Credit rating

agencies in India.

Manoj Bharti
Index:

1. Prologue.

2. Basic Understanding

3. CRA’s in India

4. Process of formation

5. Modus Operandi of Credit Rating Agencies

6. Rating Methodology

7. Functions of a credit rating agency

8. Business model of credit rating agencies

9. Credibility of the rating agencies and challenges

10. Limitations of working

11. Significance of Existence

12. Reputational Crisis

13. Way to work for the solution

14. Prospects of CRA in India.

15. Conclusion.
Prologue:
Credit rating agencies, as the name suggests are the companies which are in a business
of evaluating rating of the business entities about their debt repaying capacity. These
agencies primarily give an outlook about the overall financial health of a business unit
about it’s ability to pay back debt by making timely principal and interest payments and
the likelihood of default.

In the everchanging world, the business environment is also changing rapidly. We

presently observe the multi-dimensional changes in the business world. In the past
decade, the business environment has changed at an accelerated pace, primarily due to
advances in technology and ever-increasing customer expectations. In the changing
business environment, no industry is considered to be a risk-free industry for business.
However, the field of education and health are considered as less riskier service providers
in service industries but the internal competition in these industries is also making the
ease of business difficult and they also need to be nimble in adopting rapid innovative
ideas as per the requirement of their customers.

Changing business environments has come with the new challenges to credit providers in
the present market scenario. In present business scenario the credit providers can not be
rely on their existing model of credit evaluation. They are getting more investigative and
analytical in credit evaluation of the customer. The credit rating agencies are now very
observant on the changing risk models in different business and this is increasing their
dependency on the existing credit rating agencies.

Credit rating agencies are basically the perception creators based on some methodical and
rational facts based on their meticulous investigation about the health of a business
entity. The history of credit rating agencies are about 100 years old. This was
conceptualized in United States in early 1900’s. Basically emphasis was given to the credit
rating business soon after the Knickerbocker Crisis in the year 1907, which is also known
as bankers panic of 1907. However, precursors of the credit rating agencies, we find the
history of the existence of the Mercantile Credit Rating agencies, started in late 1830’s for
the purpose of the rating of debt repayment capacity of the merchants, which was not
considered as an appropriate rating system and followed by financial crisis of 1837 in
United States. After the Knickerbocker Crisis in the year 1907, demand rose for such
independent market information, in particular for independent analyses of bond
creditworthiness. In 1909, financial analyst John Moody issued a publication focused
solely on railroad bonds. His ratings became the first to be published widely in an
accessible format and his company was the first to charge subscription fees to investors.

Credit rating is a process, where a rating agency, analyses the credit worthiness of an
entity (Public, Private, Partnership, Sole-proprietorship), their ability to repay the debt
and if there is any likelihood to default. It takes into consideration factors of past, present
and future. This process involves business, financial and industry analysis.

Business Analysis:- This factors takes into consideration the board of directors,
management and their track record, other related entities, corporate governance issues
etc., customers, vendors, terms and conditions in the business, product diversification,
business strategies in the past and future and the success rate.

Financial Analysis:- In a rating process, rating agencies take cash flows into consideration
to judge the ability to service the debt obligations. Cash flow measures take into
consideration earning, coverage and leverage. Other Capital structure, financial
flexibility, contingent liability.

Industry Analysis:- Industry fundamentals and current. Industries that are in decline,
highly competitive, capital intensive, cyclical or volatile are inherently riskier than stable
industries with few competitors, high barriers to entry, national dominance, and
predictable demand levels. Operating environment includes the social, demographic,
regulatory and technological changes.

Health of a company is reflected in its financial. If the industry is in bad shape, but
financial health will be good, this reflects good management skills. If the industry is good
but the financial health is bad, this reflects bad management skills.

In India, the business of credit rating was first started in 1987 by large financial
institutions and creditors through CRISIL (Credit Rating Information Services of India
Ltd.). In the last 30 years, seven CRAs have been established, three with the most
influential ones being owned by Moody’s, Standard & Poor’s and Fitch. Four CRAs have
now become an essential part of the Indian financial system. They are regulated by the
Securities and Exchange Board of India (‘SEBI’) through the SEBI (Credit Rating
Agencies) Regulations, 1999 and circulars issued under it.

