credit rating project 100 marks

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INTRODUCTION

In a market, financial markets play the role of efficient

intermediary. They act as a link between savers and investors,

mobilizing capital on one hand, and efficiently allocating them

between competing users to the other hand. In addition to this an

investor can also base the investment decision on the grading

offered by credit rating agencies.

Concept of Credit Rating

A credit rating is a measure used by creditors to determine how

much they can trust a certain borrower, whether the borrower is an

individual, a corporation, or a country. The credit rating is derived

using past financial data or the borrower’s credit history. There are

several factors that can affect the credit rating of an individual

including:

- The person’s ability to pay a loan – Reflected by the person’s

salary and Other assets

- The amount of credit in existence – This is what credit limits

are for. If the Person is near his credit limit or has reached it

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is harder to get a loan. This Also reflects whether the person

is in the habit of going into debt

Definition

The process of assigning a symbol with specific reference to the

instrument being rated, that acts as an indicator of the Current

opinion on relative capability on the issuer to service its debt

obligation in a timely fashion, is known as credit rating.

According to the Moody’s, “A rating on the future ability and legal

obligation of the issuer to make timely payments of Principal and

interest on a specific fixed income security. The rating measures

the probability that the issuer will default on the security over its

life, which depending on the instrument of the expected monetary

loss, should a default occur.

According to Standard & poor’s, “it helps investors by providing

an easily recognizable, simple tool that couples a possibly

Unknown issuer with an informative and meaningful symbol of

credit quality.

According to ICRA, “Credit ratings are opinions on the relative

capability of timely servicing of corporate debt and obligations.

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ORIGIN OF CREDIT RATING

Origin in 1840 following the crisis in 1837

The First Mercantile Credit Agency was set up in New York by

Louis Tappan in 1841.

First rating guide was published in 1859

John Broad Street set up the similar agency in 1849 which

published its

Rating books in 1857

In 1900 John Moody founded “Moody’s Investors Services and in

1909

Published his manual of “Rail Road Services”

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Need and Importance of Credit Rating

1. A wide range of industries take advantage of credit scores to

improve fairness, effectiveness and efficiency.

2. Financial companies use credit scores to predict the risk of

delinquencies and losses, which enables them to better allocate

costs.

3. Insurance companies use specialized credit scores to make

fairer underwriting decisions.

4. Credit scores even provide benefits at the macroeconomic

level by helping small enterprises attain the funds they

need and by facilitating the securitization and sale of

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financial products in the secondary markets, substantially

increasing the influx of capital into a country.

Importance of credit score

A Credit rating is an indicator that reflects how well or badly you

manage your financial matters.

B By having a look at your credit rating, one can get much

information regarding your business organization and particularly

the payments made by your organization.

C There are several credit bureaus that compile this kind of

information and later on sale it to their clients.

D It's very important to know your credit score and understand it

completely, as it helps you to get loans, mortgage and even a job.

E Credit report list personal information such as name, address,

date of birth, social security number, number of family member,

your employer etc. Financial situations like bankruptcies, tax liens,

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foreclosure, late payment of your bill...etc, will also be listed in the

report.

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THE CREDIT RATING SYSTEM

Credit rating has facilitated authorities around the world to issue

mandatory rating requirements. For instance, specific rules restrict

the new issues that are rated below a particular grade.

Growth Factors Credibility and Independence. Capital Market

Mechanism. Disclosure requirements. Credit Education. Creation

of Debt Market.

Major issues in Credit Rating of a Company

Investment Vs speculative Grades

Continuous Monitoring

Grade Surveillance

Rating Ceiling

Evaluation of Line

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CREDIT SCORE

Credit score is an estimate of the risk that a bank will take to lend

you money. It is also a snapshot of your credit file at a certain point

in time.

The FICO score is developed by Fair Isaac Corporation and based

on credit files maintained by consumer credit reporting agencies. It

is widely used by banks, credit unions, insurance agencies,

financing companies and other lenders. However, it is not the only

factor determining your ability to obtain credit. Other important

factors include: income, employment history, previous and current

relationships with a lender, to name a few. Each lender decides on

its own what will be taken into account when it considers lending

money to you.

Credit score is a mathematical formula which takes into account

many different pieces of information and compares it with

hundreds of thousands of other credit reports from the past, to

create patterns, which identify statistical possibility of future credit

risk.

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Every person with a credit file has three credit scores based on

Information from three credit bureaus. They are not exactly the

same, but for most people they will be only slightly different.

Following are the helpful tips which can improve the credit scores:

1. Collect credit report from Experian, Transfusion and Equifax.

Review the report for any error or mistake.

2. Try to reduce the debt of those with high interest.

3. If not in full, try to make payment of minimum balance due of

credit cards.

4. Pay all you bills on time. Late payment can do a serious damage

to your report.

