It has been recognized by statutory authorities and other agencies in India for rating services. The authorities/agencies include: Securities and Exchange Board of India, Reserve Bank of India, Director General, Shipping and Ministry of Petroleum and Natural Gas , Government of India , National Housing Bank , National Bank for Agriculture and Rural Development , National Small Scale Industries Commission .

CARE Ratings has also been recognized by RBI as an Eligible Credit Rating Agency for Basel II implementation in India. It was promoted by major Banks/FIs (financial institutions) in India. The three largest shareholders of CARE are IDBI Bank, CANARA Bank and State Bank of India. CARE Ratings is well equipped to rate all types of debt instruments like Commercial Paper, Fixed Deposit, Bonds, Debentures, Hybrid instruments, Structured Obligations, Preference Shares, Loans, Asset Backed Securities(ABS), Residential Mortgage Backed securities etc. CARE Ratings has significant presence in all sectors including Banks / FIs, Corporate, Public finance. Coverage of CARE Ratings has extended to more than 1075 entities over the past decade and is widely accepted by investors, issuers and other market participants. It has evolved into a valuable tool for credit risk assessment for institutional and other investors, and over the years CARE has increasingly become a preferred rating agency.

Duff & Phelps Credit Rating India Private Ltd. (DCR India):

Fitch Ratings India Private Limited, formerly known as Duff & Phelps Credit Rating India Private Ltd. prior to 2001, is a wholly-owned subsidiary of the Fitch group that started operating in India since 1996.

ONRICA:

ONRICA Credit Rating Agency of India Limited was incorporated in 1993. It is an established player in the individual credit assessment and scoring services space in the Indian market. ONRICA is the first in India to launch commercial services and provide individual credit rating and reporting services to the Indian financial market. ONICRA has been acknowledged as pioneers of Individual Credit Rating in the Economic Survey of India 1993-94 issued by Ministry of Finance, Government of India and its services have been hailed by the financial sector and in the media. It delivers objective and reliable pre and post disbursement credit validation and information on credit takers and have been successfully doing the employee screening for wide gamut of requirements. It provides Dynamic Customer-Focused solutions that bridge the gap between principals and their prospective / existing customers. It provides spectrum of services which include the services like Credit Rating, Associate Rating, Employee Screening, SSI/SME Rating, Customer Verification, Lifestyle Analysis and Royalty Retention. Currently, it cater to clients in major business segments such as Telecom, Banking, Automotive, Consumer Finance, IT and other Service Industries.

Comparison of regulations related to credit rating agencies in India

The RBI prescribes a number of regulatory uses of ratings. The RBI requires that a NBFC must have minimum investment grade credit rating if it intends to accept public deposits. Furthermore, unrated or underrated NBFCs in the category of equipment leasing and hire purchase finance companies are required to disclose the fact of their being unrated, to the public, if they intend raising deposits. Finally, as per money-market regulations of RBI, a corporate must get an issue of CP rated and can issue such paper subject to a minimum rating. In the area of investments, SEBI stipulated that ratings are compulsory on all public issues of debentures with maturity exceeding 18 months. SEBI has also made ratings mandatory for acceptance of public deposits by Collective Investment Schemes. If the size of the issue is larger than Rs.100 crore, two ratings are required. Pension funds can only invest in debt-securities that have two ratings, as per the stipulations of Government of India.

In India, in 1998, SEBI constituted a Committee to look into draft regulation for Credit rating agencies that were prepared internally by SEBI. The Committee held the view that in keeping with international practice, SEBI Act 1992 should be amended to bring Credit rating agencies outside the purview of SEBI for a variety of reasons. According to the Committee, a regulator will not be in a position to objectively judge the appropriateness of one rating over another. The competency and the credibility of a rating and CREDIT RATING AGENCY should be judged by the market, based on historical record, and not by a regulator. The Committee suggested that instead of regulation, SEBI could just recognize certain agencies for particular purposes only, such as allowing ratings by Credit rating agencies recognized by it for inclusion in the public/rights issue offer documents.

In consultation with Government, in July 1999, SEBI issued a notification bringing the Credit rating agencies under its regulatory ambit in exercise of powers conferred on it by Section 30 read with Section 11 of the SEBI Act 1992. The Act now requires all Credit rating agencies to be registered with SEBI. Since then, all the four Credit rating agencies in India have been registered with SEBI. SEBI Act now defines "credit rating agency", "rating", and "securities". Details of who could promote a CREDIT RATING AGENCY and their eligibility criteria are specified. The Act also mentions about agreement with clients, method of monitoring of ratings, procedures for review of ratings, disclosure of ratings and submission of details to SEBI and stock exchanges. Restrictions have now been placed on Credit rating agencies from rating securities issued by promoters or companies connected with promoters i.e. companies in which directors of Credit rating agencies are interested as directors.