Seven SEBI registered and authorised credit rating agencies in India. The details of these
credit rating agencies is provided below:
1. Credit Rating Information Services of India Limited (CRISIL) : Credit Rating
Information Services of India Limited (CRISIL) is one of the oldest credit rating
agencies in India. It was set up in the year 1987. It is operational in countries including
the UK, USA, Poland, China, Hong Kong, and Argentina, in addition to India. It
evaluates the credit worthiness of commercial entities on the basis of their strengths,
market reputation, market share and board. It helps investors make informed
investment decisions by providing credit ratings for companies, organisations and
banks. Starting from 2016, CRISIL has also ventured into infrastructure rating.

2. Investment Information and Credit Rating Agency of India (ICRA) Limited: ICRA
Limited was set up in 1991 by leading financial/investment institutions, commercial
banks and financial services companies as an independent and professional investment
Information and Credit Rating Agency. The ultimate parent company of international
Credit Rating Agency Moody’s Investors Service is the indirect largest shareholders in
ICRA.

Today, ICRA and its subsidiaries together form the ICRA Group of Companies (Group
ICRA). ICRA is a Public Limited Company, with its shares listed on the Bombay Stock
 Exchange and the National Stock Exchange. ICRA is known for assigning corporate
governance rating, mutual funds rating, structured finance rating, performance rating,
etc.

3. Credit Analysis and Research (CARE) Limited: Credit Analysis and Research Limited
(CARE) started its operations in April 1993. Having it’s Headquarter in Mumbai, it
also has regional offices in New Delhi, Kolkata, Pune, Chandigarh, Ahmedabad,
Jaipur, Bengaluru, Coimbatore, Chennai and Hyderabad. CARE offers two categories
of bank loan ratings- short-term and long-term debt instruments. Its credit ratings can
be used by investors to make informed decisions on the basis of credit risk and risk-
return expectations. It can also help companies raise funds to meet their investment
needs.

4. Acuite Ratings & Research (earlier SMERA Ratings Limited): Established in 2011,
earlier known as Small Medium Enterprises Rating Agency of India Limited is now
known as Acuite Rating & Research. It has two key divisions – Bond Ratings and SME
Ratings. It evaluates the credibility of existing MSMEs (Micro, Small, and Medium
enterprises).

5. Brickwork Ratings India Private Limited: Besides being registered with SEBI,
Brickwork Ratings (BWR) is also accredited by RBI and empanelled by NCD, NSIC,
MSME ratings and grading services. It has Canara Bank as its leading promoter and
strategic partner. It assigns credit rating to bank loans, capital market
instruments, municipal corporations and SMEs. Besides, it also grades real estate
investments, NGOs, hospitals, MFI, etc. It provides several rating systems depending
upon the different financial instruments.

6. India Ratings and Research Private Limited: Formerly known as Fitch Ratings India
Pvt. Ltd., determines credit ratings for corporate issuers, financial institutions,
managed funds, project finance companies, structured finance companies and urban
local bodies. Headquartered in Mumbai, it also has other branch offices in Ahmedabad,
Chennai, Delhi and Hyderabad.

7. Infometrics Valuation and Rating Private Limited: Founded by former finance

professionals, bankers and administrative services personnel, Infometrics Valuation
and Rating Pvt Ltd is an RBI-accredited and SEBI registered credit rating agency. It
offers an unbiased assessment and evaluation of the creditworthiness of banks, non-
banking financial companies (NBFCs), small and medium scale units (SMUs) and large
corporates. It aims to reduce any kind of information asymmetry amongst lenders and
investors. It has transparency as its core value and thus, endeavours to provide
accurate and comprehensive reports and credit ratings to all its clients.