5. Avoid credit from financial companies. It can negatively affect

your score.

6. Don't apply for too many credit accounts. Credit score determine

your financial status, so one should always try to keep it as good as

possible and avoid any such actions that can affect it and result a

low score

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CREDIT RATING AGENCY

A credit ratings agency is a company that assigns credit ratings to

institutions that issue debt obligations (i.e. assets backed by

receivables on loans, such as mortgage-backed securities.

These institutions can be companies, cities, non-profit

organizations, or national governments, and the securities they

issue can be traded on a secondary market.

A credit rating measures credit worthiness, or the ability to pay

back a loan. It affects the interest rate applied to loans - interest

rates vary depending on the risk of the investment.

A low-rated security has a high interest rate, in order to attract

buyers to this high-risk investment. Conversely, a highly-rated

security (carrying aAAA rating, like a municipal bond which is

backed by stable government agencies) has a lower interest rate,

because it is a low-risk investment.

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Companies that issue credit scores for individuals are usually

called credit bureaus and are distinct from corporate ratings

agencies.

Definition of Credit Rating Agency

"Credit Rating Agency" means any commercial concern engaged

in the business of credit rating of any debt obligation or of any

project or programmed requiring finance, whether in the form of

debt or otherwise, and includes credit rating of any financial

obligation, instrument or security, which has the purpose of

providing a potential investor or any other person any information

pertaining to the relative safety of timely payment of interest or

principal

Big Three Rating Agencies in U.S are:

a. Moody's

b. Standard & Poor's

c. Fitch Ratings

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GROWTH OF CRDIT RATING AGENCIES

1841- Mercantile Credit Agency(USA)

1900- Moody’s Investors Services (USA)

1916- Poor Publishing Company (USA)

1922- Standard Statistics Company (USA)

1924- Pitch Publishing Company (USA)

1941- Standard and Poor (USA)

1074- Thomson Bank Watch (USA)

1975- Japanese Bond Rating Institution (JAPAN)

1987- CRISIL by ICICI (INDIA)

1991- ICRA by IFCI (INDIA)

1994- CARE by IDBI (INDIA

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Rating Grades

Each rating agency has developed its own system of rating grades

for sovereign and corporate borrowers. Fitch Ratings developed a

rating grade system in 1924that was adopted by Standard & Poor's.

Moody's grading is slightly different. Moody’s

sometimes argues that their ratings embed a conceptually superior

approach that directly considers not only the likelihood of default

but also the severity of loss in the event of default.

Long Term Credit Rankings

Fitch Ratings and Standard & Poor's use a system of letter sliding

from the best rating "AAA" to "D" for issuers already defaulting

on payments

I nvestment Grade:

AAA: best quality borrowers, reliable and stable without a

Foreseeable risk to future payments of interest and principal

AA: very strong borrowers; a bit higher risk than AAA

A : upper medium grade; economic situation can affect finance

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BBB: medium grade borrowers, which are satisfactory at

themoment

Non-Investment Grade:

BB: lower medium grade borrowers, more prone to changes in the

Economy, somewhat speculative

B : low grade, financial situation varies noticeably, speculative

CCC: poor quality, currently vulnerable and may default

CC: highly vulnerable, most speculative bonds

C : Highly vulnerable, perhaps in bankruptcy or in arrears but still

Continuing to pay out on obligations

CI: past due on interest

D : has defaulted on obligations and S&P believes that it will

Generally default on most or all obligations

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NR: not rated

Criticism for Credit Rating Companies

Credit rating agencies do not downgrade companies promptly

enough.

For example, Enron's rating remained at investment grade four

days before the company went bankrupt, despite the fact that credit

rating agencies had been aware of the company's problems for

months. Some empirical studies have documented that yield

spreads of corporate bonds start to expand as credit quality

deteriorates but before a rating downgrade, implying that the

market often leads a downgrade and questioning the informational

value of credit ratings.[7] This has led to suggestions that, rather

than rely on CRA ratings in financial regulation, financial

regulators should instead require banks, broker-dealers and

insurance firms (among others) to use credit spreads when

calculating

the risk in their portfolio.

Large corporate rating agencies have been criticized for having too

familiar a relationship with company management, possibly

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opening themselves to undue influence or the vulnerability of

being misled.

These agencies meet frequently in person with the management of

many companies, and advise on actions the company should take

to maintain a certain rating.

Furthermore, because information about ratings changes from the

larger CRAs can spread so quickly (by word of mouth, email, etc.),

the larger CRAs charge debt issuers, rather than investors, for their

ratings.

This has led to accusations that these CRAs are plagued by

conflicts of interest that might inhibit them from providing

accurate and honest ratings.

At the same time, more generally, the largest agencies (Moody's

and Standard & Poor's)are often seen as agents of globalization

and/or "Anglo-American" market forces, that drive companies to

consider how a proposed activity might affect their credit rating,

possibly at the expense of employees, the environment, or long-

term research and development.