Comparison of regulations related to credit rating agencies in other countries

Regulators of both developed and emerging markets rely on credit ratings for a variety of purposes. USA introduced the concept of regulatory use of ratings in 1931. The Office of the Comptroller of Currency used ratings as a means to determine the basis of valuation of bonds. The use of ratings spread to other activities such as determination of capital prescription or margin money for brokers/dealers, disclosure requirements under Securities and Exchange Commission norms, exemption from registration and regulation for certain issuers of asset-backed securities, etc. The National Association of Insurance Commissioners (NAIC), which determines insurance company’s regulatory capital charges, also relies on ratings. Japan promoted credit ratings in 1974 and regulators used the ratings of Japan Bond Research Institute (a rating agency) as one of the eligibility criteria for bond issues in the 1980s. The Ministry of Finance relies on ratings in a variety of ways, including regulation of money reserve funds. In 1993, the European Community stipulated capital requirements for market risk for banks and security houses based on ratings. UK adopted rating based Capital Adequacy Directives in 1996. Favoured treatment is also accorded to firms engaged in securities business based on rating. France, Italy, Australia, Switzerland, Canada, Argentina, Chile, Mexico, Indonesia, Korea, Malaysia, Philippines, Taiwan Province of China and Thailand are other countries that have regulatory uses for ratings. In fact, the adoption of rating based regulations was the main force leading to the creation of rating agencies in emerging markets in Latin America and Asia.

An important issue is the criteria for recognising a credit rating agency for use of its ratings in regulation. It is now commonly accepted that criteria are : assured continuous objectivity in methodology; independence from outside influences; credibility, though this should not be an entry barrier; access to all parties with legitimate interest; and adequacy of resources. Most regulators stipulate a list of recognised agencies whose ratings can be used to satisfy rating requirements. Broadly, there are three areas where extensive use is made of ratings in the regulatory process, viz., investment restrictions on regulated institutions; establishing capital requirements for financial and disclosure as well as issuance requirements. The issues faced by regulators in use of ratings include reconciling divergent ratings by different Credit rating agencies and deciding cut-off of level of ratings. In the aftermath of the Asian crisis and the scathing criticism on the failure of Credit rating

agencies to predict the crisis and later on its role in precipitating it through downgrades, the role of credit rating agencies has been placed under microscopic scrutiny. The merits and demerits of regulating credit rating agencies and the issue of rating the rating agencies have been discussed in many international forums.

There is no international regulatory authority overseeing rating agencies. Whether they are regulated or not depends on specific country circumstances. In general, however, countries impose a modest regulation over Credit rating agencies. In USA, Securities and Exchange Commission gives recognition to Credit rating agencies as Nationally Recognized Statistical Rating Organisations (NRSO) for specific purposes. The main form of regulation is USA is in officially recognising a credit rating agency. Thereafter, there is hardly any regulation. Similarly in UK, recognition as a rating agency is required from the Financial Services Authority (FSA). So is the case in Japan, Australia, France and Spain.

Impact of Ratings

The impacts of ratings

Costs and benefits of obtaining a rating

Booms and busts: financial crises in emerging markets and the pro-cyclicality of Ratings

Accuracy and performance of ratings

Impact of ratings on policies pursued by borrowing countries

A. Costs and benefits of obtaining a rating

As mentioned earlier, the primary purpose of obtaining a rating is to enhance access to private capital markets and lower debt issuance and interest costs. Theoretical work (Ramakrishnan and Thakor, 1984; Millon and Thakor, 1985) suggests that credit rating agencies, 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.

There are other indirect benefits from ratings for low income countries, namely: (i) to foster FDI; and (ii) to promote more vibrant local capital markets greater public sector financial transparency"7. As a result, even some sovereigns that do not intend to issue cross-border debt in the immediate future are seeking credit ratings from CRAs. For emerging markets, there is an important externality of obtaining a rating, that of the "sovereign ceiling" effect. Borenzstein et al., (2006), find that, although it has been relaxed since 1997, the effect of the sovereign ceiling remains statistically highly significant, especially for bank corporations, being more important for banks that reside in countries with a high level of sovereign debt and smaller for banks with strong foreign parents.

B. Booms and busts: financial crises in emerging markets and the pro-cyclicality of ratings

The 1997–1998, Asian crisis highlighted CRAs’ potential for reinforcing booms-and-busts of capital flows. As ratings lagged, instead of leading market events and over reacted during both the pre-and post-crisis periods, they may have helped to amplify these cycles. Other evidence points in the same direction.