Process of formation of a Credit Ration Agency (CRA) in India:

SEBI is the final authority and regulator for granting the approval for the business of
Credit Rating Agency in India. Thus, the applicant has to submit its application to SEBI
for approval purpose. SEBI (Credit Rating Agencies) Regulations, 1999 has stipulated
(under regulation 3) certain criteria/parameters for the grant of a certificate to undertake
the business of credit rating agency. They can be described as under:

A. The applicant is a setup and incorporated as a company under the Companies Act,
1956;
B. The main object clause of the applicant in its Memorandum of Association shall be
rating activity;
C. The applicant has a minimum net worth of rupees five crore. However, for the credit
rating agency already existing at the commencement of these regulations by SEBI,
with a net worth of less than rupees five crore, shall be considered to have satisfied
this net worth requirement/condition, if it raises its net worth to the required
minimum net worth within a period of three years of such commencement.
D. The applicant shall have adequate infrastructure facility enabling it to provide rating
services in accordance with the provisions/ regulations of the Act;
E. The applicant and the promoters, as mentioned in regulation 4 should have
professional competence, financial soundness and general reputation of fairness and
integrity in business transactions, to the satisfaction of the Board (SEBI);
F. No legal proceeding connected with the securities market should have been initiated
against either the applicant, or its promoter, or any director of the applicant or its
promoter, which may have an adverse impact on the interests of the investors;
G. Either applicant, or promoter, or director, or its promoter should not have at any time
in the past been convicted of any offense involving moral turpitude or any economic
offense;
H. The applicant shall have, in its employment, the persons/ staff having adequate
professional and other relevant experience to the satisfaction of the Board;
I. Either the applicant or any person directly or indirectly connected with the applicant
has not in the past been –
i. Refused by the Board a certificate under these regulations or
ii. Either applicant or any person directly or indirectly connected with the
applicant shall not be subjected to any proceedings for a contravention of the Act
or of any rules or regulations made under the Act. Explanation - For the purpose
of this clause, the expression "directly or indirectly connected person" means any
person who is an associate, subsidiary, inter-connected or group company of the
applicant or a company under the same management as the applicant.
J. The applicant, in all other respects, shall be a fit and proper person for the grant of a
certificate taking into account the criteria specified in Schedule II of the SEBI
(Intermediaries) Regulations, 2008.
K. To confirm if the grant of a certificate to the applicant is in the interest of investors
and the securities market as a whole. If all the above-mentioned criteria/parameters
are satisfied, the Board (SEBI) grants the applicant the approval to undertake credit
rating agency business.

Modus Operandi of Credit Rating Agencies:

A credit rating agency can be best defined as a private company whose main objective is
to assess the ability of borrowers, either governments or private enterprises, to repay their
debt. For this, the credit rating agency assesses the borrower and issues some credit
ratings which are based on the borrower’s solvency status.

Currently, the three biggest global rating agencies like Fitch Rating Ltd. Moody’s and
standard and poor’s control 95% business of the world market. In India, credit rating
agencies came into existence in the second half of the 1980s. And as of now, we have crisis,
ICRA, CARE, SMERA, Fitch India, Equifax and Brickwork Ratings etc. credit rating
agencies registered under SEBI. To evaluate the status of solvency of the borrower, it is
the work of the credit rating agency to issue credit ratings corresponding to the borrower’s
credit risk. This will indicate the chance of default on the part of the borrower in
repayment of the loans. Although there is no standard scale or measure, such credit
ratings are generally denoted by letters referring to the potential risk, with the highest
rating represented by AAA and the lowest rating by C or D, according to the agency.

Further, a credit rating agency may also forecast how a particular rating of the company
may change in future time. Each rating agency has its own method to calculate its ratings
for the credit risk considering quantitative (financial data), qualitative (business strategy
for a company or political stability for a country) and contextual criteria (changes in the
industry for a company or public finances for a country) of the company. However, the
final rating indicates the evaluation of a borrower’s credit risk at a point of given time
under consideration.