These accusations are not entirely consistent: on one hand, the

larger CRAs are accused of being too cozy with the companies

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they rate, and on the other hand they are accused of being too

focused on a company's "bottom line" and unwilling to listen to a

company's explanations for its actions.

.

Credit Rating Agencies in India

Credit rating information service ltd. (CRISIL)

Investment Information and credit rating Agency of India

(ICRA)

Credit Analysis and Research (CARE)

Duff p helps credit rating pvt. ltd. (DCR India)

Onida Individual Credit Rating Agency (ONICRA)

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Credit Rating Information Services of India Ltd (CRISIL)

Objectives:

To assist both individual & institutional investors in making

investment decision in fixed income securities.

CRISIL, the first credit agency was floated on Jan, 1998. It was

started jointly by ICICI & UTI with an equity capital of Rs.4crore.

Each of them holds 18% of the capital. Other contributions to the

capital are as follows:

1. Asian Development bank 15%

2. LIC, GIC & SBI 5% each

3. HDFC 6.2%

4. Banks (Indian) 19.25%

5. Banks (Foreign) Balance

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Credit Rating and Information Services of India Ltd.

(CRISIL) (BSE: 500092, NSE: CRISIL) is India's leading Ratings,

Research, Risk and Policy Advisory Company based

in Mumbai. CRISIL’s majority shareholder is Standard & Poor's, a

division of The McGraw-Hill Companies and the world's foremost

provider of financial market intelligence.

CRISIL pioneered ratings in India more than 20 years ago, and is

today the undisputed business leader with the largest number of

rated entities and rating products: CRISIL's rating experience

covers more than 24654 entities, including 14,500 small and

medium enterprises (SMEs)

CRISIL offers domestic and international customers (CRISIL

Global Research & Analytics comprising of Irevna & Pipal

Research caters to international clients) with independent

information, opinions and solutions related to credit ratings and

risk assessment; energy, infrastructure and corporate advisory;

research on India's economy, industries and companies;

global equity research; fund services; and Risk management.

.

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Process of Credit Rating

Following factors are taken into account while assigning specific

ratings to the issues:

a) i. Financial Analysis: Quality of accounting such as

profitability aspects, method of income recognition, valuation of

inventory, auditors’ comments etc.

ii. Adequate cash flows

iii. Financial flexibility.

b) Business Analysis:

i. Industry risk,

ii. Product demand,

c) Management Competency:

d) Philosophy, outlook, capacity, flexibility of the management

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Debentures

“AAA”: Highest safety of timely payment of interest and

principal.

“AA”: Offer high safety of interest and principal. Differ in safety

from

“AAA”: only marginally.

“A”: Adequate safety; however changes in circumstances can

affect

Adversely more than those in higher rated categories.

“BBB”: Sufficient safety, however change in circumstances likely

to lead a weakened capacity.

“BB”: Inadequate safety but less susceptible to default than other

Speculative grade Debentures

“B”: Greater susceptibility to default.

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“C”: Vulnerable to default.

“D”: In default and in arrears of interest or principal

Investment Information and Credit Rating Agency of India

(ICRA):

The IICRA was set up by industrial finance corporation of India on

16th Jan 1991.itis a public ltd company with an authorized share

capital of Rs 101 crore.

The initial paid up capital of Rs 3.50 cr. is subscribed by IFC, UTI,

LIC, GIC, SBI & 17 other bank. IICRA started its operation from

15th Mar. 1991.

During 94-95 IICRA rated 212 debt instruments covering a debt

volume Rs. 5343 crores.

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Cumulative number of instruments covering a debt volume of Rs.

17,638 crores.

ICRA was set up by ICICI and other leading investment

institutions and commercial banks and financial services

companies

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Credit Analysis and Research Ltd. (CARE)

The CARE was promoted in1993 jointly with investment

companies, banks &finance companies. Services offered by CARE

are –

(i) Credit rating

(ii) Information service

(iii) Equity research

(iv) Rating & parallel market of LPG & kerosene.

Since its inception till the end of March 1995, CARE has rated 249

debt instruments covering a total debt volume of Rs 9729

crores.CARE was promoted by leading financial institutions, banks

and private sector finance companies.

Care prefixes CARE to the ratings given to the issue e.g. CARE

AAA or CARE AA to the Debenture or Bond issue to indicate

High safety.

Similarly in case of Fixed / Short Deposit is sue the rating

issued is CARE AAA (FD) or CARE AA (SD) and so on.

