Costs And Benefits Of Obtaining A Rating

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02 Nov 2017

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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.

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 behavior 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 watch list 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.

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 Exchange Board of India (Credit Rating Agencies) Regulations, 1999 contains:

Regulation regarding the registration of credit rating agencies regulating the application for grant of certificate eligibility criteria for promoter of credit rating agency, furnishing of information, clarification and personal representation by the promoter, grant of certificate of the SEBI its conditions validity period, clauses of its renewal, and procedure for refusal of certificate and its effect.

General obligations of credit rating agencies regulating the Code of Conduct, Agreement with the client, Monitoring and process of ratings and the Procedure for review of rating, Appointment of Compliance Officer and compiling the letter circulars of the SEBI, maintaining of proper book of Accounts and having regular audits,

Restriction on rating of securities issued by promoters or by certain other persons regulating the securities issued by promoter, certain entities, connected with a promoter or securities already rated,

Procedure for inspection and investigation regulating SEBI’s right to inspect after a due notice and obligations to be fulfilled by taking actions on the inspection or investigation report,

Procedure for action in case of default fixing the liability of the credit company.

Credit information companies and critical proposition of the credit information companies (regulation) act, 2005

The formation of the Act is a step in the right direction and is in line with the earlier efforts of RBI in collection of information. The Credit Information Companies (Regulation) Act, 2005 allows the creation of credit information agencies or companies which will enable banks to readily access the full credit history of the borrower. A credit information bureau or a credit information company is an institution set up by lenders i.e. banks and credit card companies which maintain records of credit histories on individuals and business entities. Its membership may comprise of a banking company or companies, non-banking financial companies (NBFCs), public financial institutions (FIs), State financial corporations, housing finance companies (HFCs), companies engaged in business of credit cards and companies dealing with distribution of credit.

A credit information company indulges in the activity of credit scoring which may be beneficial for the consumer on the one hand and for the banks and financial institutions on the other. This means that on the basis of the individual credit information report of each borrower, a score is given to the borrower which indicates his/her reputation in the credit market. A good score means lower interest rates and other preferential treatment at the time of granting of credit. The establishment of a credit information company is a step towards evolving a credit-rating model that will reward borrowers with a good credit history and penalize those with a poor record16. The lender before extending the loan checks the credit profile of the borrower and the yardstick before him is the information on the borrower in the form of the credit information report to find out the creditworthiness of the borrower. The nature of the information includes full credit history i.e. previous borrowings, default in payment, repayment record, information on other lenders. This information is applicable on all loan products, credit cards and card withdrawals. CIBIL currently has information on loans advanced by member banks, financial institutions, housing finance companies and credit card companies. Before this Act the laws relating to banking secrecy prevented banks from sharing any information pertaining to their customer with any third party. Information of a default became public only when the bank filed a suit for recovery of loan.

The Credit Information Bureau (CIBIL) set up by HDFC and State Bank of India with Dun & Bradstreet of the US provides information on retail borrowers which is available to banks which share information in respect of their own borrowers. Lenders are provided with a credit information report for the purposes of informed decision-making. The financial sector reforms with the advent of economic liberalization in the 1990s led to opening up of the economy at all fronts, including the banking sector. The banking sector reforms have converted banking services into commodities with a large number of schemes being offered to the Indian banking consumer. Availability of adequate and reliable information on the prospective borrower is vital for taking decisions in relation to sanctioning of credit. In the case of lending by banks, the basis for the credit decision is the information furnished by borrowers; for a corporate customer, availability of audited balance sheet, income and expenditure and other audited financial statements bestow certain amount of authenticity to the information furnished, which facilitate an objective and commercial decision with regard to sanctioning of credit facilities. In the case of retail customers such as, small retail traders, individuals, professionals, etc. the availability of information becomes all the more important to validate, save for certain documents such as, salary certificates, income tax returns, etc.

Absence of reliable information on the existing as also the prospective borrowers has often been cited as one of the major causes for financial crises. With the financial sector becoming more complex and with the blurring of distinction between various financial intermediaries, the need for adequate, full and reliable information has been felt by credit institutions time and again. Credit information acts as a tool of risk management. A credit report summarizes historical financial information collected to determine an individual's or an entity's creditworthiness, that is, the means and willingness to repay an indebtedness. Financial institutions utilize credit reports to gauge credit reputation, and thus determine whether to extend credit, and on what terms. With this in mind, the Credit Information Bureaus (India) Ltd. was set up in the year 2001 in the form of a company registered under the Companies Act, 1956 with a view to provide timely, accurate and relevant information to the members.

