PROJECT REPORT ON

“CREDIT RATING AGENCIES- A CHALLENGING

FIELD”
Submitted by
XYZ
Roll No.: 13

ABC
Roll No.: 14

LMN
Roll No.: 15

MITHILESH KISHOR GIDAGE

Roll No.: 16

OPQ
Roll No.: 17

FGH
Roll No.: 18

MMS (FINANCE)

UNIVERSITY OF MUMBAI’S
ALKESH DINESH MODY INSTITUTE FOR
FINANCIAL AND MANAGEMENT
STUDIES

1|Page
 GROUP NUMBER: 03

LIST OF GROUP MEMBERS

Roll Number Name of Student Signature

13

14

15

16 Mithilesh Kishor Gidage

17

18
 CERTIFICATE

This is to certify that the project report entitled “CREDIT RATING AGENCIES-
A CHALLENGING FIELD” submitted to Alkesh Dinesh Mody Institute for
Financial and Management Studies is a bonafide record of work done by …..,
……. , ……., Mr. Mithilesh Kishor Gidage, ……. , ……… under my supervision.

Mr. Uday Patil

(Project Guide)
 ACKNOWLEDGEMENT

This project has been a great learning experience for us.

We take this opportunity to thanks Mr. Uday Patil Sir, our project guide whose
valuable guidance and suggestions made this project possible. We are extremely
thankful to him for his support.

We also express our profound gratitude towards Dr. Smita Shukla, I/c Director
of Alkesh Dinesh Mody Institute of Financial and Management studies for
giving us constant support and guidance.

We would like to acknowledge the support and encouragement provided by our

family and friends for the completion of this project.
 INDEX
SR
NO. TOPIC PAGE NO.
1 INTRODUCTION
1A Objectives
2 CREDIT RATING
2A Different rating related products and activities
3 RATING PROCESS
3A BRM process flow
3B Process overview
3C Policy of appeal in case of Initial Rating
3D Policy of unexpected ratings
3E Validity of CRA's credit ratings
3F Policy regarding review/surveillance of ratings
3G Policy for appeal in case of review/surveillance
3H Criteria for placing rating on Credit Watch
3I Policy with respect to Non - Cooperation by Issuer
3J Policy on withdrawal of ratings
3K Policy of Unsolicited ratings
4 RATING METHODOLOGY
4A Scope
4B Industry profile and operating management
4C Company Profile
4D Management Strategy and Corporate governance
4E Ownership, Support and Group Factors
4F Financial Profile
4G Project risk
5 LIMITATION OF CREDIT RATING AGENCY
6 SEBI REGULATIONS
6A Regulatory changes abou CRA's business model
6B Changes in the regulatory norms of credit rating agency
7 CASE STUDY
8 CONCLUSION
9 BIBLIOGRAPHY
 EXECUTIVE SUMMARY

This report was made by researching various publicly available material about
the Credit Rating Agency’s. The report includes description of a CRA, wide
range of assignments it takes instruments CRA’s rates.
Additionally, its functioning mechanism right from acquiring clients to
providing ratings to the client and evaluation till the expiry of the instrument
rated. The project also includes regulations it faces along with analysis of
different revenue model.
The project also addresses the recent regulatory changes while assigning the
rating to the instrument and the current limitations to the Credit Rating
Agencies (CRAs).
 INTRODUCTION

CRA performs a very crucial role in the financial markets, by way of addressing
the issue of data asymmetry. This report research CRA through privately
available literature.

Credit rating agencies play an important position in assessing risk and its place
and distribution in the financial system. By facilitating funding choices, they
can assist investors in attaining a stability in risk return profile and at the same
time assist companies in having access to capital at low price. CRAs can help to
allocate capital efficaciously across all sectors of the financial system through
pricing risk correctly. However, in view of the reality that CRAs that rate capital
market instruments are regulated by SEBI and that entities regulated via
different regulators (IRDA, PFRDA and RBI) predominantly use the ratings.

While examining the functioning of a Credit Rating Agency it's miles critical to
understand what credit rating is, what are the different financial instruments that
are rated, what are the processes which they observe while rating and what are
the methodology which they use. Through doing so, and analyzing diverse
issues do we be able to come to return to feasible conclusions.

In this report, I have studied the functioning of the CRA; beginning from what
is credit rating, what are the different instruments which are rated, what's the
rating process, what are the distinctive problem decision mechanism in place
while rating, what's the rating method observed and how SEBI policies are
complied with.
 OBJECTIVES:

 Understanding credit rating

 Understanding various instrument which are rated
 Understanding how a Credit Rating Agency functions
 Understanding the methodology used for credit rating
 Understanding regulations in place
 Understanding various issues related to a CRA and trying to pitch
possible solutions
What is credit rating? CREDIT RATING
A credit rating is evaluation of the creditworthiness of a borrower in standard
phrases or with respect to a particular debt or financial obligation. A credit
rating can be assigned to any entity that seeks to borrow money – an individual,
a company, state or provincial authority, or sovereign government.

What are credit rating agencies?

A credit rating agency (CRA) is an organisation that assigns credit ratings,
which rate a debtor's capability to pay back debt by means of making timely
essential principal payment and interest payments and the chance of default.
There are six credit rating corporations registered under SEBI specifically,
CRISIL, ICRA, CARE, SMERA, Fitch India and Brickwork Ratings.

CRAs had been set up to offer unbiased evidence and research-based opinion on
the capacity and willingness of the issuer to fulfil debt service obligations,
quintessentially attaching a possibility of default to a selected instrument.

Comparing the creditworthiness of an instrument contains of both qualitative

and quantitative examination, making credit rating a ways from a standard
mathematical calculation.

What does credit rating convey?

A credit rating is an opinion on the creditworthiness or the relative degree of
risk of timely payment of interest and principal on a debt instrument. Most
rating agencies adopt some version of this definition for their credit ratings. The
ratings are a comment on the relative likelihood of default in evaluation to other
rated instruments. In different phrases, a rating suggests the probability of
default of
the rated instrument and therefore presents a benchmark for measuring and
pricing credit risk. A credit rating compresses an enormous amount of various
information into a single rating symbol. An easy alphanumeric symbol, such as
AAA‘or A1‘, is usually used to describe a credit rating. Currently, rating
agencies have standardised rating nomenclatures for long term ratings, short
term ratings, medium term ratings, fixed deposits, corporate/issuer credit rating,
long and brief term debt fund portfolios, IPO grading and many others. The
rating symbol for the used by credit different instruments used by credit rating
agency prescribed by means of the regulator – Securities and Exchange Board
of India (SEBI)
 Rating Symbols and Definitions for Long Term Debt Instruments
Long term debt instruments: The instruments with original maturity exceeding one
year
Rating symbols should have CRA’s first name as prefix

Long
Long
Long term
term
term Structur
debt
Indicator debt ed
mutual
instrum Finance
fund
ents Instrume
schemes
nts

Instruments with this rating are considered to have the

highest degree of safety regarding timely servicing of AAA
AAA AAAmfs
financial obligations. Such instruments carry lowest (SO)
credit risk.
Instruments with this rating are considered to have high
degree of safety regarding timely servicing of financial AA AA (SO) AAmfs
obligations. Such instruments carry very low credit risk.
Instruments with this rating are considered to have
adequate degree of safety regarding timely servicing of
A A (SO) Amfs
financial obligations. Such instruments carry low credit
risk.
Instruments with this rating are considered to have
moderate degree of safety regarding timely servicing of BBB
BBB BBBmfs
financial obligations. Such instruments carry moderate (SO)
credit risk.
Instruments with this rating are considered to have
moderate risk of default regarding timely servicing of BB BB (SO) BBmfs
financial obligations.
Instruments with this rating are considered to have high
risk of default regarding timely servicing of financial B B (SO) Bmfs
obligations.
Instruments with this rating are considered to have very
high risk of default regarding timely servicing of C C (SO) Cmfs
financial obligations.
Instruments with this rating are in default or are
D D (SO) Dmfs
expected to be in default soon.
 Rating Symbols and Definitions for Short Term Debt instruments
Short term debt instruments: The instruments with original maturity of up to one year
Rating symbols should have CRA’s first name as prefix

Short
Short term term
Short term
Structured debt
Indicator debt
Finance mutual
instruments
Instruments fund
schemes
Instruments with this rating are considered to
have very strong degree of safety regarding
A1 A1(SO) A1mfs
timely payment of financial obligations.
Such instruments carry lowest credit risk.
Instruments with this rating are considered to
have strong degree of safety regarding
A2 A2(SO) A2mfs
timely payment of financial obligations.
Such
instruments carry low credit risk.
Instruments with this rating are considered to
have moderate degree of safety regarding
timely payment of financial obligations.
A3 A3(SO) A3mfs
Such instruments carry higher credit risk as
compared to instruments rated in the two
higher categories.
Instruments with this rating are considered to
have minimal degree of safety regarding
timely payment of financial obligations. A4 A4(SO) A4mfs
Such
instruments carry very high credit risk and
are susceptible to default.
Instruments with this rating are in default or
D D(SO) Dmfs
expected to be in default on maturity.
Rating related products and activities CRAs in India rate a large number
of financial products:
1. Bonds/ debenture
2. commercial paper
3. dependent finance products
4. bank loans
5. Fixed deposits and bank certificates of deposits
6. Mutual fund debt schemes
7. preliminary Public offers (IPOs)
CRAs additionally undertake customised credit research of a number of
borrowers in a credit portfolio, for the use of lender. CRAs use their
understanding of companies business and operations and their expertise in
building frameworks for relative evaluation, which are then applied to arrive at
overall performance grading.