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USES OF CREDIT RATING

A credit rating agency (CRA) assigns credit ratings for issuers of

certain types of debt obligations as well as the debt instruments

themselves. In some cases, the servicers of the underlying debt are

also given ratings. In most cases, the issuers of securities are

companies, special purpose entities, state and local governments,

non-profit organizations, or national governments issuing debt-like

securities (i.e., bonds) that can be traded on a secondary market. A

credit rating for an issuer takes into consideration the issuer's credit

worthiness (i.e., its ability to pay back a loan), and affects the

interest rate applied to the particular security being issued. (In

contrast to CRAs, a company that issues credit scores for

individual credit-worthiness is generally called a credit bureau or

consumer credit reporting agency.) The value of such ratings has

been widely questioned after the2008 financial crisis. In 2003 the

Securities and Exchange Commission submitted report to Congress

detailing plans to launch an investigation into the anti-competitive

practices of credit rating agencies and issues including conflicts of

interest.

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FUTURE OF CREDIT RATING IN INDIA

At present, commercial paper, k bonds and debentures with

maturities exceeding18 months & fixed deposits of large non-

banking companies registered with RBI are required to be

compulsorily rated.

These are moves to make rating compulsorily for other types of

borrowings such as fixed deposit programmed of manufacturing

companies.

In addition, the rating agencies are expected to be called upon to

enlarge volumes of securitization of debt & structuring of

customized instruments to meet the needs of issuers or different

class of investors.

There are number of areas where rating agencies will have to cover

new grounds in the coming years.

The rating of municipal bonds, state govt. borrowings, commercial

banks & public sector.

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Cumulative Historic Default Rates (in percent)

------------------------------------------------------------------------

Moody's S&P

Rating categories ---------------------------------------

Muni Corp Muni Corp

-------------------------------------------------------------------------

Aaa/AAA......................... 0.00 0.52 0.00 0.60

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Aa/AA........................... 0.06 0.52 0.00 1.50

A/A............................. 0.03 1.29 0.23 2.91

Baa/BBB......................... 0.13 4.64 0.32 10.29

Ba/BB........................... 2.65 19.1 2 1.74 29.93

B/B............................. 11.86 43.34 8.48 53.72

Caa-C/CCC-C..................... 16.58 69.18 44.81 69.19

Investment Grade................ 0.07 2.09 0.20 4.14

Non-Invest Grade................ 4.29 31.37 7.37 42.35

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All............................. 0.10 9.70 0.29 12.98

----------------------------------------------------------------------------

CODE OF CONDUCT

1. A credit rating agency shall make all efforts to protect the

interests of investors.

2. A credit rating agency, in the conduct of its business, shall

observe high standards of integrity, dignity and fairness in the

conduct of its

Business.

3. A credit rating agency shall fulfill its obligations in a prompt,

ethical and professional manner.

4. A credit rating agency shall at all times exercise due diligence,

ensure proper care and exercise independent professional judgment

in order to achieve and maintain objectivity and independence in

the rating process.

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5. A credit rating agency shall have a reasonable and adequate

basis for performing rating evaluations, with the support of

appropriate and in depth rating researches. It shall also maintain

records to support its decisions.

6. A credit rating agency shall have in place a rating process that

reflects consistent and international rating standards.

7. A credit rating agency shall not indulge in any unfair

competition nor shall it wean away the clients of any other rating

agency on assurance of higher rating.

8. A credit rating agency shall keep track of all important changes

relating to the client companies and shall develop efficient and

responsive systems to yield timely and accurate ratings. Further a

credit rating agency shall also monitor closely all relevant factors

that might affect the creditworthiness of the issuers.

9. A credit rating agency shall disclose its rating methodology to

clients, users and the public.

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10. A credit rating agency shall, wherever necessary, disclose to

the clients, possible sources of conflict of duties and interests,

which could impair its ability to make fair, objective and unbiased

ratings. rating committee participating in the rating analysis, and

that of its client.

11. A credit rating agency shall not make any exaggerated

statement, whether oral or written, to the client either about its

qualification or its capability to render certain services or its

achievements with regard to the services rendered to other clients.

12. A credit rating agency shall not make any untrue statement,

suppress any material fact or make any misrepresentation in any

documents, reports, papers or information furnished to the board,

stock exchange or public at large.

13. A credit rating agency shall ensure that the Board is promptly

informed about any action, legal proceedings etc., initiated against

it alleging any material breach or non-compliance by it, of any law,

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rules, regulations and directions of the Boarder of any other

regulatory body.

(b) In case an employee of the credit rating agency is rendering

such advice, he shall also disclose the interest of is dependent

family members and the employer including their long or short

position in the said security, while rendering such advice.]

14. A credit rating agency shall maintain an appropriate level of

knowledge and competence and abide by the provisions of the Act,

regulations and circulars, which may be applicable and relevant to

the activities carried on by the credit rating agency. The credit

rating agency shall also comply with award of the Ombudsman

passed under the Securities and Exchange Board of India

(Ombudsman) Regulations, 2003.

15. A credit rating agency shall ensure that there is no misuse of

any privileged information including prior knowledge of rating

decisions or changes.