Several empirical studies show that sovereign ratings are sticky, lagging market sentiment and overreacting with a lag to economic conditions and business cycles. (Larrain et al., 1997; Reisen and von Maltzan, 1997) have found that ratings are correlated with sovereign bond yield spreads. In the aftermath of the 1994–1995 Mexican crisis, the authors find a two–way causality between sovereign ratings and market spreads. Not only do international capital markets react to changes in the ratings, but the ratings systematically respond, with a lag to market conditions as reflected in the sovereign bond yield spreads. This study also indicates a highly significant announcement effect when emerging markets sovereign bonds are put on review with negative outlook. Moreover, the study finds a significant negative effect of rating announcements following a rating downgrade, investors need to readjust their portfolios. Positive rating announcements, by contrast, do not seem to have a significant effect on bond spreads.

Moody's more recent 2003 report on pro-cyclicality claims that the relative stability of credit ratings compared to market-based indicators suggests that ratings were more likely to dampen rather than to amplify the credit cycle, and that most rating changes reflected long lasting changes in fundamental credit risk rather than temporary cyclical developments. The relationship between credit ratings and the cyclicality –and thus the impact of changes in the CRAs’ practices in response to shortcomings revealed by the crises of the 1990s – thus remains an open empirical question.

C. Accuracy and performance of ratings

CRAs’ failure to predict the Mexican and Asian financial crises was due, among other things, to the fact that contingent liability and international liquidity considerations had not been taken into account by CRAs. Concerning the Asian crisis, Moody's acknowledged that it had been confronted with a new set of circumstances requiring a paradigm shift in the following areas:

• Greater analytic emphasis on the risks of short-term debt for otherwise creditworthy countries;

• Greater emphasis on the identity and creditworthiness of a country’s short-term borrowers;

• Greater appreciation of the risks posed by a weak banking system;

• Greater attention to the identity and likely behaviour of foreign short-term creditors; and

• Increased sensitivity to the risk that a financial crisis in one country can lead to contagion effects for other countries.

A balance has to be found in the trade-off between accuracy and stability. Rating agencies are averse to reversing ratings within a short period of time. Both Moody's and Standard and Poor's intend their ratings to be stable measures of relative credit risk. Moody's claims that this corresponds to issuers' as well as institutional investors' wishes and that its "desire for stable ratings reflects the view that more stable ratings are 'better' ratings".

An economist argues that measured "failures" are based on ratings stability (Bhatia, 2002).

With exceptions for some of the lowest ratings, he defines a "failed rating" as one that is

lowered or raised by "three or more notches within 12 months". The choice of three notches is

related to the small probability of a three notch rating change among CRAs. Applying the

Bhatia definition of rating failure to the long-term foreign currency sovereign ratings of

Moody's and Standard and Poor's in 1997–2002, shows that Moody's and Standard and Poor's

both experienced failures during the Asian crisis; Standard and Poor's failed also during the

Russian and Argentinean crisis; and Moody’s failed during the Russian but not the

Argentinean crisis (see table below). Bhatia's failure definition suggests that rating failures

was less prevalent in 1999–2002 than in 1997–1998.

In response to criticism concerning such failures, Moody's has introduced watchlist and

Standard and Poor's outlook reports to alleviate the tension between accuracy and stability by

providing timely warnings of likely rating changes.

Ratings performance can also be compared with market indicators. (IMF,1999) conducted an

analysis of yield spreads in relation to the Asian crisis and found that one year ahead of the

crisis in Thailand, Indonesia and the Republic of Korea, sovereign spreads were quite low –

of the order of 100–150 basis points. In the Russian Federation and Brazil, they were higher –

about 300 basis points. Thus, in relative terms, the markets were in broad agreement with the

CRAs with respect to these countries, indicating a higher risk of default for the Russian

Federation and Brazil than for the Asian countries. Moreover, spreads did not widen much

initially in response to the onset of the Asian crisis, a pattern conforming to that of the ratings.

Thus the performance of financial markets broadly paralleled that of the major CRAs.

D. Impact of ratings on policies pursued by borrowing countries

For borrowing countries, a rating downgrade has negative effects on their access to credit and

the cost of their borrowing (Cantor and Packer, 1996). Although precise information is not

available on the way in which macroeconomic policies are taken into consideration by CRAs

in establishing sovereign ratings, it is reasonable to assume that orthodox policies focusing on

the reduction of inflation and government budget deficits are favoured. There is a risk, therefore, that in order to avoid rating downgrades, borrowing countries adopt policies that address the short-term concerns of portfolio investors, even when they are in conflict with long-term development needs. However, this is an issue which has not been the subject of systematic research.