1 Application of the Act:

There are places where the Act leaves a open questioned unanswered, the Act has its definitions clause throwing light on various aspects of the extent of operation of the legislation, there is a needs to be highlight here the definition of borrower in Section 2(b) which states "any person" or "client" inclusive of companies, persons, individuals, partnership firms, HUFs but is silent on State

Government entities, PSUs and public corporations.

2 Importance of credit rating for assessment purposes:

Fundamentally credit rating implies evaluating the creditworthiness of a borrower by an independent rating agency. Here the objective is to evaluate the probability of default. As such, credit rating does not predict loss but it predicts the likelihood of payment problems. Credit rating agency helps in forming an opinion of the future ability, legal obligation and willingness of a bond issuer or obligor to make full and timely payments on principal and interest due to the investors. Banks do rely on credit rating agencies or companies to measure credit risk and assign a probability of default. Credit rating agencies generally slot companies into risk buckets that indicate company's credit risk and is also reviewed periodically. Associated with each risk bucket is the probability of default that is derived from historical observations of default behavior in each risk bucket.

3 Formation of credit information companies:

A credit information company formed under the Act is subject to regulations framed by RBI in the prescribed manner while the existing companies before the commencement of the Act need to get themselves registered within 6 months from commencement of the Act. The Act allows for the formation of multiple credit information companies. Generally, the powers of determining the number of credit information companies at any given time vests in RBI which is subject to further review as required and it also holds powers to cancel registration upon the satisfaction of certain conditions as accorded in Section 6 of the Act.18 Prescribed limit on issued capital is 20 crores and minimum paid-up capital is 75% of the issued capital.

4 Management of a credit information company:

The management of a credit information company is under a whole time chairperson and a part-time chairperson who can be of a non-executive nature. The Board of Directors shall be constituted of persons having special knowledge in the fields of public administration, law, banking, finance, accountancy, management and Information Technology. RBI has powers under the Act to supersede the Board under certain circumstances which shall affect the structure of the credit information company in a considerable manner.

5 Dispute settlement and applicable law: There is remedy available under the Act for settlement of dispute by the modes of conciliation or arbitration as per the Arbitration and Conciliation Act,

1996. The dispute settlement is available by credit information companies, credit institutions, borrowers and clients associated with the business of credit information in any other manner. The arbitrator should be appointed by RBI and the matter has to be resolved by the arbitrator within three months.

6 Credit information and the privacy concern:

The Act deals with the critical areas of security and accuracy of credit information thereby facilitating the provision of information to the users or members of such companies and at the same time maintenance privacy of the consumer. The data relating to the credit information being provided by he them has to be fully accurate, complete and duly processed and protected against any loss or unauthorized access or use, it is the responsibility of the credit information company. Section 20 of the Act provides for the privacy principles which should be applicable on the credit information company, credit institution and the specified user so it is applicable for the purposes of recording, processing, preserving and protecting the information or data. The privacy of the consumer or the borrower extends to the purposes of the information provided by the credit information company. The significance of the privacy of the consumer or the borrower with regard to the credit information is gauged by the fact that a heavy penalty of Rs 1 crore has been specified in sub-section (2) of Section 23.

7 Furnishing of documents and prescribed punishment and penalties:

The act mandates proper furnishing of documents to the relevant authorities and any violation of it imposes strict penalties upto of Rs 1 crore can be imposed23. Even Individual penalties can be imposed on the officials of a credit information company or other associated officials in their official capacity. The basic idea underlying offences and penalties prescribed under the Act is to prevent the circulation of false information amongst the credit information companies, credit institutions, specified user, and amongst themselves. Such an act is prohibited if done by commission or omission. With regard to powers of the court with regard to dealing with offences, its powers are subject to complaint made by the officer of credit Information Company or RBI. Apart from the prescribed mechanism of courts, RBI also has been given powers to impose punishment as it thinks fit to so.