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16. (a) A credit rating agency or any of his employees shall not

render, directly or

Indirectly any investment advice about any security in the publicly

accessible media.

(b) A credit rating agency shall not offer fee-based services to the

rated entities, beyond credit ratings and research.

17. A credit rating agency shall ensure that any change in

registration status/any penal action taken by board or any material

change in financials which may adversely affect the interests of

clients/investors is promptly informed to the clients and any

business remaining outstanding is transferred to registered person

in accordance with any instructions of the affected

clients/investors.

18. A credit rating agency shall maintain an arm’s length

relationship between its credit rating activity and any other

activity.

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19. A credit rating agency shall develop its own internal code of

conduct for governing its internal operations and laying down its

standards of appropriate conduct for its employees and officers in

the carrying out of their duties within the credit rating agency and

as a part of the industry.

20. A credit rating agency shall provide adequate freedom and

powers to its compliance officer for the effective discharge of his

duties.

21. A credit rating agency shall ensure that the senior management,

particularly decision makers have access to all relevant information

about the business on a timely basis.

22. A credit rating agency shall ensure that good corporate policies

and corporate governance are in place.

23. A credit rating agency shall not, generally and particularly in

respect of issue of securities rated by it, be party to or instrumental

for—

(a) Creation of false market;

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(b) Price rigging or manipulation

(c) Dissemination of any unpublished price sensitive information

in respect of securities which are listed and proposed to be listed in

any stock exchange, unless required, as part of rationale for the

rating accorded.

IPO GRADING/IRATING

When the Securities and Exchange Board of India (SEBI) decided

to scrap discretionary allotment for qualified institutional buyers

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(QIBs) and switch to the more transparent proportionate allotment

system, it became the first regulator to stand up to the powerful

investment banking community anywhere in the world. Once the

decision was taken, it was evident that the exaggerated outrage and

predictions that large institutional investors would shun IPOs were

completely baseless.

That decision recognized the specific needs of the Indian capital

market and was the result of pressure from investor groups. The

path to mandatory grading of IPOs has been rocky, with enormous

opposition from companies, investment bankers, fund managers,

market experts and SEBI board members. We learn that the final

decision came about in the face of strong opposition by certain

board members(apparently not full-time) and that too only, with a

twist in the tail, which dilutes the original proposal.

The alleged opposition of the regulator’s board members raises an

interesting question. All board-level discussions must, indeed,

remain confidential in order tonsure free and frank expression, but

what is the fiduciary responsibility of board members of a

watchdog organization, who have no knowledge, training or

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expertise about capital markets, when they choose to oppose

recommendations of the Primary Market

Advisory Committee that are endorsed by the regulator? It is also

important to remember that investor groups have been pressing for

IPO grading for several years; first with the Investor Education and

Protection Fund (attached to the ministry of company affairs),

which developed cold feet and dropped even its plans for a pilot

project and later with the capital market regulator Over the years,

those opposed to IPO grading have constructed several elegant

arguments to rubbish its utility, but from an investor standpoint,

the logic is simple. The disclosure-based model adopted by the

regulator, leads to a bulky, jargon-filled prospectus that can neither

be read nor understood by the average investor; consequently, a

simple, one-page evaluation of disclosures by an expert agency,

which also helpfully condenses its findings into a single numerical

grade on a scale of five, is clearly a blessing.

INTRODUCTION TO IPO GRADING

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IPO grading is the grade assigned by a Credit Rating Agency

registered with SEBI; to the initial public offering (IPO) of equity

shares or any other security which may be converted into or

exchanged with equity shares at alter date. The grade represents a

relative assessment of the fundamentals of that issue in relation to

the other listed equity securities in India. Such grading is generally

assigned on a five-point point scale with a higher score indicating

stronger fundamentals and vice versa as below.

IPO grade1: Poor fundamentals

IPO grade2: Below-average fundamentals

IPO grade3: Average fundamentals

IPO grade4: Above-average fundamentals

IPO grade5: Strong fundamentals

IPO grading has been introduced as an endeavor to make

additional

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Information available for the investors in order to facilitate their

assessment of equity issues offered through an IPO.

IPO grading can be done either before filing the draft offer

documents with SEBI or thereafter. However, the

Prospectus/Red Herring Prospectus, as the case may be, must

contain the grade/s given to the IPO by all CRAs approached by

the company for grading such IPO.

The company desirous of making the IPO is required to bear the

expenses incurred for grading such IPO.

IPO grading is not optional. A company which has filed the draft

offer

document for its IPO with SEBI, on or after 1st May, 2007, is

required to obtain a grade for the IPO from at least one CRA.

IPO grade/s cannot be rejected. Irrespective of whether the issuer

finds the grade given by the rating agency acceptable or not, the

grade has to be disclosed as required under the DIP Guidelines.