Non-rating associated activities:

CRAs frequently undertake an expansion of non-rating associated activities.
Those include the following:

1. Economy and Organization studies:

Some Indian CRAs have set up research arms to supplement their rating
activities. Those arms carry out studies on the financial system, industries and
unique businesses, and make the same available to outside subscribers for a rate.
similarly, they disseminate opinions on the performance of the financial system
or specific industries, available through releases to the media. The studies would
additionally be used internally by the rating agencies for arriving at their rating
evaluations. SEBI lets in CRAs to carry out this interest situation to relevant
firewalls.
2. Risk consulting:
With the application of Basel II guidelines for banks, there is a considerable for
for tools and products a good way to permit banks to compute their capital
adequacy ratios under the revised guidelines of Basel II. The risk consulting
businesses of credit rating groups could leverage the agencies‘ understanding of
credit risk to broaden and offer the toold and records that banks would require.
The products in this area consist of equipment for internal ratings, operational
risk evaluation, and overall capital calculation.

3. Funds research:
Some CRAs have assorted from mutual fund ratings into mutual fund research.
The services which are available below this head encompass fund ratings,
overall performance attribution equipment (to help customers apprehend the
motives for funds‘ overall performance), desktop tools, and fixed income
research.

4. Advisory services:
CRAs offer numerous sorts of advisory offerings, typically via committed
advisory arms. Most of this is within the nature of developing policy
frameworks, bid system management, public private partnership consulting, and
developing an permitting surroundings for enterprise in India and globally.

5. Knowledge process Outsourcing:

some Indian CRAs (CRISIL and ICRA) have KPO arms that leverage their
analytical abilities and different method and manpower abilities. Those arms
provide services to the CRAs ‘affiliates in developed markets, and additionally
to other clients outside of India.
 RATING PROCESS:

Source: CRISIL
BRM (process flow)

The BRM Team is responsible for sourcing & maintaining issuer relationship. It
is usually headed by a MD, supported by regional heads responsible for their
respective regions. Their role involves organization of new rating mandates and
managing existing rating relations with respect to commercial negotiations of
rating mandates for assigning of ratings. BRM team is responsible for mapping
the market, target the relevant issuers and originate the rating mandates. Rating
fees negotiations done and the rating mandates (as per the regulations) are
executed.

The commercial negotiations & the resultant agreements containing the same
are stored in separate folders which are not accessible to the analyst group.

Once the rating mandate is signed, the client on-boarding is done to the
Analytical group. The Analytical groups are informed on the rating assignment,
issuance details and the key personnel from the company whom the Analysts
should get in touch to initiate the analytical process. BRM team is not part of
the rating process including data assimilation, data processing, analytical
modelling, site visits, management interactions and Rating Committees.

Steps:

1. Initial pitch for Rating mandate to Issuer by BRM

2. Finalizing quantum of Issuance
3. Execution of mandate (Rating Agreement as per SEBI Regulations) by
Issuer and BRM
4. BRM enters the agreement & deal ticket along with fees information in
SAP meant for recording the Rating Agreement. The SAP database is
only assessable to BRM & Accounts Tea
 5. Mail is sent to the Analytical Heads which includes (The commercial
negotiations & the resultant agreement containing the same are stored in
separate folders which are not accessible to the Analyst Team):
a) Name of Issuer
b) Facility to be rated and amount
c) Sector which the issuer belongs to (Corporate / Financial Institutions
/ Infrastructure / Structured Finance)
d) Name of key official’s issuer side and their contact information

Analytical Teams progresses with the Rating mandate, conducts the analytical
work and intimates the rating to the issuer post the rating committee.

The rating process is initiated once a rating agreement is signed between CRA
and the client/ on receipt of a formal request (or mandate) from the client. Once
this is done, a rating committee is formed, with the relevant expertise and skills
for evaluation of the business of the client. The client is then provided with a list
of information required to carry out the rating and the broad framework for
discussions.

The primary focus of the rating exercise is to assess future cash generating
capabilities of the entity and its adequacy to meet debt obligations, even in
adverse conditions. The analysis attempts to determine the long-term
fundamentals and the probabilities of change in these fundamentals.

This requires extensive interactions with the client’s management, visit to the
client’s plant (in case of manufacturing firms), and a study of many factors,
including industry characteristics, competitive position of the client, operational
efficiency of the client, quality of the management, their funding policies and
past and projected financials.
After understanding the business of the client and level of operations the
company works in, the rating team carries out business and financial risk
analysis. The rating team undertakes an in-depth analysis of the client’s past and
projected financial statements to understand the client’s business fundamentals,
financial position, liquidity and flexibility and its ability to service their debts.

CRAs also carries out a due diligence exercise by interacting with the client’s
auditors, bankers, financial institutions and other stakeholders, and additionally
conducts a review of other secondary sources of information.

Audited financial statements given by the company along with the auditors’
report form the main basis for understanding the current financial position of the
company. CRA also seeks various other operational and financial information
from the client in order to better understand the various aspects of businesses/
financial statements. CRA also seeks unaudited results for recent period to
understand the current financial position. In the case of entities implementing
the projects, CRA analyses factors like the rationale for implementing the
project, size of the project vis-à-vis the current scale of operations and net-
worth of the company and the funding pattern of the project apart from project
implementation risk and post implementation risk. The team also interacts with
the top management of the company to take a view of business goals and future
strategies and policies of the company.

After completing the analysis of the company, the rating team prepares a rating
notes based on the information received from client as well as other information
received from other reliable sources and the management evaluation. CRA does
not conduct an audit or investigation exercise while doing the rating exercise.
The rating note is based on the CRA’s rating Criteria as also sector specific
methodologies. The final rating (including rating outlook) to the client is
assigned by the Rating Committee. A risk profile for each company made by the
rating
team helps the Rating Committee in assigning the rating.

CRA conveys the rating to the client over email/letter. Once the client accepts
the rating, the CRA issues Rating Letter, Press Release and detailed Rating
Rationale to the client.

The rating and the rationale for the rating is released to the public through a
Press Release on CRA’s website. CRA also publishes a monthly list of
outstanding ratings on its website. CRA monitors all accepted ratings over the
tenure of the rated instrument.

Policy for appeal in case of Initial Rating:

If the client does not accept the Initial rating, the client can then appeal to CRA
to review the rating within a reasonable time period. While representing, the
client may provide additional information to CRA for the review of rating. Each
such representation is placed before the Rating Committee, which considers the
additional details given by the client and then reviews the rating. The after-
review decision of the Rating Committee is again conveyed to the client over
electronic mail/ letter who has the right to just accept or reject the rating.

Policy for Unaccepted ratings

If the initial rating is not accepted within 60 days from the date of its
communication to the client, the rating is classified as ‘unaccepted’ and would
be delivered to the list of unaccepted ratings on the website of the credit rating
agency. An unaccepted rating can be converted into acceptable rating if the
client so desires; However, it would require a review process before that.

CRAs publishes information of unaccepted credit ratings assigned from January

1, 2017. Information consists of name of the issuer, name/type of the
instrument,
size of the issue, rating and outlook assigned, date of rating. Those disclosures
are a part of the ‘Regulatory disclosures’ under Credit Rating agencies website.
CRAs do not monitor unaccepted ratings.

Validity of CRA’s credit ratings

Rating letters for short term instruments have a validity duration of two months
whilst those for long time/medium term instruments are legitimate for 6 months.
But, as soon as the instrument has been placed, CRA's ratings are valid for the
life of the instrument, until the rating is withdrawn. Withdrawal of the rating is
certainly communicated to the public through CRA’s website.