A credit rating agency (CRA) is a commercial concern engaged in the business of credit
rating of any debt obligation or of any project or program requiring finance in the form of
debt or otherwise. CRA is different from a mercantile credit agency, which usually
supplies general information on corporates. It is also different from a credit bureau, which
collates information on credit record of corporates or even individuals. Nor is it a credit-
assessing agency like the credit department of a commercial bank. The most significant
aspect of credit rating is that it is an opinion made available for public, influencing
decisions by participants in financial markets.

Rating Methodology :
The Rating Methodology is generalized in the table below. It explains what is done and
what is not done, with a view to provide a comparison between the current state of the art
and the scope for improvement.

What is Done What is Not Done

Financial Statements Analysis Audited Statements not questioned
Site Visit Usually not more than 1 Site visit
Management Meeting Usually not more than 1 Manage- ment
meeting. Subsequent interactions by email
Nature of queries is general and Nature of queries is not too probing
clarificatory
Financial Projections sought Projected figures are not probed too
 from issuers much

Meeting third parties: Auditors and Besides Auditors and Bankers, not much of
Bankers corroboration is sought
Formal sources of information Informal sources of information not tapped
Rumors cannot be factored in unless Rumor verification mechanism is reactive,
confirmed not proactive.
Building a consensus on ratings at rating Dissenting view is subsumed by the
committee meetings. consensus view. Dissent note or rea-sons for
dissent are not recorded.
The basis of rating is a blend of objective No fixed weight between objective and
and subjective factors. subjective factors.
Sophisticated tools such as Credit- No sophisticated models are used. Final
metrics, LGD and KMV models are used ratings could be based more on judgement.
by S&P and
Moody’s in USA
Rating is an outcome of judgement. Neither a precise model nor a black box
Rating could be based on inputs of Depending on the composition of the teams
Analyst, followed by discussion and and the pattern of the discussions, ratings
review. could change, based on perception of inputs.

A careful look at the right-hand side (What is Not Done) reveals that there is scope for
improvement. It is no surprise, therefore, that financial markets, which, in totality have
a greatest number of surveyors and is equipped and empowered to price even unconfirmed
news into asset prices, react faster to new information than the CRAs. By contrast, CRAs
are required to be more guarded and restrained in either upgrading or downgrading issues
on account of protocols – namely, to wait for a confirmation. Until then, the CRAs can, at
best, place an issue under Rating Watch.

Functions of a Credit Rating Agency:

Credit rating agencies generally rates followings:
 Debt securities;
 Short term debt instruments, like commercial papers;
 Structured debt obligations;
 Loans; and
 Fixed deposits.

Followings are the basic functions which a Credit Rating Agency undertake during
evaluation of a rating proposal.

1. Business Analysis: A credit rating company will analyse the business condition of the
borrowing company not merely by the profits the borrowing concern has made, but by
the use of capital in a more productive purpose. The return on capital and the cost of
capital will be analysed.
2. Evaluation of industrial risks: Every industry will have its risks which are due to
natural or market conditions such as competition or due to the substitutes that have
arrived in the market. The extent of risks and measures to overcome them will be taken
into account while judging the credit rating of the company.

3. Market position of the company within the industry: What is the share of the market
of the company seeking credit rating? A higher percentage of market share will involve
more risks as the company has to be vigilant to maintain its share. So, a credit rating
agency will give due weightage for the market share of the borrowing concern.

4. Operating efficiency: This is judged from the point of view of utilization of the capacity.
When full capacity is utilized, the company has an advantage over others. This may be
possible due to location advantage or better labour relations. These will be looked into
by the credit rating agency.

5. Legal position in terms of prospectus: The statements made in the prospectus, should
be true and factual. If tall claims are made, they will hamper the growth of the company
and the credit rating agency will not rely on the prospectus of the company. It may also
be construed as a wilful fraud for attracting more funds. So, the contents of prospectus
will also be a factor for credit rating considerations.

6. Financial analysis based on accounting quality: If accrued incomes are taken for
making a window-dressing of balance sheet, it will not reflect well on the quality of
accounting of the borrowing concern. Companies relying on realized income, will be in
a better position to provide a realistic balance sheet. So, the true financial position of
the company will be judged not merely on the books of accounts but also on their market
conditions in meeting their debt commitments.