PUBLIC POLICY CONCERNS

A. Recent regulatory initiatives

In view of the critical role played by CRAs in the modern financial architecture, policymakers have recently focused on some shortcomings arising from the following concerns:

• Barriers to entry and lack of competition;

• Conflicts of interest;

• Transparency; and

• Accountability.

These concerns have been raised by the International Organization of Securities Commission, (IOSCO), the United States Securities and Exchange Commission, (SEC), the European Commission Committee of European Securities Regulations, (CESR), and by the United States Congress and Senate. On the basis of Section 702 of the Sarbanes-Oxley Act of 2002, the United States Congress mandated the SEC to issue a "Report on the Role and Function of Credit Rating Agencies" in the operation of the Securities Markets. This was to address several issues pertaining to the current role and functioning of CRAs including the information flow in the credit-rating process, barriers to entry artificially created by the Nationally Recognized Statistically Rating Organizations (NRSRO) designation in the United States and conflicts of interest or abusive practices.

In response to IOSCO's Code of Professional Conduct, Moody's and Standard and Poor's published their own Code of Professional conduct in the second half of 2005, thus aligning their policies and procedures with IOSCO's Code. In the spring of 2006, Moody's and Standard and Poor's published their first report on the implementation of the Code of conduct. Here, it was stated that, even before the SEC and IOSCO had recommended new rules of conduct in 2003, the two agencies had already established internal codes of conduct and procedures to prevent and manage potential conflict of interests and to safeguard the independence and objectivity of their rating processes.

Consideration of the issues related to CRAs by the United States Congress eventually culminated in the Credit Rating Agency Reform Act which was signed into law in early September 2006. This amended the Securities Exchange Act of 1934 to redefine an NRSRO as any CRA that has been in business for at least three consecutive years and is registered under the Act. It also prescribed procedural requirements for mandatory NRSRO registration and certification. It granted the SEC exclusive enforcement authority over any NRSRO and authorized the SEC: (i) to take action against an NRSRO that issued credit ratings in contravention of procedures, criteria and methodologies included in its registration application; and (ii) to censure, limit, suspend or revoke the registration of an NRSRO for violations of the Act.

In the European Union, the Enron and Parmalat breakdowns prompted discussions on CRA reliability. In response to a call by Commission for Advice, the CESR released in March 2005 "CESRs" Technical Advice to the European Commission on possible Measures Concerning Credit Rating Agencies.

B. Issues of concern

1. Barriers to entry and lack of competition

In the United States, there are only 5 CRAs designated by the SEC as NRSROs: (i) A.M. Best.; (ii) Dominion Bond Rating Service (DBRS); (iii) Fitch; (iv) Moody's Investors Service; and (v) the Standard and Poor's Division of McGraw Hill. A.M. Best is a global agency which rates the debt only of insurance companies. DBRS is Canadian-based with a regional scope and the only non-US NRSRO designated agency. Thus, the number of global NRSROs providing a comprehensive service in the United States are three, of which two agencies, Moody’s and Standard and Poor's control over 80 per cent of the market. The mean number of CRAs recognized among the BCBS' member countries is around six and there are between 130–150 credit rating agencies in the world. However, only a small number of CRAs are recognized internationally and the number has not changed much since the 1970s (BCBS, 2000).

According to the United States Department of Justice, the NRSRO designation has acted as a barrier to entry in a catch-22 manner.8 A new rating agency cannot obtain national recognition without NRSRO status and it cannot obtain NRSRO status without national recognition. In the words of the Rapid Ratings testimony before the Committee on Financial Services9, "the effect of this catch-22 has been to preserve a duopoly that has thwarted competition and innovation".

In an effort to increase competition and improve the quality of credit ratings, Representative Fitzpatrick introduced H.R. 2990, The Credit Rating Agency Duopoly Relief Act of 2005. He believed that the SEC-NRSRO designation constituted an "insurmountable and artificial barrier to entry". Lack of competition in the industry has led to inflated prices, stifled innovation, lower quality of ratings, and unchecked conflict of interests and anti-competitive practices10. This bill was the basis of the Credit Rating Agency Reform Act of 2006

In its 2005 report to the European Commission mentioned above, the CESR also stated that new CRAs face a number of barriers to entry and existing CRAs face a number of natural barriers to expansion. Issuer’s usually only desire ratings from those CRAs that are respected by investors and which tend to be only those with a long performance record11. The CESR report concluded that "the impact of regulatory requirements on competition is not clear and therefore it cannot conclude that any regulatory requirements would either increase or decrease the entry barriers to the rating industry. Thus CESR does not recommend the use of regulatory requirements as a measure to reduce or remove entry barriers to the market for credit ratings."12 The CESR recommended a "wait and see" attitude and implementation of IOSCO's Code.