Surveillance:
All ratings are under continuous surveillance. After a rating has been assigned,
CRA continues to monitor the performance of the issuer and the economic
environment in which it operates. The surveillance process is conducted in order
to ensure that the analysts are updated on current developments, review
sensitive areas, and learn about changes in issuer’s plans. CRA analysts
maintain periodic contact with the issuer and ensure that financial and other
information are shared with CRA regularly. Moreover, CRA endeavours to
interact with issuer’s management at least once a year. These interactions
essentially focus on developments over the period since the last interaction, and
the outlook for the coming year.

Policy for appeal in case of reviews/surveillances:

CRA gives the client a reasonable possibility to seek an assessment on the
rating action taken via it at the time of evaluation/surveillance. However, as
soon as such opportunity is provided via CRA, the decision in respect of the
revision/
reaffirmation/ withdrawal of the rating is final and is binding upon the customer,
and is made public by the Credit rating agency via their website.

Criteria for placing rating on credit watch

CRA may place a rating on ‘Credit Watch’ when any event or deviation from
the expected trend has occurred or is expected and additional information is
necessary to take rating action. For example, the issuer is placed on Credit
Watch as a result of its merger with another entity or regulatory actions imposed
on the industry in which it is operating or any other unanticipated operating
developments.

Credit Watch highlights potential changes in ratings of instruments. At the same

time, placing a rating on Credit Watch does not always mean that a rating
change is inevitable. However, in some cases, it is certain that a rating change
will occur and only the magnitude of the change is unclear.

CRA places a rating on ‘Credit Watch’ with “Positive”, “Negative” or

“Developing” implications, indicating the possible direction of movement of the
rating consequent to the resolution of the credit watch event.

Non-cooperation by the issuers:

Assigning and monitoring of a rating requires adequate and timely information

and cooperation from clients. In the absence of the same, it is not possible, in a
reasonable manner, to arrive at the credit quality of an instrument/facility being
rated. In case the issuer does not provide the information sought by CRA for
monitoring the rating in a timely manner, despite adequate efforts by CRA,
CRA shall categorize the issuer as ‘non-cooperating’. CRA also construes non-
payment of fees by the issuer for conducting the surveillance as a form of non-
cooperation.
In case of non-cooperating clients, CRA shall review the rating of
instrument(s)/facilities on the basis of the ‘best available information’. This will
include any information shared by the client with CRA, any publicly available
information including the report published by the debenture trustees from time
to time, feedback from bankers/auditors/debenture trustees etc.

Withdrawal of ratings:

Debt instruments rated by CRA are under continuous surveillance over the life
of the instrument. CRA policy for withdrawal of ratings stipulates that ratings
on securities/facilities that have scheduled repayment dates (such as bonds, or
term loans), may be withdrawn only on redemption/maturity of the rated
facilities. The ratings may also be withdrawn if obligations on these instruments
are pre-paid by the borrower, with the lender’s consent, before maturity. In such
instances, CRA relies on independent confirmation from the banks or auditors
or any other independent sources on whether the obligations have been repaid in
full. Ratings on bank loan facilities can also be withdrawn by CRA after
receiving request for withdrawal from the client/borrower along with No
Objection Certificate (NOC) from all the lending bank(s) and on clearance of
fees due (if any) to CRA. CRA withdrawal policy is in line with the recent SEBI
circular titled ‘Enhanced Standards for Credit Rating Agencies (CRAs)’ that is
applicable for all Credit Rating Agencies.

Preliminary Analysis:

The rating process starts with a rating request from the issuer. Thereafter, the
rating agreement is signed and the fees are collected from the issuer. All
interactions with regard to rating fees are carried out by Credit Rating Agency
business development team and there is no involvement of Credit Rating
analytical team in the process. When the process of business development is
completed, an analytical team is assigned the responsibility of analysing the
issuer’s credit risk profile. This rating team then collates preliminary
information from the issuer to understand its business, management, and
financial risk profiles.

Management Interaction:

Interactions with management are wide-ranging, covering competitive position,

strategy, financial policy, historical performance, and near and long term
financial and business prospects. In these discussions, Credit Rating Agency
teams focus on the issuer’s business risk profile and strategies, in addition to
reviewing financial data. Credit Rating Agency teams focus on the issuer’s
business risk profile and strategies, in addition to reviewing financial data.
Credit ratings are not based solely on financial projections made by the issuer or
the management’s outlook. Instead, they serve as a valuable input in CRA
assessment of the issuer’s profile as they shed light on the management’s
assumptions, strategy, and contingency plans.

Rating committee and assignment of ratings:

Rating committee and assignment of ratings after the interaction with the
issuer’s management, CRA analysts prepare a report detailing their assessment
of business risk, financial risk, and management risks associated with the issuer.
The report is based on rating methodologies and criteria that are clearly spelt
out, published, and consistently applied. The report is then presented to the
rating committee. This is the only aspect of the process in which the issuer does
not directly participate. The rating committee comprises experienced
professionals who bring with them extensive experience in credit assessment.
The rating committee assigns a rating after thorough discussion on the report
prepared by the analysts.
The Rating Committee Meeting (RCM) process ensures objectivity of the
rating, as the decision results from the collective thinking of a group of
experienced professionals. The RCM process also ensures high quality and
consistency of analysis because the reports and discussions are focused on key
rating factors that are relevant to the issuer. If CRA and the issuer have any
common directors, such directors do not participate in the RCM or rating
process. A disclosure to this effect is also made with the announcement of the
rating.

Communicating the rating to the issuer:

On finalisation of a rating at the RCM, the rating decision is communicated to

the issuer. Thereafter, a document (rating rationale) highlighting the key reasons
for assigning the rating is shared with the issuer. This is to assist the issuer in
understanding the key analytical factors that have been assessed for arriving at
the rating decision. If the issuer decides to accept the rating, it can do so by
sending a letter of acceptance to CRA. If, on the other hand, the issuer disagrees
with the rating decision, it can appeal for a fresh look at the rating assigned. In
such a case, the issuer needs to submit additional facts, data or new information
to the ratings team, to be presented to the rating committee. Such information
must be material to the appeal, and should ideally address areas that have been
highlighted as factors constraining the rating in the rating rationale. The rating
committee then discusses the information submitted. It may or may not change
the rating, depending on the facts of the case. If the rating is not changed and
issuer continues to disagree with the rating, then the issuer has an option of not
accepting the rating.

Recently, Securities and Exchange Board of India (SEBI) has mandated CRAs
to publish such unaccepted credit ratings on their website. Hence in line with
these guidelines, the unaccepted ratings shall be disclosed on CRA website.
Publication of accepted ratings The accepted ratings are disseminated to CRA
subscriber base, and to local and international media. Rating information is
also updated
online on the CRA website, in the form of a rating rationale, which provides
information about the company, rated instrument, assigned rating and outlook,
rationale for assigning the rating, applicable criteria, etc. Also, CRA, in
compliance with International Organization of Securities Commission (IOSCO)
code of conduct, publishes a more detailed credit rating report (CRR) on its
dedicated website. The publication of the CRR ensures transparency in CRA
ratings methodologies and assumptions and also enables investors to understand
how CRA arrives at a rating. In addition, CRA publishes credit insights derived
from its rated universe through periodic publications called Ratings Roundup
(published semi-annually) and Default Study (published annually).

Timeframe:

From the initial management meeting to the assignment of rating, the rating
process can take up to four to eight weeks, but CRA sometimes arrives at rating
decisions in shorter timeframes to meet urgent requirements.

Confidentiality:

A substantial portion of the information shared by the company is highly

sensitive, and is provided by the issuer only for the purpose of arriving at the
rating. Such information is kept strictly confidential by the ratings group and not
shared with other divisions or group companies of CRA. CRA doesn’t
disseminate confidential information about entities it rates. However, in
accordance with recent SEBI guidelines, CRA has started to disclose
unaccepted ratings on its website from January 2017. All CRA employees are
required to sign a confidentiality agreement. CRA does not disclose issuer-
specific confidential information that it has obtained for the purpose of credit
rating to anyone (other than to market regulators or law enforcement authorities,
if required).
Unsolicited Ratings:

CRAs in some countries have come under criticism for issuing unsolicited
ratings. Anecdotal evidence from newspaper reports reveal that some CRAs
have indulged in ‗notching‘ – lowering their ratings or refusing to rate
securities issued by certain asset pools unless a substantial part of the assets was
also rated by them. It appears that there is no consensus on this point among
CRAs in India. Currently CRAs in India do not provide unsolicited ratings.
According to some CRAs any unsolicited rating exercise will not have the
benefit of inputs obtained with the cooperation of Management and to that
extent it will be incomplete. The output of such an incomplete exercise cannot
be compared with that obtained from solicited ratings. In contrast others
consider unsolicited ratings to be an important tool by which new rating
agencies can develop their business model. According to them unsolicited
ratings can combat ‗rating shopping‘. On balance it is recommended that if
unsolicited rating is to be allowed such ratings may be issued with appropriate
disclosure indicating whether issuer has participated in the rating process or
only public information disclosed by the issuer, including its audited financial
statements, strategic objective and investor presentation have been used in the
assessment.
 RATING METHODOLODY:

Key rating Drivers

Qualitative and Quantitative factors: CRA's company ratings replicate both
qualitative and quantitative elements encompassing the business and financial
dangers of constant-earnings issuers and their character debt trouble.
Historical and Projected Profile:
CRA’s analysis typically covers at least one economic cycle of the issuer under
review. The analysis should cover at least three years of operating history and
financial data, as well as the agency’s forecasts of future performance. These
are utilized in a comparative analysis, through which the agency evaluates the
strength of an issuer’s company operations and financial risk profile relative to
that of others in its industry and/or rating category peer group.