RBI draft and SEBI rules and regulations

RBI has the powers to determine the policy of the credit information companies with regard to their functioning. RBI shall give directions to the credit information companies; wherever it thinks it is in public interest, or in the interest of credit institutions, specified users, banking policy and proper management. The use of the words "as it deems fit" gives a lot of discretionary powers to RBI.12 The duties of the officials of the company formed under the Act have also been specified like the auditors has been entrusted with the task of ensuring that the credit information company furnishes all the relevant documents to RBI and RBI has simultaneous powers to instruct for an audit of the company under certain circumstances. This audit has been termed as a special audit under the Act. Section 14 of the Act enumerates in substantial detail the functions to be performed by a such company, like collection of information pertaining to the financial standing of borrowers, providing credit information to other companies, the relevant provision of credit rating to be done, research activities and any other work as directed by RBI.13 Directions are also in store for the credit institutions which are to become members of the credit information companies such as requirement of registration and the period within which it is to be obtained for prospective as well as existing credit institutions. The credit information company has been given powers to refuse registration at RBI’s discretion and in due observance of natural justice and other administrative principles law.14 The problem is that the order of RBI has been given unprecedented finality in terms of its implementation thus taking away the jurisdiction of ordinary civil courts as well as tribunals. The credit information company has been given powers to ask for credit information from its members as and when it thinks necessary, the information being provided to the specified user only and the information so obtained by the credit information company is not to be disclosed to any other person and this applies with equanimity on the specified user as well.

The Act was passed with a view to regulating credit information companies and to facilitating efficient distribution of credit and for matters concerned or incidental to it. The Credit Information Companies (Regulation) Act, 2005 required Rules and Regulation to be notified under the Act. The Central Government was empowered to make the Rules while the Reserve Bank was empowered to make the Regulations to carry out the purposes of the Act. Therefore the RBI has prepared the Regulations for implementation of the Credit Information Companies (Regulation) Act, 2005 and placed them on the website for feedback.

SUMMARY OF DRAFT RULES AND REGULATIONS

Rules:

(i) The Rules enumerate the procedure for appeal and other incidental matters when an aggrieved

credit information company whose application for certificate of registration has been rejected or whose certificate of registration has been cancelled have the power to approach the Appellate authority designated by the Central Government.

(ii) Rules provide that the credit information company should formulate appropriate policy and

procedure duly approved by its board of directors, specifying the steps and security safeguards in regard to

(a) collecting, processing and collating of data relating to the borrower; (b) steps for security and protection of data and the credit information maintained at their end; and (c) appropriate and necessary steps for maintaining an accurate, complete and updated data. Moreover the credit institution or the credit information company should ensure that the credit information is accurate and complete with reference to the date on which such information is furnished or disclosed to the credit information company or the specified user as the case may be.

(iii) The specified user should consider and decide such requisite steps for ensuring and verifying the

Accuracy and completeness of data received from a credit information company and protect the data from unauthorized access; formulate and adopt an appropriate policy and procedure in this behalf duly approved by its board of directors.

(iv) The credit Information Company or credit institution or specified user shall adopt all reasonable

Procedures to ensure that their managers, officers, employees are obliged to fidelity and secrecy in respect of credit information under their control or to which they have access.

(v) The credit information company should maintain a high standard of customer service by

Maintaining help desk, attending to complaints, feedback, queries, etc., in speedy and efficient manner.

Regulations:

(i) The Regulations indicate which companies can obtain credit information as specified users

(Insurance company, cellular/phone Company, rating agency, broker, trading member, SEBI,

IRDA etc. in addition to those provided under section 2(l) of the Act..

(ii) The Regulations also deal with submission of application, grant of certificate and the form in which application can be submitted and certificate can be issued.

(iii) The Regulations provide for the form of business in which credit information companies can engage in addition to those provided under section 14(l) of the Act.

(iv). The regulations give the format in which a credit information company can issue notice to the credit institutions or other credit information companies for calling for the information.

(v) The privacy principles which will guide the credit Information companies, credit institutions and

Specified users have been indicated in the Regulation. These encompass accuracy, security, secrecy,

Adequacy of data collected as also limitation on the use of data, that is, the purpose for which the Credit

Information Reports can be made available and the procedure to be followed by specified uses for getting reports.

(vi) Regulations provide that the maximum amount of fees livable to specified users should not exceed Rs.500 for individuals and Rs.5000 for non-individual borrowers. Further, the fees charged to the credit institutions or credit information companies for admission of a credit information company should not exceed Rs.15,00,000.

(vii) Regulations provide for the principles and procedures relating to personal credit information in

Respect of manner and purpose of collection of personal data, solicitation of personal data, accountability in Transferring data to third party, protection of personal data etc.

(viii) Regulations provide that an individual can file a complaint against a credit information company, credit institution or a specified user for contravening any provision of the Act.

SECURITIES AND EXCHANGE BOARD OF INDIA (CREDIT RATING AGENCIES)

REGULATIONS, 1999

Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 was passed which made even the SEBI keep a watchful eye on the Credit Rating Companies in India with the help of various regulation needed for it. The Securities and