Credit rating is the opinion of the rating agency on the relative ability and willingness of the issuer of a debt instrument to meet the debt service obligations as and when they arise.
A credit rating estimates the credit worthiness of an individual, corporation, or even a country. It is an evaluation made by credit bureaus of a borrower’s overall credit history. A credit rating is also known as an evaluation of a potential borrower’s ability to repay debt, prepared by a credit bureau at the request of the lender. Credit ratings are calculated from financial history and current assets & liabilities. A credit rating tells a lender or investor the probability of the subject being able to pay back a loan.
A poor credit rating indicates a high risk of default of a loan, and leads to high interest rate, or the refusal of a loan by the creditor.
It should be noted that a credit rating is assigned to the investment instrument and not to the company issuing it as a whole.
Credit Rating Agency (CRA):
A Credit Rating Agency is a company that assigns credit ratings for issuers of certain types of debt obligations as well as debt instruments.
Four Main Credit Rating Agencies in India:
- Credit Rating Information Services of India Limited (CRISIL), Associate of Standards & Poor’s
- Credit Analysis & Research Ltd. (CARE Ratings)
- Investment Information and Credit Rating Agency of India Limited (ICRA), Associate of Moody’s Investors Service
- Fitch Ratings
Who needs credit ratings?:
- Commercial Banks
- Mutual Funds
- Investment Banks
- Leasing companies
- Insurance companies
- Bond Issuers
Why the need of Credit Rating:
As said earlier, credit rating is an opinion expressed by an independent professional organisation, after making a detailed study of all relevant factors. Such an opinion is of great assistance to investors in making investment decisions. It also helps the issuers of debt instruments to price their issues correctly and to reach out to investors and win their confidence.
Regulators like Reserve Bank of India (RBI) and Securities & Exchange Board of India (SEBI) often use credit rating to determine eligibility criteria for some instruments. For example, the RBI has stipulated a minimum credit rating by an approved agency for issue of Commercial Paper. Credit Rating also proves as a valuable input in establishing business relationships of various types.
A certain methodology is adopted by rating agencies to ascertain the credit worthiness of the debt issuers.
In brief, following aspects are taken into consideration while assigning a rating:
- Industry Risk
- Market position
- Earnings & Performance
- Cash flows
- Management structure and composition
- Capital & Debt Structure
- Corporate Governance
- Other factors like (for financial institutions): Capital adequacy & Liquidity, Quality of asset, Asset/Liability structure, Sourcing of funds, cost of funds,
(List is indicative)
Monitoring and Revision of Ratings:
A rating assigned does not remain static forever. It may go revision due to factors like change in economic environment, corporate restructuring, management of the organisation, etc. therefore the need of revision of ratings arises.
One needs to note that, a rating is an opinion given on the basis of information available at a particular point of time. As time goes by, many things change, affecting the debt servicing capabilities of the issuer, one way or the other. It is, therefore, essential that as a part of their investor service, rating agencies monitor all outstanding debt issues rated by them. In the context of emerging developments, the rating agencies often put issues under credit watch and upgrade or downgrade the ratings as and when necessary, although after making intensive interaction with the issuers.
Each rating agency uses different rating scales for different kinds of ratings. Most common rating scales are AAA, AA, A, BBB, BB, B, A+, AA+, B+ and so on.
The role of Credit Information Bureau India Limited (CIBIL) in Credit Rating:
Credit Information Bureau (India) Limited (CIBIL), incorporated in the year 2000, plays a very vital role in credit ratings in India.
CIBIL – India’s first credit information bureau- is a repository of information, which contains the credit history of commercial and consumer borrowers. CIBIL provides this information to its Members in the form of credit information reports.
The establishment of CIBIL is an effort made by the Government of India and the Reserve Bank of India to improve the functionality and stability of the Indian financial system by containing NPAs while improving credit grantors’ portfolio quality. CIBIL provides a vital service, which allows its Members to make informed, objective and faster credit decisions. CIBIL’s aim is to fulfill the need of credit granting institutions for comprehensive credit information by collecting, collating and disseminating credit information pertaining to both commercial and consumer borrowers, to a closed user group of Members. Banks, Financial Institutions, Non Banking Financial Companies, Housing Finance Companies and Credit Card Companies use CIBIL’s services.