Weighting of Factors Varies:

This comparative evaluation includes consideration, wherein appropriate, of the
ability for adjustments inside the company’s working environment or monetary
strategy relative to its ratings. The weighting between an individual and
aggregate qualitative and quantitative factor varies between entities sector wise
as well as considering the overall time. As a general guideline, where one factor
is significantly weaker than others, this weakest element tends to attract a
greater weight in the analysis.

Industry Profile and Operating Environment:

CRA determines an issuer’s rating within the context of each issuer’s industry
fundamentals. Industries which are in decline, tremendously competitive, capital
intensive, cyclical or unstable are inherently riskier than sturdy industries with
few competitors, high barriers to entry, country wide dominance, and
predictable demand levels.
In assessing the issuers rating industry evaluation and industry specific factors
are considered. CRA publishes Sector Credit Factors (SCF) for many important
industries. These SCFs include those published for manufacturing sectors such
as cement and steel and service sectors such as telecom and construction.
Industry trends are considered in terms of their likely impact on future
performance of the company. The inherent riskiness and/or cyclicality of an
industry may bring about an absolute ceiling for ratings within that industry.
Consequently, an issuer in such an industry is unlikely to get hold of the highest
rating viable (‘AAA’) despite having a totally conservative financial profile.
These equally, reflects variations in the financial and management profile, not
all issuers in low-threat industries can anticipate excessive ratings. Rather, many
credit rating issues are weighed alongside the risk characteristics of the industry,
to arrive at a balanced assessment of credit rating quality.

Operating Environment:
CRA explores the possible risks and opportunities in an issuer’s operating
environment resulting from social, demographic, regulatory and technological
changes. The corporation considers the results of geographical diversification
and traits in enterprise enlargement or consolidation required to maintain an
aggressive function. Industry overcapacity is a key issue, as it creates pricing
pressure and, as a consequence, can erode profitability. Additionally, the critical
part is Industry life cycle and the growth or maturity of the product segment the
industry offers which determines the need for expansion and additional capital
spending.
In rating cyclical companies, CRA’s forecasts take a view on credit-protection
measures and profitability “through the cycle” — to identify an issuer’s
equilibrium or mid-cycle rating. The primary challenge in rating a cyclical
company is identifying whilst a essential shift in monetary coverage or a
structural trade in the running surroundings has occurred that could necessitate a
rating change. Even for less cyclical companies which might go through
earnings downturns in a recession, CRA’s analysis the consequent forecast of
the financial profile and/or a decline in prospects for the business model may
also leave an issuer essentially weakened by way of the passage through a
recession.
More data on CRA’s method for analysis of cyclicality in commodity prices on
rating stages is contained in the special record “How CRA uses Commodity
charges in its Projections”.

Company Profile:
Many different factors imply an issuer’s ability to resist competitive pressures,
that can include, for instance, its position in key markets, its stage of product
dominance, and its ability to persuade the price of the product offering.
Maintaining a high level of operating performance regularly relies upon on
product diversity, geographical spread of sales, diversification of major clients
and suppliers, and the comparative cost position of the company.

Size can be a component if it confers major advantages in terms of operating

performance, economies of scale, financial flexibility, and competitive position
among others. Size will not, however, constantly aid higher ratings. For
example, in commodity industries, size isn't always as important as price
positions, because the potential of one participant to influence price in a global
commodity is typically not significant.

Management Strategy and Corporate Governance:

CRA’s consideration of management strategy focuses on operating strategy, risk
tolerance, financial policies and corporate governance. Corporate goals are
evaluated, centering upon two main factors — strategy and track record. Key
factors considered are the mix of debt and equity in funding growth, the issuer’s
ability to support higher levels of debt, and the funding requirement of new
assets. The historical mode of financing acquisitions and internal expansion
provides insight into management’s risk tolerance.

CRA considers management’s track record in terms of its ability to create a

healthy business mix, maintain operating efficiency, and strengthen its market
position. Financial performance over time provides a useful measure of
management’s ability to execute its operational and financial strategies.

Corporate governance – effective controls for ensuring sound policies and

procedures in boardroom effectiveness, board independence, management
compensation, related-party transactions, and integrity of accounting and audit –
operates as an asymmetric consideration. Where it is deemed adequate or strong,
it typically has little or no impact on the issuer’s credit ratings, i.e. it is not an
incremental positive in the rating calculus. Where a deficiency which may
diminish bondholder protection is observed, the consideration may have a
negative impact on the rating assigned. Refer to CRA’s master criteria on
Evaluating Corporate Governance in this regard.

Ownership, Support and Group factors:

Group structure: CRA also considers the relationship between parent company
and their subsidiaries in assigning issuer and debt issue ratings. In many of the
cases, separate issuers of debt within a parent and their subsidiaries are typically
assigned separate ratings (though potentially identical). The criteria report
“Parent and Subsidiary Rating Linkage – Approach to Rating Entities within a
Corporate Group Structure” explains CRA’s linkage framework reflecting the
multi-faceted relationships between group entities. These include legal
jurisdiction, corporate structures, company by-laws, loan documentation, the
degree of integration between the entities, and the strategic importance of each
subsidiary.
Where the rated entity is a developer of projects being executed in Special
Purpose Vehicles (SPVs), CRA consolidates the debt of such SPVs if the debt is
with recourse to the parent. If not, the relationship is assessed using PSL criteria
and if necessary expected cash flow support is factored into the cash flows of
the
company. See the special report on “Treatment of non-recourse debt”.

Where a consolidated approach is not taken – because of material minority

interests or other considerations – CRA typically considers the sustainability
and predictability of its income streams (including cash pooling within the
group, and conditional dividends being up streamed) used to service its debt,
including the credit qualities of relevant entities and their contribution to the
group’s financial profile.
Financial Profile:
The quantitative aspect of CRA’s corporate ratings focuses on an issuer’s
financial profile and its ability to service its obligations from a combination of
internal and external resources. The sustainability of these credit-protection
measures is evaluated over a period of time – using both actual historical
numbers but more importantly CRA’s forecasts – to determine the strength of an
issuer’s debt-servicing capacity and funding ability.

Those credit metrics with the greatest relevance are still not used in a
determinate fashion to assign ratings, as the same ratio (if relevant) should be
expected to vary among these different sectors. For example, an industry with
low earnings volatility can tolerate higher leverage for a given credit rating than
an industry with high earnings volatility. In the Sector Credit Factor series of
reports, CRA has published observations of financial ratios per rating category
for various sectors.

Cash Flow Focus CRA’s financial analysis emphasizes cash flow measures of

earnings, coverage and leverage. Sustainability of cash flow from operations

provides an issuer with both internal debt- servicing resources and a stronger
likelihood of achieving and retaining access to external sources of funding.

CRA regards the analysis of trends in a number of ratios as more relevant than
any individual ratio, which represents only one performance measure at a single
point in time. CRA’s approach attributes substantially more weight to cash flow
measures than equity-based ratios such as debt-to-equity and debt-to-capital.
The latter rely on book valuations, which do not always reflect current market
values or the ability of the asset base to generate cash flows to service debt.

Cash Flow and Earnings Key elements in determining an issuer’s overall

financial health are profits and cash flow, which affect the maintenance of
operating facilities, internal growth and expansion, access to capital, and the
ability to withstand downturns in the business environment. While earnings
form the basis for cash flow, adjustments must be made for such items as non-
cash provisions and contingency reserves, asset write-downs with no effect on
cash, and one-time charges. CRA’s analysis focuses on the stability of earnings
and continuing cash flows from the issuer’s major business lines. Sustainable
operating cash flow supports the issuer’s ability to service debt and finance its
operations and capital expansion without the reliance on external funding.