7. Statement of profits: There may be over statement or understatement of profits

depending upon the purpose for which the statement is prepared. Here, again the credit
rating agency has to scrutinize the realistic position of the company.

8. Earnings protection: To what extent, the earnings of the companies are consistent?
Does it show any growth? What is the extent of profitability? All these will be judged
under these criteria.

9. Adequacy of cash flow: Is the cash flow sufficient to meet its current commitments as
well as any other contingencies? This factor is taken into consideration by the rating
agencies.

10. Financial flexibility: How far the company is in a position to arrange for alternative
financial plans for raising its funds, if its existing idea does not work out successfully?
Rating agencies adjudge the financial flexibility of companies.
11. Management evaluation: What is the track record of management? How far they
are successful in steering the company under difficult conditions? Evaluation of
management is one of the important functions of credit rating agencies.

12. Capacity to overcome adverse situations (catastrophe management): Rating

agency studies the available mechanism for recovery with the company for meeting any
sudden unforeseen calamities.

13. Goals philosophy and strategy: Here, what kind of organizational goals are
adopted? What are the strategies adopted for achieving the goals, etc.? Such aspects
are considered when evaluation of an organization by rating agency.

14. Labour turnover: How far the nonalignment is looking after the welfare of its
labour? What is the extent of punctuality, discipline and morale of the labour force? To
what extent they continue with the employment in the company? A rating agency looks
for all these issues.

15. Regulatory and competitive environment: If there are more regulations, restricting
competition, then there will be more protection to the company, whereas under
condition of deregulation, providing more scope for competition, the efficiency of the
company will be tested. A rating agency studies the regulatory and competitive
environment from these angles.

16. Asset quality: Here, the value of assets and the price of the assets according to the
market conditions and the provisions made for these assets will be taken into account
credit rating authorities. Performance of assets will also be taken. The extent of
standard, sub-standard, doubtful and bad assets will also be taken into account while
granting credit rating.

17. Financial position — interest / tax sensitivity: If there is increase in the interest
rate due to the market condition, how far the company will be able to bear it? What
will be the impact on the company’s earnings? Similarly, if the government increases
tax on income, what will be the tax burden? What impact it will have on the company’s
earnings. These factors are taken into consideration.

Rating Category Description: Generally the rating described by the rating agencies are
given as under:
AAA :- Highest Safety
AA :- High Safety
A :- Adequate Safety
BBB :- Moderate Safety
BB :- Inadequate Safety
B :- High Risk
C :- Substantial Risk
D:- Default
Business Model of Credit Rating Agencies:
This is the most important part of the report. In today’s world we often hear the name of
the top credit agencies of the world quite frequently, they are Moody’s, S&P and Fitch.
These three big rating agencies has captured almost 95% business of the world in terms
of the Credit rating.

Credit rating agencies are expected to predict the possibly of default in future. Based on
the future prediction an investor or a lender take risk of business, in present financial
world where business styles and terms are getting complexed. Understanding the models
of different business is not an easier task for the investors and financial institutions. To
have an ease about understanding the risk, credit rating is becoming imperative for
bankers and financial institutions in present era.
Credit rating agencies mainly adopts two business model for earning: 1) Issuer Pay Model
and another is known as 2) Subscription Model. We will elaborate both the business model
here:

1. Issuer Pay Model: This model is generally applicable in rating of debt instruments
issued by various organisations for raising the money from the market in form of
bonds and other debt instruments. Issuer’s credit rating is mandatory as per the
government regulations and statuary requirements which provides a firm and
regular source of revenue generation for the credit rating companies. The issuer
companies need to share relevant data and information to the credit rating
agencies, based on the available information, data and their own research and
investigation, the credit rating companies provides rating to the issuer and made
it available for general public.

In short, the rating of a bond is a clear reflection of if the company will be able to
repay its creditors. When a bond gets a good rating from a credible CRA, people
trust that their invested money will be repaid. More people would want to buy the
bond. Therefore, a good rating is a good advertisement for the enterprise.