However the issuer has the option of opting for another grading by

a different agency. In such an even tall grades obtained for the IPO

will have to be disclosed in the offer documents, advertisements

etc.

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Bond Rating

Bond Rating Variability and Methodology:

Evidence from the Indian Bond Market

Credit rating is an indicator of the current opinion on the capability

of capital to service its debt obligations in a timely fashion. It is a

useful source of information for investors, companies, banks and

other financial intermediaries. While the various bond rating areas

have been extensively evaluated for mature markets, similar

evidence for emerging markets such as India is limited. In

particular, the issues relating to bond rating variability over time

and the consistency of bond rating methodology have been

ignored.

In an attempt to fill this lacuna, Sanjay Sehgal and Mamta Arora

conduct a two-part study. In the first part, which deals with bond

rating variability over time, the time-series variability of bond

ratings has been analyzed. The issue is also addressed sector-wise

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and industry-wise. A separate analysis has been carried out for the

two leading bond rating agencies - CRISIL and ICRA. The second

part relates to consistency in bond rating methodology adopted by

rating agencies.

The results indicate that bond ratings are becoming extremely

variable over time and the majority of these rating changes are on

the downside, with price risk implications for investors. While

bond rating variability is high for both the manufacturing and the

financial sectors, the figures are relatively higher for the latter.

Rating changes also seem to have an industry pattern with a greater

concentration in industries more affected by economic slowdown

and global competition. The findings for consistency of bond

rating methodology are also not encouraging. While the key

financial ratios do not vary for companies belonging to the same

rating class, they also do not vary across companies belonging to

different rating classes. This points at probable weaknesses in

rating methodology as the important financial factors fail to

discriminate across rating classes. Perhaps the subjective

judgments of rating analysts taint the relationship between bond

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ratings and key financial factors. Inconsistency in bond rating

methodology mayPartly explain the increasing bond rating variability over time.

CRISIL S.M.E RATINGS

Background

Recent years have seen rapid growth in the Small and Medium

Enterprises (SME) sector, and an enhanced appreciation of this

sector's critical role in driving economic growth. However,

authentic and independent credit research in this sector has so far

been minimal. With many private and public sector banks directing

resources and focus towards SME lending, the need has arisen for

independent credit opinions. CRISIL offers its rating services to

SMEs to meet this need.

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SME ratings are offered on an exclusive rating scale, distinct from

regular ratings offered to large corporations, banks and government

entities.

Credit evaluation in the SME sector needs a specialized approach,

as the issues and drivers of credit quality are different from those

applicable for large companies. The weight ages assigned to

various parameters of evaluation therefore need to be different.

There has to be a good understanding of the particular cluster or

area where the SME is operating. When Lalchand Nathalal Gandhi was approached by Crisil three

years ago to get accredit rating exercise done for his companies,

LN Chemicals and Modera Chemicals, he was skeptical but

decided to go ahead anyway. The experiment worked. While

Gandhi’s businesses already had a good relationship with Saraswat

Bank for years, the rating helped them get an additional 0.5%

interest rate reduction on their bank borrowings. “We were also

noticed by other companies and new enquiries began to flow in,”

says Gandhi, whose firms—with a combined turnover of Rs 40

crore—make chemicals that are used in textile processing, and

soap, paper and paint manufacture.

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Now, as Gandhi looks to expand his business, he’s already being

approached by other banks to fund his expansion plans. “This

could be due to the rating we got from Crisil over the past three

years,” he says. Cultivating healthy relationships with banks may

have helped small companies tide over credit access issues to an

extent.

However, banks’ reluctance to lend to MSMEs often stems from

lack of information, and the fact that evaluating risk in such firms

is often a difficult and time consuming process. Credit rating could

be the solution. A rating report provided by an independent

agency like Crisil, ICRA or CARE offers deep insights into a

company’s operations.

It can reveal the creditworthiness of the company in relation to

its peers in the sector, and an assessment of its strengths and

weaknesses based on its financial condition. “Anyone who sees

the report is instantly appraised of the health of the company,”

says Yogesh Dixit, head-SME Ratings at Crisil. Large corporates

have been getting themselves rated for many years now, but in

the world of small business this is a relatively recent and emerging

trend.

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Four years ago, the National Small Industries Corporation (NSIC)

launched a programme where a micro or small enterprise (with a

maximum investment of Rs 5crore in plant and machinery) would

receive a 75% subsidy on rating fees (around RS 50,000) charged

by any of the six empanelled rating agencies–Crisil, ICRA,D&B ,

SMERA, Fitch and CARE. This has had a positive effect with

around 5,000units getting rated last year, and NSIC expects that at

least another 7,000 will follow suit this year.

Under the new Basel II norms that came into effect from April 1

this year, rating is mandatory for businesses with investments over

Rs 10 crore. For those firms that are below the Rs 10-crore level,

rating is also beneficial, especially when it comes to dealing with

customers.