Capital Structure CRA analyses capital structure to determine an issuer’s level

of dependence on external financing. Several factors are considered to assess

the credit implications of an issuer’s financial leverage, including the nature of
its business environment and the principal funds flows from operations.
Because industries differ significantly in their need for capital and their capacity
to support high debt levels, the financial leverage in an issuer’s capital structure
is considered in the context of industry norms.

As part of this process, an issuer’s level of debt is typically adjusted, where

applicable, for a range of off-balance-sheet liabilities by adding these to the
total on-balance-sheet debt level.

Such items include the following:

 Borrowings of partly owned companies or unconsolidated subsidiaries that

may involve claims on the parent issuer;

 Disclosed debt associated with receivables securitizations, if there is

recourse to the issuer

 In cases where material amounts of debt are described as non-recourse to

the rated entity, CRA typically forms a view on the economic incentives
behind the non-recourse status before excluding the debt (and associated
cash flows) in its calculations;
 Operating lease obligations. Refer the criteria Operating Leases:

Implications for Lessee’s Credit in this regard. In situations where specific

liabilities are excluded from the debt calculation, CRA may also exclude
any related cash flow, income or assets. Where appropriate, the issuer’s
history in supporting off-balance-sheet investments with additional funds
will also be a factor in determining the appropriateness of including or
excluding these amounts from total debt in the absence of a formal
guarantee or commitment.

Preferred stock issues with fixed dividend payments or redemption dates may
be considered as quasi-debt instruments, and may be granted a degree of
“equity credit” of 50% or 100%, depending on their terms. As CRA’s
corporate analysis is heavily cash flow-oriented, the level of equity credit
which is granted only affects the quantum of debt in adjusted leverage ratios,
and 100% of the coupons on hybrid instruments continue to be incorporated in
coverage ratios used to measure the issuer’s debt-servicing ability. This
reflects CRA’s view that hybrids predominantly offer protection to senior
creditors by reducing loss given default, rather than decreasing default
likelihood. For details of CRA’s approach to equity credit for these hybrid
instruments, see the criteria report “Treatment of Hybrids in Non-Financial
Corporate and REIT Credit Analysis”.
Financial Flexibility Financial flexibility allows an issuer to meet its debt-

service obligations and manage periods of volatility without eroding credit

quality. The more conservatively capitalized an issuer, the greater its financial
flexibility. In general, a commitment to maintaining debt within a certain
range allows an issuer to cope better with the effect of unexpected events on
the balance sheet.

Other factors that contribute to financial flexibility are the ability to redeploy
assets and revise plans for capital spending, strong banking relationships, and
the degree of access to a range of debt and equity markets. Committed, long-
dated bank lines provide additional support. A large proportion of short-term
debt in the capital structure can indicate reduced financial flexibility, except in
cases where overall gross leverage is very modest — as is the case for a small
number of very highly-rated issuers whose very moderate debt burdens are
predominantly based on Commercial Paper funding with liquidity back-up.
Refer to “Short Term Ratings Criteria for Non-Financial Corporate” for
CRA’s methodology for calculation of sufficient CP back-up coverage for
corporate.

Contingent Liabilities and Pensions Financial flexibility can also be

diminished by significant contingent obligations such as guarantees, collateral

requirements for derivative exposures, and legal liabilities. Each of these can
cause substantial drains on cash flow, which can severely reduce or even
eliminate financial flexibility.

In incorporating pension risks into its analysis, CRA's key focus is on the cash
flow implications of pension obligations over the rating horizon. If the issuer
has a defined benefits plan for employees, and actuarial valuation of
investments made under the plan reveal that there is a shortfall between
market value of investments and quantum of defined benefits, then the
unfunded
portion will have to be added to the debt for the purpose of analysis.
Similarly, if there is a shortfall in the provision for gratuity, the same would
also be treated as debt for computation of adjusted leverage ratios.

Accounting CRA’ rating process is not and does not include an audit of an

issuer’s financial statements. The issuer’s choice of major accounting policies

may inform CRA’s opinion on the extent to which an issuer’s financial
statements reflect its financial performance. Relevant areas include
consolidation principles, valuation policies, inventory-costing methods,
depreciation methods, income recognition and reserving practices, and
treatment of off-balance-sheet items. As part of its rating analyses, CRA will
restate figures, where necessary, to enhance the comparability of financial
information across issuers.

Because different accounting systems can affect an issuer’s assets, liabilities

and reported income, CRA may on occasion make adjustments as appropriate
to increase comparability with other companies in the peer group. Such
adjustments include those made for revenue recognition, asset values, leased
property, contingency reserves, and treatment of tax and off- balance-sheet
liabilities. The general principal CRA applies in its adjustments is to get back
to measurements of cash: cash balances, cash flow, and cash needs.

CRA analysts typically use audited accounts that are prepared according to
Local Generally Accepted Accounting Principles, International Financial
Reporting Standards or US Generally Accepted Accounting Principles. If such
statements are not available, CRA will use other statements provided, and
published management comments to make appropriate adjustments for
comparative analysis, if appropriate and provided the quality of the auditors or
other reviewing parties employed – and disclosure – is adequate.
Project Risk

In analyzing expansion projects within a corporate structure, CRA analyses its

impact on both the financial and business risks of the issuer. The impact on the
capital structure of the company and the risks associated with the cash flow
generation after the expansion in the overall context of the business
environment is analyzed. The expansion may be for producing more of the
existing product or for new ones or in fields unrelated to the existing lines of
business. It may be implemented in several phases spread over several years and
may be funded with no borrowings or entirely through external borrowings. In
analyzing the associated risks of these different scenarios, CRA focuses on the
cash flow impact of these projects and its impact on the ability to service debt.
 LIMITATIONS OF CREDIT RATING

Specially, a credit rating, within the words of the CRAs, is:

• It is not a recommendation to purchase, hold or sell any stocks, bonds,
debentures or different other instruments issued with the aid of the rated entity,
or derivatives thereof. However, a rating is one of the many inputs that is used
by investors to make an investment decision.
• It is not intended to measure many other factors that debt traders should take
into account in relation to the risk - which includes yield offered to the
instrument, risk of liquidity, pre-payment risk, interest rate risk, taxation
elements, risk of secondary market loss, exchange loss risk, etc.
• It is not a general - purpose credit rating or performance evaluation of the
rated entity, unless otherwise specified. The rating is usually particular to the
instrument and isn't always the rating of the company.
• It is not an opinion on accomplice, associate or institution groups of the rated
entity, or on promoters, administrators or officials of the rated entity.
• It is not a statutory or non-statutory audit of the rated entity
• It is not illustration of compliance or in any other case with legal or statutory
necessities
• It is no longer an assurance in opposition to default of the rated instrument.
Even the very best-rated instrument faces a few danger of default, although the
risks associated with this are lower than lower-rated devices.

Credit Ratings are typically ordinal in nature – for example we know that a
rating of BB has a higher likelihood of default than BBB, but we do not know
how much higher. It is not until each rating is assigned a probability of default
that we can
say how much more risky a BB rated instrument is thus making the system
cardinal. Cardinality is more useful for pricing an instrument. Translation of
credit ratings to default probabilities is, however, not a straight forward task.
Some of the serious limitations of credit rating are its backward looking nature
(depends on past data) which in a dynamic market framework can have serious
consequences including accentuating a systemic crisis like the current global
crisis, and its failure and unwillingness to capture/cover market risks.
Estimating market risk can potentially make the rating exercise forward
looking, could avoid sudden, multiple downgrades and reduce the pro-
cyclicality of rating. A really informed forward looking rating could potentially
also capture tail risks and forewarn the system to help take systemic steps well
in advance to avoid panic and knee-jerk reactions. If rating is to straddle the
high ground it aspires to hold rating exercise has to achieve this dynamism to
really help measure all the risks of the market, rather than sticking to a partial
methodology of expressing an opinion on a few aspects of the product they rate.
No product can be usefully rated in a vacuum, isolated from the caprices of the
market as a whole.
Whither Credit Rating Agency
The informational value of credit rating and informational effect of credit
ratings are matters of continuing debate. The central issue is whether institutions
of credit rating are in a better position to decipher the default risk present in
financial instruments than the financial markets. Empirical evidence from some
countries have suggested that markets do this information processing better than
credit rating institutions. Academic studies argue that by looking at the market
price it would be easy to infer an effective credit rating of each instrument.
Since market prices are available at near zero cost , there would appear to be no
role for credit rating.
The rationale for credit rating may be expressed on the following counts:
1. If markets do not trade a particular instrument actively, then there is an
informational challenge. In general impact cost on the market is lowered when
more is publicly known about the securities being traded. In such cases a
―good‖ credit rating (for eg. one which forecasts the interest rate at which
bonds are traded on the secondary market. If issue A is rated above B then
markets should demand a lower interest from A than B) helps reduce
informational asymmetry and enhance liquidity in the market.
2. Suppose a company wants to do a primary market issue of bonds/ equity. At
the time of issue, in the absence of trading, the default risk may not be clearly
known to the market. This could generate a phenomenon like IPO under-
pricing. Hence it is optimal for the issuer to obtain a credit rating so as to place
the bonds
/ equity at a superior price.
3. International obligations like Basel 2 require prudential provisioning of
capital on the basis of risk weights attached to assets. Computation of capital
required to be maintained by banks then requires rating of its assets. In practice,
by nudging more trades to the exchange platform the problem of informational
challenge can be addressed. Till such time greater disclosure of reliable
information can help the market in pricing the issue. Recent financial crisis has
shown that ratings provided by credit rating agencies despite access to non-
public information have been faulty.
However where market asymmetries are strong and financial literacy low,
sound credit rating can continue to bridge the information gap considerably.
 SEBI REGULATIONS:

The Securities and Exchange Board of India (Credit Rating Agencies)

Regulations, 1999 empower SEBI to regulate CRAs operating in India. In fact,
SEBI was one of the first few regulators, globally, to put in place an effective
and comprehensive regulation for CRAs. In contrast, the US market saw CRA
regulations only recently (in 2007), and the European Union is still in the
process of framing its regulations. SEBI‘s CRA regulations have been used as
model by other regulators in the emerging economies. In terms of the SEBI
Regulations, a CRA has been defined as a body corporate which is engaged in
or proposes to be engaged in, the business of rating of securities offered by way
of public or rights issue. The term ―securities‖ has been defined under the
Securities Contract (Regulation) Act, 1956. SEBI has also prescribed a Code of
Conduct to be followed by the rating agencies in the CRA Regulations.
However, SEBI administers the activities of CRAs with respect to their role in
securities market only.

SEBI regulation for CRAs has been designed to ensure the following:

 Credible players enter this business (through stringent entry norms and
eligibility criteria)
 CRAs operate in a manner that enables them to issue objective and fair
opinions (through well-defined general obligations for CRAs)
 There is widespread investor access to ratings (through a clearly
articulated rating dissemination process).
The detailed SEBI regulations for CRAs are given in Annexure 2.
 Code of Conduct stipulated by SEBI
 Agreement with the client
 Monitoring of ratings
 Procedure for review of rating
 Internal procedures to be framed by the CRA
 Disclosure of Rating Definitions and Rationale by the CRA
 Submission of information to the Board
 Compliance with circulars etc., issued by the Board
 Appointment of Compliance Officer
 Maintenance of Books of Accounts records, etc.
 Confidentiality
 Rating process
These regulations cover issues with respect to confidentiality of information and
disclosure with respect to the rationale of the rating being assigned. Several
other provisions exist, like the regulator‘s right to inspect a CRA. An important
feature of the regulation is that CRAs are prohibited from rating their promoters
and associates.
 REGULATORY CONCERNS ABOUT CRA BUSINESS
MODEL

There is a concern about the potential gap between expectation and realization-
between reliance on credit ratings and the reliability of such ratings. The
concern emanates from the fact that inaccurate credit ratings could disturb the
market allocation incentives, cost structures and competition. In view of the
multiple activities performed by the rating agencies and the complexity of
certain instruments for which the CRAs render their service, there are
apprehensions about regulatory arbitrage, non-maintenance of arm’s length
distance, porosity of Chinese Walls, inappropriate conflict management etc.
arising out of the activities of the rating agencies. In short there is real
regulatory (and market) apprehension that the self-regulation model of conflict
regulation has failed substantively in the CRA realm and that the model of
multiple businesses of CRAs is riddled with inherent conflict that cannot be
solved with internal Chinese walls and codes of conduct alone. The gate-
keeper’s commercial aspirations appear to be too high so that they have become
just enterprises driven by the profit
/ revenue only agenda like other market intermediaries, rather than the ethos of
institutions.

In India CRAs rate money market instruments and also play an important role in
the pension and insurance sector. A basic conflict of interest which is partly
inherent, since the sponsor/issuer of new instruments pays the CRA for being
rated. A general lack of accountability as CRAs do not have a legal duty of

accuracy and are often protected from liability in case of inaccurate ratings.

CRAs sometimes provide ancillary services in addition to credit ratings. The

issuer may use the incentive of providing the CRA with more ancillary business
in order to obtain higher ratings. There is a clear conflict of interest in offering
advisory services or consulting services to entities rated by the CRA.

The following are the major areas of concern:

1. Issuer pay model

2. Inter agency coordination and regulatory arbitrage

3. Conflict of interests

4. Regulatory issues

a. Accountability b. Methodology c. Other services d. Industry structure

Investor over- reliance on credit ratings has been long recognised as

undesirable, although by embedding ratings in various regulations some
authorities have inadvertently encouraged their overuse. For example the
longstanding use of credit ratings to screen eligible collateral for various central
bank liquidity backstop facilities is viewed as encouraging ―rating
shopping‖ Regulations relating to pension fund holdings, for example, typically
restrict fixed-income investment to those with investment-grade ratings (i.e.
BBB and higher). Furthermore, although the differentiation of structured credit
ratings is welcome, the ratings remain based on one-dimensional metrics
(default probabilities or expected losses) that fail to capture all of the risk
dimensions peculiar to tranched products Currently rating for complex products
like structured obligations are indicated by using special symbols. It also
highlights the need for greater awareness generation.

CRAs follow a reputational model. Users will approach CRAs for ratings only
if its opinions carry creditability with investors whom the issuers are trying to
signal. Ratings which undergo frequent downgrades may not inspire confidence
of the market. This incentivizes CRAs to maintain high quality of ratings.
Rules, regulations, statutes as well as compliance with international covenants
ensure
that CRAs behave in a transparent manner. Misdemeanour can be punished
through tight regulations. Regulatory arbitrage can be resolved by following
lead regulatory model or greater inter agency coordination.

CRAs argue that advisory or consulting services are offered by different legal
entities with whom physical, organizational and functional separation is
maintained.
 PROS AND CONS OF “ISSUER PAYS MODEL”

Under ‘issuer-pays-model’ the entity that issues the security also pays the rating
agency for the rating.

Quality/ accuracy of ratings:

Conceptually, the issuer-pays model may appear to imply an inherent bias

which may lead to CRAs assigning higher-than-warranted ratings to issues they
rate. CRAs have argued that they have several checks and balances and robust
operating guidelines and procedures to ensure that the quality of ratings is high
and objective. One example of this is separation of business development,
analytical, criteria, and quality teams. CRAs point to a long-term track record of
default and transition statistics which demonstrate that higher ratings are
consistently more stable and have a lower probability of default than lower
ones.
Specifically, it is argued that

i) Ratings are ordinal; that is the higher the rating, the lower are the observed
default levels.

ii) Ratings have been assigned across the entire rating scale, with no bias in
their distribution towards higher ratings, which would be the pattern expected
had the CRAs been influenced by the issuer-pays model.

iii) Rating actions are distributed across both upgrades and downgrades, which
is also a different pattern from the one expected where the issuer-pays model
might influence the decision to upgrade rather than downgrade and also work to
prevent downgrades.

CRAs have a strong incentive to maintain the highest quality of rating, since
issuers will approach a CRA for ratings only if its opinions carry credibility
with investors whom they are trying to access. Nevertheless, there are questions
about
whether all CRAs adopt uniformly high governance and process standards.

Widespread availability of ratings:

This is the strength of the issuer-pays model. The goal of ratings is to reduce
information asymmetry. Because issuers/borrowers pay for ratings, the market
and lenders significantly benefit from the wide availability of credit ratings.
Today, all ratings and rating changes are available to the entire market --
including retail investors -- free of charge, as they are widely disseminated by
rating agency websites and the media. An investor can compare the ratings of a
wide array of instruments before making an investment decision, and can
continuously evaluate the relative creditworthiness of a wide range of issuers
and borrowers.