Also, if the rating is poor, the investors would ask better returns, like a higher
coupon rate, before investing.

2. Subscription Model: There are business entities who are constantly in requirement
of the funds for their business needs. They are in regular contact with the bankers
and financials institution of their requirements of funds and for this purpose the
need to get rated from the CRA’s on regular basis. In short, they become the
regular customers of the rating agencies and pay subscription fee on regular basis
for obtaining their services. Credit rating companies provide rating based on the
subscriber’s industry, business model and overall financials status. CRA’s also
renew their rating generally at annual basis. However, in special conditions like
requirement of emergency funds or in other conditions they may request for a mid-
term rating also. Banks and other financial institutions also regularly provide
funding such customers and they keep a regular observation on their ratings.
 This is regular revenue generation model for the credit rating agencies. However,
if the subscriber is not satisfied with the rating given by the company, he may
switch to the other rating company for seeking a revised and betting rating.

This kind of ratings are not necessarily available to the general people and most
of the time it is meant for the specific purposes like uses of the bankers and
financiers. Credit ratings also has no obligation to publish such ratings or make
rating available in public domain.

The Credit rating agencies generates high revenues not only because of the ratings
demand is higher in the financial world. But also because of the Oligopoly. Oligopoly is a
market term where small number of companies dominant the specific kind of business,
none of which can keep the others from having significant influence. This term fully
applies in the Indian market. There are only seven credit rating companies are present in
the market which is catering the high requirement of the enormous business client in
India. Though the CRA’s are regulated by SEBI (The Securities and Exchange Board of
India is the regulator of the securities and commodity market in India owned by the
Government of India), but still being a situation of Oligopoly, the credit rating agencies
dominates the terms of business.

Credibility of the Rating Agencies and the Challenges:

The credibility of the rating agencies is also found questionable in many instances both
at the national and international level. The working, understanding, prediction and the
result produced by various rating agencies has been a part of a large criticism many times.
Role and approaches of credit agencies has always been a hot topic of the debate among
many financial regulatory institutions.

Following are the common allegations on the Credit Rating Agencies world wide:
o False Ratings.
o Flawed methodology;
o Encroaching on government policy;
o Political biasness,
o Selective aggression and
o Rating shopping.

There has been many instanced when the people raised fingers towards the credibility of
a Credit Rating Agencies, few known incidents at world level are as follows:
 Enron scandal-2001
 Global Financial Crisis-2007-08
 During the global financial crisis, hundreds of billions of dollars’ worth of triple-A-
rated mortgage-backed securities were abruptly downgraded from triple-A to
“junk” (the lowest possible rating) within two years of the issue of the original
rating (2007-08).
Such failures have been noticed in India also many times, few of the recent incidents has
been highlighted below:
 The collapse of Satyam-2009
 PNB crisis
 IL&FS (Even with AAA ratings)

All these recent events (commenced in last 10 years) raised serious questions about the
effectiveness of the credit rating agencies (CRA) in alerting the system and investors of
risks lurking beneath the surface. The blowout at Infrastructure Leasing and Financial
Services (IL&FS) was the wake-up call for lenders and credit rating agencies – the
rating was cut to junk status from triple-A rated in a matter of weeks.

CRAs have missed impending defaults in several companies including IL&FS, DHFL
and Zee group, leading to sharp downgrades in ratings of instruments that were of
supposedly high credit quality.

Limitations of working:
Bad governance can contaminate financial statements, and hence annul the entire credit
rating exercise. It is sad to know that CRAs heavily depend on the audited financial
statements and do very little to gain the maximum from cross-verification from formal
and informal sources. While this is a lacuna on the part of auditors and CRAs, much needs
to be done on Corporate Governance, since a governance code works only on paper. It is
much easier and practical for the Regulators rather than CRAs to enforce governance.