In a response to such initiatives, Moody's stated that it "has supported eliminating regulatory barriers to entry". But, with regard to competition issues, Moody's argues that the "costly nature of executive time" would not allow issuers to have many different ratings. Because of network externalities, only a small number of CRAs would be favored by investors, who would desire "consistency and comparability in credit opinions". Newly established CRAs would need time to gain credibility in the market.

Standard and Poor's also recommended its support to "a more open and transparent process to designate NRSROs reduce barriers to entry and ensure that the markets remain the ultimate judge of the rating process"13. However, Standard and Poor's did not believe that the whole NRSRO process should be withdrawn.

In its September 2003 "Report of Analyst Conflict of Interests", IOSCO highlighted potential conflict of interests facing the industry that can interfere with the independence and objectivity of its analysis. Conflict of interests may arise when a rating agency offers consulting or other advisory services to issuers it rates since issuers could be unduly pressured to purchase advisory services in return for an improved rating. The report also drew attention to the issue of "notching" by CRAs, lowering ratings for issues which they had not rated, and that of "'solicited" versus "unsolicited ratings, where aggressive tactics might be used to induce payments for a rating an issuer did not request.

The IOSCO Code addresses the first of these issues with the following recommendation: (i) the credit rating, a CRA assigns to an issuer or security should not be affected by the existence of a potential business relationship between the CRA (or its affiliates); and (ii) the issuer (or its affiliates) or any other party, or the non-existence of such a relationship."15 This principle has been integrated into Moody's and Standard and Poor's own Codes of Professional Conduct.

3. Transparency

Many market participants have expressed concern over the lack of transparency over CRAs’ rating, methodologies, procedures, practices and processes. In this context, the IOSCO Code Stresses the following in order to promote transparency and improve the ability of market Participants and regulators to judge whether a CRA has satisfactorily implemented the Code Fundamentals: (i) CRAs should disclose how each provision of the Code Fundamentals is Addressed in the CRA’s own Code of Conduct; and (ii) CRAs should explain if and how their own Code of Conduct deviate from the Code Fundamentals and how such deviations Nonetheless achieve the objectives laid out in the Code Fundamentals and the IOSCO-CRA Principles. This will permit market participants and regulators to draw their own conclusions about whether the CRA has implemented the Code Fundamentals to their satisfaction, and to react accordingly.

IOSCO requires the CRAs' methodologies to become public to enhance transparency in an industry which is very opaque in nature. CESR goes further and proposes, as an alternative to self-regulation, the need to introduce some specific rules on fair representation which would establish a minimum level of disclosure on those elements and assumptions which make clear for market operators and investors to understand how a specific rating was determined by a credit rating agency.

The nature and extent of information made available to the public still varies from agency to agency. Since the publication of the IOSCO Code and its integration into the CRAs' own Code of Conduct, the CRAs have increased the number of lengthy research reports and publications on their web sites and published some of the criteria used to assess credit risk in their bid to improve transparency. However, the view is still widespread that CRAs' methodologies, the variables and weights which they employ, and the criteria used in the deliberations of rating committees remain opaque to both investors and borrowers. Credit rating agencies should aim for transparency as the best way forward to enable investors and issuers to understand the quality and objectivity of the credit rating. Credit rating agencies should therefore implement measure 2.7 of the IOSCO Code.

4. Accountability

There is no mechanism to protect investors and/or borrowers from mistakes made by CRAs or any abuse of power on their part. This is true even if reputable interests and competition provide incentives for generating quality financial information. In order to promote transparency and improve the ability of market participants and regulators, to judge whether a CRA has satisfactorily implemented what it pledges it is doing, the IOSCO Code recommends only that CRAs give full effect to the Code by publishing their own, adhering to it and justifying publicly any deviation between this code and their activities.