• Other features of the issuer-pays model:

Access to information enhances quality of analysis

The issuer-pays model provides CRAs access to company managements on a

regular basis. CRAs submit that this allows them to provide superior quality and
depth of analysis to the market, which would be difficult under public
information-based and model-driven approaches. The CRAs contract with the
issuer/borrower places an obligation on the issuer’s management to cooperate in
sharing information, which is critical for maintaining continuous surveillance on
rated credits. Because the issuer’s management has commissioned the rating
exercise, its level of engagement in providing information to the CRA is high.
Issuer managements often provide CRAs insights into future strategy that might
not be in the public domain. Moreover, interactions also help rating agencies
evaluate management capabilities better. For rating structured finance issuances,
the question assumes even greater criticality, since it is virtually impossible to
rate these instruments without access to information from the originator of the
underlying assets.

Cost of ratings is kept low

Currently, rating fees are the smallest element in the cost of raising money.
With large and frequent issuers of debt, rating agencies typically work on the
basis of fee caps (negotiated lump-sum fees as opposed to issue-by-issue or
loan-by-loan pricing). Not only does this keep rating fees low, it also results in
smaller issuers being, in effect, subsidised by larger ones.

Pros and Cons of alternatives to 'issuer pays model'

Besides ‘Issuer Pays Model’, the three other potential commercial models for
rating agencies are:

1. Investor pays

2. Government/regulator pays

3. Exchange pays model

1. The investor-pays model

Under ‘investor-pays-model’ the user of the ratings pays for the ratings.

• Quality/accuracy of ratings:

According to CRAs this model does not eliminate the conflict of interest- it only
shifts the source of conflict from issuer to investors. Under the investor-pays
model, CRAs could give lower ratings than indicated by the actual credit quality
of the rated debt, so that investors would get a higher yield than warranted.
Pressures from investors to avoid rating downgrades would increase
considerably under the investor-pays model, since downgrades result in mark-
to-market losses on rated securities. In fact, even under the current issuer-pays
model, CRAs face
a high level of pressure from investors to not downgrade ratings. In particular, it
is possible that a large investor who has a large exposure on an issuer would
like to have a more favourable rating for that issuer. On the other hand, a short
seller would prefer if the rating is lowered. Internationally, the experience with
the investor-pays models has not been successful. Nevertheless, the potential
conflicts seem substantially less severe than for the ―issuer pays model.

This is the strength of the issuer-pays model. The goal of ratings is to reduce
information asymmetry. Because issuers/borrowers pay for ratings, the market
and lenders significantly benefit from the wide availability of credit ratings.
Today, all ratings and rating changes are available to the entire market --
including retail investors -- free of charge, as they are widely disseminated by
rating agency websites and the media. An investor can compare the ratings of a
wide array of instruments before making an investment decision, and can
continuously evaluate the relative creditworthiness of a wide range of issuers
and borrowers.

• Other features of the issuer-pays model:

Access to information enhances quality of analysis

The issuer-pays model provides CRAs access to company managements on a

regular basis. CRAs submit that this allows them to provide superior quality and
depth of analysis to the market, which would be difficult under public
information-based and model-driven approaches. The CRAs contract with the
issuer/borrower places an obligation on the issuer’s management to cooperate in
sharing information, which is critical for maintaining continuous surveillance on
rated credits. Because the issuer’s management has commissioned the rating
exercise, its level of engagement in providing information to the CRA is high.
Issuer managements often provide CRAs insights into future strategy that might
not be in the public domain. Moreover, interactions also help rating agencies
evaluate management capabilities better. For rating structured finance
issuances, the question assumes even greater criticality, since it is virtually
impossible to rate these instruments without access to information from the
originator of the underlying assets.

Cost of ratings is kept low

Currently, rating fees are the smallest element in the cost of raising money.
With large and frequent issuers of debt, rating agencies typically work on the
basis of fee caps (negotiated lump-sum fees as opposed to issue-by-issue or
loan-by-loan pricing). Not only does this keep rating fees low, it also results in
smaller issuers being, in effect, subsidised by larger ones.

Pros and Cons of alternatives to 'issuer pays model'

Besides‘Issuer Pays Model’, the three other potential commercial models for
rating agencies are:

1. Investor pays
2. Government/regulator pays
3. Exchange pays model

1. The investor-pays model

Under ‘investor-pays-model’ the user of the ratings pays for the ratings.

• Quality/accuracy of ratings:

According to CRAs this model does not eliminate the conflict of interest- it only
shifts the source of conflict from issuer to investors. Under the investor-pays
model, CRAs could give lower ratings than indicated by the actual credit quality
of the rated debt, so that investors would get a higher yield than warranted.
Pressures from investors to avoid rating downgrades would increase
considerably
under the investor-pays model, since downgrades result in mark-to-market
losses on rated securities. In fact, even under the current issuer-pays model,
CRAs face a high level of pressure from investors to not downgrade ratings. In
particular, it is possible that a large investor who has a large exposure on an
issuer would like to have a more favorable rating for that issuer. On the other
hand, a short seller would prefer if the rating is lowered. Internationally, the
experience with the investor-pays models has not been successful. Nevertheless,
the potential conflicts seem substantially less severe than for the ―issuer pays
model.

Widespread availability of ratings:

The investor-pays model is weak on this count. If investors pay for ratings, only
investors who pay will get access to ratings. The goal of reduced information
asymmetry is therefore compromised under this model. Investors would also not
be able to benchmark the quality of their investments against other companies,
since they may not be willing to pay for ratings of companies in which they do
not invest. This model also favors large investors who can afford to pay for
ratings. The biggest losers are the smaller institutional investors and the retail
investors, who would have had free access to all ratings under the issuer-pays
model or the Government/regulator pays model (discussed later).

Other advantages and limitations of the investor-pays model:

Greater responsiveness to investor concerns

Under the investor-pays model CRAs could be more responsive to investor

concerns and further the investor protection agenda as they would be positioned
as quasi-investor representatives. Also, an investor paying for a specific rating
could demand customised analysis from the rating agency which is attuned to
their goals or organisational requirements.
Investor is not known at the time of assigning ratings

Issuers/borrowers intending to raise money approach CRAs for an independent

evaluation, based on which they approach prospective investors. This means
that typically, when the rating is assigned, the investor is not known. If the
investor were to commission and pay for ratings, it would lead to huge
inefficiencies and practical problems in the fund-raising programmes of
issuers/borrowers.

Bias against smaller issuers/borrowers

The problem of investors not being known can be addressed by rating agencies
assigning ratings suo-moto to large/frequent issuers and borrowers; investors
can later pay for this on a subscription basis. However, this system creates a
strong bias against smaller issuers which would not get rating coverage, and
their funding programmes could be severely impaired. Suo-moto ratings also
suffer the disadvantage of not getting a meaningful interaction with the
management to make an assessment about them and their strategy. In fact, this
is the main reason why rating agencies that operate on the investor-pays model
have limited coverage and impact.

Costs of ratings would increase

Investors would choose to pay for ratings of those companies that they are
interested in, and even here, only for rating specific issuances by a particular
company. The benefits of fee caps as described above would be lost and the
overall rating costs could go up. From the point of view of investors, it will
increase information asymmetry as ratings opinion will be available only with a
few large investors which is detrimental to the liquidity and development of the
market.
Limited access to information could affect quality of analysis

If investors were to pay for ratings, issuers would not be contractually bound to
provide rating agencies access to information and regular management
interactions. This is important if the rating agency has to carry out surveillance
on an ongoing basis. Moreover, regular meetings with management and insights
on company strategy enable rating agencies to make a thorough evaluation of
management capabilities and risk appetite. It is hard to envisage the same level
of access, information and sharing of insights as exists under the issuer-pays
model. Further this may also involve rating of the same issue by multiple
agencies resulting in the issuer being required to meet and share information
with all agencies.

The Government/regulator-pays model

In this model, the Government funds the rating costs.

• Quality/accuracy of ratings:

Conceptually, this model would carry less inherent bias, since in most cases
there is no incentive to provide either higher-than-warranted or lower-than-
warranted ratings. The one exception that could arise would be in case of public
sector enterprises; the perception could be that the government could influence
rating outcomes in this case.

• Widespread availability of ratings:

This can also be easily ensured under the government/regulator pays model as
they could stipulate that rating agencies make all ratings and rating changes
freely available on their websites and disseminate them through the media as
happens currently.
• Other positive and negative aspects of the Government/regulator pays
model:

Control over/guidance of rating agencies becomes simpler

If Government/regulators pay for ratings, it becomes easier to monitor and

control the activities of rating agencies

Moral hazard: Rating opinions being seen as being endorsed by the

Government

This is a major limitation of the Government/regulator pays model. Investors

and markets could see the opinions provided by rating agencies as having
government endorsement. This carries the serious risk of expectation of
Government support in the event of default by a rated entity. This risk is larger
than it may seem as evident in recent actions across the globe.