“For a small business, a rating by a recognized agency helps it

command better terms with its buyers,” says HP Kumar, chairman

and managing director of NSIC.

A robust rating process includes a visit to the factories and

warehouses to authenticate information provided by the company,

verifying if the insurance of assets is in order and also taking

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feedback from suppliers, customers and bankers of the firm, among

other aspects.

The NSIC rating scale takes into account two factors—

performance capability and financial strength. For example, a

company with moderate performance capability and high financial

strength will be rated SE3A, while one with weak performance

capability and moderate financial strength will be rated SE4B.

On the basis of rating reports, banks are able to take faster

decisions on project loans as well as on renewing and increasing

credit limits for those clients. Every bank has its own internal

guidelines on lending but Dixit says ratings are useful since

information about small companies is not readily available. “It is

an independent third-party assessment of the overall condition of

the SME,” he says. In that sense, ratings bring credibility and a

better image to a sector that’s fragmented and often opaque about

the financial health of its companies.

“Ratings can be revealed to vendors and customers without

furnishing all financial data, “says Rajesh Dubey, executive

director, ICRA Online

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Take the case of In Marco Industries, which makes high-tech

industrial sealing products. The Rs 25-crore (turnover) firm has

been getting rated by Crisil every year for the past four years and

has managed to obtain the highest level of SE1Aeach time. “We

have been able to establish JVs and partnerships with the help of

the rating,” says Chetan Doshi, executive director, In Marco,

adding that it’s a calibration tool for his business that could come

handy when he decides to go for an IPO later. “It helps us in self-

analysis as we expand.” Many companies have been leveraging

ratings to enhance their brand image and acquire new clients.

For instance, Gandhi says his firms’ rating is displayed

prominently on the company stationery and website. “It gives us an

identity in new markets and with new customers,” he says.

Moreover some supply tender notices insist the applying

companies be rated. Rating is also bringing a shift in thinking

among SMEs in terms of self-regulation. “Rated companies today

understand that good corporate governance, transparency and a

sound accounting policy are all important in this changing world,”

says Dixit.

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That doesn’t mean ratings have become fully accepted among

small companies and their bankers. There have been cases reported

where banks have not honored ratings done by external agencies,

and have relied only on their own due diligence. Rajeev Karwal,

CEO, Mila grow Business and Knowledge Solutions, a small

business advisory firm says, “Banks should accept it. Only if they

give loans on the basis of the rating will it have any meaning.” At

Meerut-based Kanohar Electricals, managing director Dinesh

Singhal contends that mandatory rating due to Basel IIadds to his

cost and provides no additional value. “These rating agencies are

not fully equipped to rate according to Basel II.

They prepare reports after just looking at the balance sheets,” he

says. While the maximum benefit to a company getting rated is an

interest reduction of 0.5%, the cost of rating works out to be higher

than the savings, he says. There are other limitations to the ratings

system as well, says Anil Bhardwaj, secretary general of the

Federation of Indian Micro and Small & Medium Enterprises

(FISME). “Most banks have a tacit understanding with one or two

rating agencies and they do not accept ratings by other agencies.

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STANDARD & POOR'S

Standard & Poor's (S&P) is a United States-based financial

services company. It is a division of the McGraw-Hill

Companies that publishes financial research and analysis

on stocks and bonds. It is well known for the stock market indices,

the US-based S&P 500, the Australian S&P/ASX 200, the

Canadian S&P/TSX, the Italian S&P/MIB and India's S&P CNX

Nifty. It is one of the Big Three (credit rating agencies) (Standard

& Poor's, Moody's Investor Service and Fitch Ratings)

Standard & Poor's, as a credit rating agency (CRA), issues credit

ratings for the debt of public and private corporations. It is one of

several CRAs that have been designated a Nationally Recognized

Statistical Rating Organization by the U.S. Securities and

Exchange Commission.

It issues both short-term and long-term credit ratings.

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History of Standard and Poor’s

Standard & Poor's traces its history back to 1860, with the

publication by Henry Varnum Poor of History of Railroads and

Canals in the United States.

This book was an attempt to compile comprehensive information

about the financial and operational state of U.S. railroad

companies. Henry Varnum went on to establish H.V. and H.W.

Poor Co with his son, Henry William, and published updated

versions of this book on an annual basis.

In 1906 Luther Lee Blake founded the Standard Statistics Bureau,

with the view to providing financial information on non-railroad

companies. Instead of an annually published book Standard

Statistics would use 5" x 7" cards, allowing for more frequent

updates.

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In 1941, Poor and Standard Statistics merged to become Standard

& Poor's Corp. Then in 1966 S&P was acquired by The McGraw-

Hill Companies, and now encompasses the Financial Services

division

From this source, it shows that Standard & Poor’s expects a brief

earnings dip in the fourth quarter of 2007 with the earnings trend

returning to the prior growth pattern by the second quarter of 2008.