There remains the need for more formal regulation to address market failures in the form of imperfect competition and principal-agent problems in the credit rating industry. The CESR technical report clearly puts its finger on the issue involved here: "The reason for having a regulatory mechanism should rather be that there exists some market failure that has to be dealt with. In essence, all the issues discussed in the previous chapter arise, because of the existence of conflict of interests between the CRAs and the issuers and/or the users of ratings (the investors). This type of conflict of interests between professional players on the financial markets are natural and exist in numerous areas of the markets. They become especially apparent in the rating market because of the lack of balance of power between the different players. Issuers are relatively weak compared to the CRAs because of their dependence on the ratings they get. Investors have not historically invested large resources in improving rating agencies' behavior because of CRAs insufficient transparency on its operations. This meant that CRAs historically have a very strong position. What the IOSCO Code is trying to do is to rebalance the interests between the different players."

Rousseau (2005), sums up concern over the resulting "accountability gap" as follows: (i) this accountability gap is worrisome for CRAs as well as market participants; (ii) for the former, the accountability gap may affect their credibility in the marketplace; and (iii) for the latter, it is of particular concern given the role that CRAs play in capital markets. There is a need for a mechanism to take over if reputation fails.

For the first time in the history of ratings in the United States, the Credit Rating Agency Reform Act of 2006 has clearly designated the SEC to monitor CRAs' compliance with new securities laws and regulations. The SEC will be able to act as deemed necessary, study and report to congressional committees any problems faced in the future in all matters related to the credit rating industry.

CONCLUSIONS

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 (corporate risk) or countries (sovereign risk). 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.

In making their ratings, CRAs analyse public and non-public financial and accounting data as well as information about economic and political factors that may affect the ability and willingness of a government or firms to meet their obligations in a timely manner. However, CRAs lack transparency and do not provide clear information about their methodologies.

Ratings tend to be sticky, lagging markets, and then to overreact when they do change. This overreaction may have aggravated financial crises in the recent past, contributing to financial instability and cross-country contagion. Moreover, the action of countries which strive to maintain their rating grades through tight macroeconomic policies may be counterproductive for long-term investment and growth.

The recent bankruptcies of Enron, WorldCom, and Parmalat have prompted legislative scrutiny of the agencies. Criticism has been especially directed towards the high degree of concentration of the industry, which in the United States has reflected a registration and certification process in the form of NRSRO designation biased against new entrants. The effect of such concentration has been the absence of the discipline enforced by competition and a low level of innovation.

In the United States, policy action has included the 2006 Credit Rating Agency Reform Act which has overhauled the regulatory framework by prescribing procedural requirements for NRSRO registration and certification and by strengthening the powers of the SEC.

At international level, the main initiative has been the publication by IOSCO of its Code of Conduct. This Code aims at developing governance rules for CRAs to ensure the quality and integrity of the rating process, the independence of the process and the avoidance of conflict of interest and greater transparency. In its 2005 Technical Advice to the European Commission on possible Measures Concerning Credit Rating Agencies, the CESR recommended the implementation of the IOSCO Code and adoption of a "wait and see" attitude.

Definitive assessment of these initiatives would still be premature. The industry will receive a fillip from implementation of Basel II. The major CRAs will undoubtedly seek a substantial share of the new business which will result. Promotion of competition may require policy action at national level to encourage the establishment of new agencies and to channel business generated by new regulatory requirements in their direction. Regulatory action at the national level may also be necessary to ensure that the agencies operate in accord with levels of accountability and transparency matching the recommendations of the IOSCO Code.

The credit rating in India is governed by Credit Information Companies (Regulation) Act, 2005, State Bank of India Act, 1955, Banking Regulation Act of 1949, Banking Regulation Act of 1949 and Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 even then few important aspects of credit rating system are untouched, like:

1. Sometimes the regulation imposed on the Credit rating agencies becomes to much that its independence of ratings becomes questionable and destroys the basic purpose of its existence.

2. Credit rating agencies should be made accountable for the ratings given by them.

3. There even have been cases of Credit rating agencies manipulating the credit to increasing the volatility of capital flows from market leading to major financial crises28. This is even done to forces on certain portfolio managers to sell.