It is necessary for CRAs, Merchant Bankers and Regulators to initiate studies on patterns
of deviant behavior. Some important variables being conglomeracy, forays into real estate
& construction, aggressive chase for growth through mergers & acquisitions, leveraged
balance sheet size, dictatorial management, ‘inner circle of management’, cartelization,
influence- peddling, unfair trade practices and so on. Put simply, corporate governance
addresses the issue of abuse of the corporate structure for personal gain. The links
between these traits of bad governance and defaults need to be studied as part of more
detailed research. Today, the entire edifice of corporate finance – shareholder wealth
maximization is under question. The focus is shifting towards stakeholder satisfaction
and societal well-being. Auditors and CRAs are the watchdogs of society as also the
conscience keepers of the nation, hence corporate governance is even more relevant as the
first filter. It is often said, in credit wisdom, that balance sheets do not repay loans – it is
the people behind the organization.

Significance on existence: Do we really need Credit Rating Agencies?

Such repeated events have raised question that do we really need such in-effective and
inefficient credit rating agencies:

‘Rating the raters’ has been a hotly debated issue in the press after every crisis of
confidence in financial markets. There is also a widespread view that the financial
markets are more aware of the weakness in issuing companies and factor this information
into asset prices before the financial markets react. This places the role and functioning
of CRAs under critical public review. To address this question, it needs to be considered
as to whether there is any person or entity that is superior to the CRAs in skill and
knowledge to pass judgement. It would be more practical, therefore, to ascertain whether
reasonable standards of due diligence have been exercised in order to mitigate credit risk.

One more important question arises is whether the rating agencies are able to predict
the default risk better than the markets. If market-determined spreads on corporate
debt paper are far better at predicting defaults than rating agencies, why should the
market dole out generous fees to a handful of rating agencies

There is seven rating agencies are practicing in India as stated above, these rating
agencies are regulated by both SEBI and RBI. Out of these, two have financial and
technology tie-ups with global leaders, while one is subsidiary to a global leader. So,
three out of seven companies have access to global best practices.

Though credit rating agencies are registered with the capital markets regulator SEBI,
they are jointly regulated by both SEBI and RBI as they rate bank loans, which
constitute 70 per cent of their business. Globally, rating agencies limit themselves to
ratings and research related to credit ratings. All other businesses like market research,
training, risk solutions are carried out under separate entities with no common
directors, employees and shareholding from the rating entity.

In India, the same rating agency rates and provides valuation opinions on the same set
of securities to investors like mutual funds and provides advisory services too.

Reputational Crisis: Rating Shopping

There are instances where the credit rating agencies have faced the allegation of “Rating
Shopping’. Rating shopping refers to how, a company or a debt paper manages to get
same or better rating in spite of deteriorated financial conditions, they change the rating
agency if they find that the previous agency is provided a lower rating to them or
negotiate for a better rating. According to some report extracted by one of the editions
of Financial Stability Report, recent SEBI findings noting instances where rating
agencies have provided 'indicative ratings' to issuers without entering into written
agreements with such issuers. In such instances 'indicative ratings' are not disclosed by
CRAs on their websites, it becomes difficult to identify instances of possible rating
shopping".

Since all rating agencies approach the same set of clients, they have little bargaining
power in terms of selecting the instruments to rate. Regrettably, on many occasions, the
CRA quoting the lowest price or quite shockingly promising an investment-grade rating
beforehand, wins the mandate.

CRAs also face the issue of company managements refusing to share critical details.
While taking the final decision on ratings, CRAs are cognizant of the impact a rating
may have on future business opportunities with the issuer. The system does not permit
publishing a rating without the issuer’s consent. In essence, if the rating is not as high
as the issuer expects it to be, it can choose to go to another CRA and fish for a better
rating.

The issue of possible rating shopping behaviour on the part of obligors clearly requires
serious attention. This is particularly relevant as some of the rating agencies have a
much greater share in ratings assigned compared to their share in ratings withdrawn.

While transparency levels in India are quite low, especially in the unlisted space,
excessive competition among the rating agencies has resulted in not-so-good practices
and a race to the bottom in terms of quality. The questions extend to the business model
of these rating agencies, where conflicts of interest can crop-up between business
interests and credit analysis functions.