Remember that much of the growth in earnings was driven by the

growth in revenues which was fueled by the rapid expansion of

credit that is now contracting significantly. The problem is this

earnings forecast doesn’t do not seem very logical nor does it

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follow history. According to McKinsey & Company, the strategic

consulting firm, in order for overall S&P 500 earnings to reach the

long-run average proportion of GDP, profits would have to fall 20

percent from their 2007 levels. This excludes the financial and

energy sectors, so we get a better focus on the underlying

economy.

Standard and Poor’s Rating Comparison

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Standard and Poor’s Credit Rating

Long-term credit ratings

S&P rates borrowers on a scale from AAA to D. Intermediate

ratings are offered at each level between AA and CCC (e.g.,

BBB+, BBB and BBB)

Investment Grade

AAA: the best quality borrowers, reliable and stable (many of them

governments)

AA: quality borrowers, a bit higher risk than AAA. Includes:

AA+: equivalent to Moody's and Fitch

AA: equivalent to Aa2

AA-: equivalent to Aa3

A: quality borrowers whose financial stability could be affected by

certain economic situations

A+: equivalent to A1

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A: equivalent to A2

BBB: medium class borrowers, which are satisfactory at the

moment

Non-Investment Grade (also known as junk bonds)

BB: more prone to changes in the economy

B: financial situation varies noticeably

CCC: currently vulnerable and dependent on favorable

economic conditions to meet its commitments

CC: highly vulnerable, very speculative bonds

C: highly vulnerable, perhaps in bankruptcy or in arrears but

still continuing to pay out on obligations

CI: past due on interest

R: under regulatory supervision due to its financial situation

SD: has selectively defaulted on some obligations

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D: has defaulted on obligations and S&P believes that it will

generally default on most or all obligations

NR: not rated

Short-term issue credit ratings:

S&P rates specific issues on a scale from A-1 to D. Within the A-1

category it can be designated with a plus sign (+)

A-1: obligor's capacity to meet its financial commitment on the

obligation is strong

A-2: is susceptible to adverse economic conditions however the

obligor's capacity to meet its financial commitment on the

obligation is satisfactory

A-3: adverse economic conditions are likely to weaken the

obligor's capacity to meet its financial commitment on the

obligation

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B: has a significant speculative characteristic. The obligor

currently has the capacity to meet its financial obligation but

faces major ongoing uncertainties that could impact its financial

commitment on the obligation

C: currently vulnerable to nonpayment and is dependent upon

favorable business, financial and economic conditions for the

obligor to meet its financial commitment on the obligation

D: is in payment default. Obligation not made on due date and

grace period may not have expired. The rating is also used upon

the filing of a bankruptcy petition.

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Recent Activity

A congressional panel is examining whether the Obama

administration tried to unduly influence Standard & Poor’s before

the credit rater revised its outlook on the debt rating to negative.

Randy Neugebauer, the Republican chairman of a House oversight

panel, said on Wednesday his staff is probing whether Treasury

tried to make material changes to a draft of S&P’s news release

announcing the negative outlook revision in April.

His concern was if the administration was trying to influence this

rating decision some — above what would be a normal practice.

Neugebauer told reporters after a hearing examining oversight of

the credit rating industry and the role the raters are playing in U.S.

debt talks.

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CONCLUSION

The credit market turmoil that began in the U.S. in the summer of

2007 has been amplified in recent months by dramatic slowing of

broader economic activity. What began as a significant, but

relatively isolated, deterioration in the performance of sub-prime

housing loans has led to a wave of negative events that have

reverberated across a highly-leveraged, interconnected and, at

times, opaque global financial system. More importantly, a credit

crisis has transformed into a much wider and deeper crisis of

confidence in the global markets. Credit rating

agencies have an opportunity to help restore confidence in markets

by restoring confidence in our industry. Many necessary actions

can and have been undertaken at the individual firm and industry

level and we are committed to continuing along that path.

Nonetheless, a

few key actions and reforms as I have described above require help

from the broader market and oversight authorities. For 2009, the

description of credit is identical to the “way forward” for credit

markets: confidence. The rebuilding process will be far more

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protracted than the events that necessitated it – which is all the

more reason to get on with the task with energy, tenacity and

coordination.

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BIBLIOGRAPHY

http://en.wikipedia.org/wiki/Credit_rating

http://www.smera.in/Compliance.aspx

http://www.nsic.co.in/creditrating.asp

www.crisil.com

www.icra.in

www.sebi.com

http://www.sebi.com/

http://www.icra.in/

http://www.crisil.com/

http://www.nsic.co.in/creditrating.asp

http://www.smera.in/Compliance.aspx

http://en.wikipedia.org/wiki/Credit_rating

credit rating project 100 marks

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