The results of studies are not uniform leading to uniformity in the ratings of the Credit rating agencies. Apart from these, also there are various issues related to the credit rating industry in India. The credit ratings are being institutionalized into the regulatory framework of banking supervision. This raises four important issues that need to be looked into. These are – the quality of credit rating in India, the level of penetration of credit rating, lack of issuer ratings in India and last but not the least, the effect of the credit rating scheme on Small and Medium Enterprises (SMEs) and Small Scale Industry (SSI) lending. The credit rating industry in India presently consists of five agencies: Credit

Rating Information Services of India Limited (CRISIL), Investment Information and Credit Rating Agency of India (ICRA), Credit Analysis & Research Limited (CARE) and Fitch India and ONRICA.

These agencies provide credit ratings for different types of debt instruments of short and long terms of various corporations. Very recently, they have also commenced credit rating for SMEs. Apart from that, ICRA and CARE also provide credit rating for issuers of debt instruments, including private companies, municipal bodies and State governments.

The four issues that need to be looked into are:-

Credit Rating quality

Low penetration of Credit Rating

Issuer Ratings

Effect of the Credit Rating scheme on Small and Medium Enterprises (SMEs) and Small Scale Industry (SSI) lending

1. Credit Rating quality:

The literature on India’s credit rating industry is scanty. However, the few studies available point to the low and unsatisfactory quality. In Gill (2005),ICRA’s performance in terms of credit rating and provision of timely and complete information on the rated companies has been studied. Analyzing the ICRA ratings for the period 1995-2002, the study finds that many of the debt issues that defaulted during the period were placed in ICRA’s ‘investment grade’ until just before being dropped to the ‘default grade’. These were not gradually downgraded, rather they were suddenly dumped into ‘default grade’ at the last moment from an ‘investment grade’ category.

2. Low penetration of Credit Rating:

The second important issue in India’s credit rating industry is the low penetration of credit rating in India. A study in 1999 revealed that out of 9,640 borrowers enjoying fund-based working capital facilities from banks, only 300 were rated by major agencies. As far as individual investors are concerned, the level of confidence on credit rating in India is very low. In an all-India survey of investor preference in 1997, it was found that about 41.29 per cent of the respondents (out of a total

number of 2,819 respondents) of all income classes were not aware of any credit rating agency in India; and of those who were aware, about 66 per cent had no or low confidence in the ratings given by credit rating agencies.29 The legitimacy brought about by Basel II for credit ratings of borrowers will definitely increase the penetration of the industry. However, until such time, most loans will be given 100 per cent risk weightage (since an unrated claim gets 100 per cent weightage); thus leading to no significant improvement of Basel II over Basel I.

3. Issuer Ratings: Presently credit rating in India is restricted to ‘issues’ (the instruments) rather than to ‘issuers’. Ratings to issuers become important as the loans by corporate bodies and SMEs are to be weighted as per their ratings. Of late agencies like ICRA and CARE have launched issuer ratings for corporations, municipal bodies and the State government bodies. Further, all agencies, with direct support from the Government of India, have launched SMEs rating. Until such efforts pick up rapidly, issuers will be assigned 100 per cent weightage, leading to no improvement in the risk-sensitive calculation of the loans. Thus, in this account too, the implementation of Basel II would not lead to significant improvement over Basel I.

4. Effect of the Credit Rating scheme on Small and Medium Enterprises (SMEs) and Small Scale Industry (SSI) lending:

Besides agriculture and other social sectors, Small Scale Industry is treated as a priority lending sector by RBI. SSI accounts for nearly 95 per cent of industrial units in India, 40 per cent of the total industrial production, 35 per cent of the total export and 7 per cent of GDP of India. In spite of its importance on Indian economy, SSI receives only about 10 per cent of bank credit. As banking reforms have progressed, credit to SSI has fallen. The SSI sector in India is so far out of the reach of the credit rating industry. Under the proposed Basel II norms, banks will be discouraged to lend to SSI that is not rated because a loan to unrated entity will attract 100 per cent risk-weight. Thus, bank lending to this sector may further go down.

LIMITATIONS

Resources for this project are on the basis of secondary data which are available in the internet about the ratings and downgrading of the countries. Websites of rating agencies like Standard & Poor , Moody, Fitch.

The another thing we can do is we can make a survey form to get an idea about the ratings of the countries and the agencies what people think about these ratings and how much they are aware of these. And also it will help to get an idea about how these ratings effects to the countries.

Limitations are in secondary data like project will be depending on the data which available in internet there will not be the primary data which we can get direct from those ratings company. Data which are available in the internet may be not the fresh one.



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