Use of public money for companies and institutional investors who can
afford to pay for ratings

It is questionable whether paying for ratings is the best use of public funds as
compared to other objectives like improving financial literacy and small
investor protection. Both issuers and institutional investors can well afford to
pay for ratings. As explained above, under the issuer-pays model, the small
retail investor too benefits as ratings are freely available in the public domain.
India has emerged as the second-largest rating market, with the widespread
acceptance of rating by the regulators and the markets. The budget for
supporting this industry could be quite substantial.
Limited access to companies could affect quality of analysis

If Government/regulators pay the rating agencies, issuers would not be

contractually bound to provide rating agencies access to information, and
regular management interactions, which could affect the quality of analysis.

Several practical problems in implementation

The challenge under the Government/regulator pays model is: how would the
choice of rating agency for a rating a specific issuer/company be made, and by
whom? How would the rating fees be decided? If a company desiring to raise
money approaches the regulator to request that a rating be commissioned, would
they also specify which rating agency they would prefer? This in effect, would
make it an issuer-driven choice. Would companies or issues be allocated on a
random basis amongst all rating agencies? This would lead to huge
inefficiencies and the costs of ratings would increase from a system perspective.
Adequate safeguards also need to be put in to ensure that the oversight of the
work allocation to the rating agencies remains objective, lest any subversion of
rating outcomes take place as a result of undue influence.

These measures could also breed complacency amongst CRAs, who will begin
to see it as a steady assured business, rather than the current situation of fending
for themselves. For example, if the selection of rating agencies is done on a
random basis, then rating agencies will have no incentive to produce the most
analytical rigorous, independent, objective rating on a timely basis which will
provide best insights for investors.

The Exchange-pays model

Under this model the exchanges pay for the ratings and recover the cost through
an additional trading fee.
The major advantage of this model is that the investors would be paying for the
rating thereby eliminating the conflict of interest inherent in 'issuer pays model'
and at the same time the rating agencies would not be influenced either by the
rated company or the investors. The major disadvantage of this model is that
this model can work only for securities that are listed.

The above discussion indicates why the issuer-pays model has prevailed over
other possible alternative models. What they recognize is that rating agencies
should be subject to scrutiny to ensure that conflicts of interest do not influence
rating decisions. Their recommendations to manage this conflict include greater
transparency and disclosures, and better governance practices to ensure
independence.
 CHANGES IN THE REGULATORY NORMS FOR
CREDIT RATING AGENCY

The recent spate of defaults, delayed payments and missed payments by several
large bond market borrowers has heightened the focus on the role of credit
rating agencies. The insinuation is that credit rating agencies generally issue
optimistic ratings with little ex-post accountability for their ratings. To fix this,
the Securities and Exchange Board of India (Sebi) recently issued a fresh set of
guidelines that among other things increased the disclosure requirements for
rating agencies.

SEBI has introduced a concept of:

Probability of default (PD)

Uniform interpretation of rating categories
Claw back of fees

In its circular dated June 13, 2019, SEBI has increased the disclosure
requirements for credit rating agencies and for the first time mandated that
rating agencies disclose a Probability of Default (PD) benchmark for each
rating category. What this means is that every rating agency must now put a
number to its rating categories. A rating agency will now publicly state, what
a ‘AAA’ or ‘BBB’ rating means. For instance, as per the SEBI circular, a
‘AAA’ rating has to mean a 0 percent probability of default over a three-year
time frame. While Sebi has stated the PD for a couple of categories, for most
other categories the rating agency has to come up with its own PD after
consultation with Sebi. This, as per the Sebi circular, is to ‘enable investors
to better discern the performance of a credit rating agency’.
It was difficult to distil the de-jargonised meaning of a ‘AAA’ or ‘AA’ or
‘BBB+’ (SO) rating. A rating agency would use words such as ‘highest
safety’ to describe a ‘AAA’ rating or ‘high degree of safety’ to describe a
‘AA’ rating or ‘moderate safety’ to describe a ‘BBB’ rating. But there was
no way to judge what phrases like ‘highest safety’ or ‘high degree of safety’
or ‘moderate safety’ actually meant for an investor. Every rating agency has
to now link their rating category with a quantitative number. If,
hypothetically, a rating agency says that a ‘BBB’ rating means a 10 percent
three-year default rate and if the actual default rate was 15 percent, one can
point finger at the rating agency and say that they have had lax standards over
the preceding three years in this particular cohort. The new rules give a
quantitative and objective way of judging a rating agency’s performance.
This is welcome. But it is not enough. There are two other things SEBI must
do, building on the PD concept, to better align the incentives of rating
agencies with those of investors.
The first is to standardise PD benchmark across rating agencies. A ‘AAA’ or
a ‘BBB’ rating should connote the same thing to investors irrespective of
which rating agency has given the rating. In the current regulations, it is
possible that one rating agency defines a ‘BBB’ rating as a 10 percent PD
while another defines it as a 15 percent PD. Instead, the interpretation of
rating categories ought to be standardised across agencies and the agencies
are then free to assign different ratings depending on their individual
assessment. So presumably Sebi will not allow a significant difference in PDs
across different rating categories. A scenario wherein, hypothetically
speaking, a ‘BBB’ rating of one agency corresponds to a ‘BB’ rating of
another, in PD terms, would be very confusing for investors and should be
avoided.
The second is a provision for clawback of rating fees if the post-facto
performance of ratings is out of sync with ex-ante disclosed PDs. The higher
the deviation from PD, the higher the revenue which is clawed back. This
revenue should either go back to the original investors or the Sebi’s investor
protection fund. This ensures that if a rating agency does make mistakes, it
not only has a loss of face but also a loss of profits. The 2007 global financial
crisis, for example, did not cause any lasting damage to the rating agencies
or throw any of them out of business. The point is that there aren’t any
fundamental incentives for a rating agency to be conservative.
One way to fix this issue is by linking rating revenues to rating outcomes.
This is now possible given that rating agencies have to commit to a PD for
every rating category. This is akin to the standard practice of providing a
‘warranty’ by manufacturing companies in general and consumer goods
companies in particular. These companies give a warranty that the product
will perform to certain specifications for a certain period post purchase. And
if it does not, the company repairs to replace the product, at its cost. There is
no reason why the opinion of a rating agency about servicing of a bond
should not be subject to this principle.
Of course, this principle cannot be ported as it is since a rating agency deals
with workings of business and economy which are far less precise than
workings of machines. Hence, there have to be modifications to this principle.
So, instead of applying the clawback principle to every rated instrument, it
should be applied at a portfolio level (for every category) which allows for
some unexpected scenarios to cancel each other out. Perhaps the clawback can
kick in only after the PD threshold has been exceeded by a certain margin
– say half a standard deviation.
A likely pushback against this will be that this will make rating agencies
conservative and increase the cost of capital to some issuers. But then, getting
rating agencies to become conservative is very much the objective here. If that
means that some esoteric structures face a higher cost of capital or some types
of borrowings and lending becomes unviable, then so be it. It is not the
job of a rating agency to ensure the availability of low-cost finance to any
and every borrower. The job of a rating agency is to present an investor with
an objective assessment of the issuer. The primary accountability of a rating
agency lies to the investor, not to the borrower.

AAA – Rated Paper Tolerance level

One year default 0 percent
Two year default 0 percent
Three year default 1 percent

AA – Rated Paper Tolerance level

One year default 0 percent
Two year default 2 percent

A – Rated Paper Tolerance level

One year default 3 percent

SEBI also plans to overhaul the governance structure of ratings firms by

revamping the composition of their boards and enhancing disclosures norms,
seeking to address conflict of interest in business practises.
 CONCLUSIONS

 CRA’s play a very important role in the financial markets by reducing

the information asymmetry
 CRA’s by virtue of getting access to non-public information, can make
a better-informed decision
 There must be some gap bridged to make CRA’s more accountable, if
not completely accountable
 Issuer pay model, despite its short comings seems most
appropriate. Regulations and compliance can be made better to
improve further.
CASE STUDY
 BIBLIOGRAPHY
https://www.iimcal.ac.in/sites/all/files/pdfs/wps_746_0.pdf

https://www.cnbctv18.com/economy/making-rating-agencies-accountable-sebi-
has-taken-the-first-step-but-it-is-not-enough-3859771.htm

https://www.google.com/search?q=comprehensive+disclosures+of+credit+ratin
g+agencies+mca+december+2009&rlz=1C1GCEA_enIN847IN847&oq=co&aq
s=chrome.0.69i59j69i57j69i59l2j0l2.981j0j8&sourceid=chrome&ie=UTF-8

https://www.sebi.gov.in/sebi_data/attachdocs/1288588001441.pdf