Benefits of Credit Ratings:
For corporates, a good credit rating enables them to have lower interest costs, win confidence of investors. Also there is a compulsion from the regulators to have credit rating assigned to certain debt issues.
For investors it is a boon since they can take informed investment decisions, can rely on the issues / offers, they get an ease of selection of investment products.
Given the benefits of credit ratings, recently, the role of rating agencies has come under the scanner during the global financial crisis, as many companies and their issues collapsed despite high rating.
Reasons for this being like, abnormally high payment of fees to the rating agencies for getting a high / good rating, biasedness of agencies in analysis and judgement, etc.
Also a debate has arised as to who should pay for the rating – the company or the investor? Since every issuer / company has a vested interest in getting a higher rating for the paper issued by it, to lower the cost of borrowing. Similarly, every investor gains from lower ratings, since he can negotiate for a higher interest rate.
Measures introduced for improving credit ratings & working of credit rating agencies:
A couple of regulations, circulars towards improving the quality of ratings have been issued by SEBI in this year. Some of the major ones are:
- Standardizing the definition of defaults by bond issuers, and the formula for computing default rates.
- The rating agencies should recognize ‘default’ at the first instance of delay in paying interest or principal on the rated debt instrument.
- Rating agency will now have to ensure that its analysts do not participate in any kind of marketing and business development, including negotiations of fees with the issuer whose securities are being rated. Also, the employees involved in the credit rating process and their dependants cannot own shares of the issuer.
- Mandatory for rating agencies to publish information about the historical default rates of their rating categories and whether the default rates of these categories have changed over time.
- Rating Agency should disclose the general nature of its compensation arrangements with the issuers. It will also have to disclose the details of any relationship it has with the issuer whose securities are being rated and any of its associate of such issuer and the CRA or its subsidiaries.
- Credit rating agencies to disclose the fees they charge companies for assessing their debt profile and the default rate on their previous ratings.
- The new guidelines ask the credit rating agencies to maintain records (till five years) of the important factors underlying the credit rating and a summary of discussions with all the stakeholders involved, as well as decisions of the rating committee, including voting details and notes of dissent.
- In case of unsolicited credit ratings, the rating symbol shall be accompanied by the word “unsolicited” and the CRA has to monitor and disclose ratings during the life of the rated securities, as if it were a solicited rating.
Credit Rating now has also become important on personal / individual level:
Having a good credit rating is important to individuals as well, since a good credit rating can help individuals to Finance a car, Rent an apartment, Get a home mortgage, Setup utility accounts, Obtain employment, etc.
Credit card companies, lending companies have become very strict while offering credit these days, due to rising defaults of loans taken by people. They now check the credit worthiness of their prospective customers before disbursing a loan or determining the credit limit on credit cards.
Factors that may influence a person’s credit rating are: ability to pay a loan, interest, amount of credit used, saving patterns, spending patterns, debt, etc.
CIBIL Credit Report is a factual record of your credit payment history compiled from information received from different credit grantors. Credit grantors are leading Banks, Financial Institutions, State Financial Corporations, Non-Banking Financial Companies, Housing Finance Companies, Credit Card Companies, who are Members of CIBIL. The purpose is to help credit grantors make informed lending decisions – quickly and objectively, and enable faster processing of credit applications to provide speedier access to credit at better terms to customers.
One can now access its own Credit Information Report (CIR) directly from CIBIL.
One can request a copy of his/her CIBIL CIR, by writing to CIBIL. Complete details can be had from the following link: http://www.cibil.com/accesscredit.htm
Credit Rating is the need of the time since investors should be equipped with easy methods to make their investment decisions. If ratings are assigned in a proper, systematic, transparent way, then it will be a boon for investors and will go a long way in making the investment world a safe place.
However, investors should not forget the Contract Law tenet ‘Caveat Emptor’. Caveat Emptor means ‘let the buyer beware’. It should be forgotten that everything cannot be guaranteed and investments cannot be risk-free. Investors should observe caution while investing their money and be aware themselves before taking their investment decisions. Investors should self study the facts and information available about the investment products and the creditability of the issuers, before zeroing on their decisions.
It is equally important for individuals to maintain their good credit history by repaying loans on time and not breaching any rules of law in respect of investments, taxation, etc. Having a good credit history and a clean credit report will go a long way in making the individual’s future secure and smooth.
Author: Anand Wadadekar, M.A Economics, MBA Finance, AMFI, DIT, Author | Information Expert