Ways to work for solution:

The Indian credit rating market is an oligopolistic one due to high entry barriers. SEBI’s
proposed move to impose further quality requirements on rating agencies is unlikely to
change things for the better, or raise further barriers.

SEBI tightened disclosure norms for credit rating agencies on November 13, 2018. The
rating agencies will now need to disclose the liquidity position of the company being
rated. A company’s liquidity position would include parameters such as liquid
investments or cash balances, access to unutilised credit lines, liquidity coverage ratio,
and adequacy of cash flows for servicing maturing debt obligation.

Credit rating agencies would also need to disclose if a company is expecting additional
funds to pare its debt along with the name of the entity that will provide the money.

Credit rating firms will also have to analyse the deterioration of liquidity and check for
the asset-liability mismatch. Sebi has said when the rating factor has support from a
parent company or the government, the names of the promoter and the rationale for any
expectations shall be provided by the rating agency. Also, when the subsidiaries or
group companies are consolidated to arrive at a rating, CRAs will have to list all such
companies and state the rationale for consolidation.

There have been some suggestions also from regulators to conceptualise a workable
model to prevent ‘Rating Shopping’ is that regulators create a centralised clearing
platform for rating agencies. While issuers still pay the rating fee, the centralised
clearing platform would assign a rating firm for an issue using its discretion.

Conceptually, the ‘government or regulator pays’ model can eliminate biases in ratings
because there is no pecuniary incentive for the CRA. Here, the regulator can also
mandate free dissemination of ratings to all.

Professional fees will be paid by the regulator or exchanges to the credit rating agencies
from the investor protection fund. Rating agencies can be shortlisted based on pre-
defined criteria and fee can be based on competitive bidding for the work allocation
between credit rating agencies.

But there are some other issues as well. The choice of the CRA and the payment
mechanism are extremely problematic, as the government or the regulator may not
choose a CRA quality beyond a minimum threshold, or pay market-
determined/negotiated fees for ratings. If fees are no not market-determined, CRAs
would be hard-pressed to build capability and retain sharp analysts.

However, such regulations will be against the autonomous model of the rating agencies.
It will be like nationalisation of the credit regulators’ which by no means will increase
credibility of the Indian business organisations in the investor market. Moreover, the
regulators will have to own the ratings, they will also be held responsible for the losses
occurred due to the market risk. This concept also will be the biggest killer of the spirit
of entrepreneurships.

How CRA’s can improve performance & perception?

 Avoid arriving at ratings with limited information, even if it means giving up the
mandate.
 Disclose underlying assumptions, allowing potential investors to factor inbuilt risk in
the final rating.
 Operate on fixed agreed fee structure, limiting competition to quality and not pricing.
 Increase objectivity of rating models, thereby reducing subjectivity and perceptive
bias

Regulator’s additional role:

o Encouraging peer reviews if another CRA disagrees on a particular rating.
o Mandating disclosure of an assigned rating to all CRAs, even if it is not published.
o Building a surveillance policy, requiring stringent monitoring of an outstanding
rating.
o If CRAs are providing research or advisory services to the rated entities, build
governance and policy firewalls.

Prospects of the CRA’s in India:

Future outlook of the credit agencies in India is colossal. The Indian debt market, one of
the largest in Asia, is developing rapidly buoyed by a multitude of factors including new
instruments, increased liquidity, deregulation of interest rates and improved settlement
systems. The major players in the Indian debt markets today are banks, financial
institutions, insurance companies, FIIs and mutual funds. All these entities are required
a good credit rating to be sold through.

Apart from the above all the banks and financial institution are putting a great emphasis
on the credit rating of a customer even in retail finance segment for which companies like
CIBIL, Equifax, Experian etc. are providing credit history of individuals as well as firms
and companies has become very relevant these days.
In present financial world, the role of credit rating agencies is becoming important day by
day. As far as the prospects of the Credit Rating Agencies in India, we must understand
few important facts about world credit scenario.

Domestic credit to private sector is one of the important indicator or signs of economic
development and prosperity. Increasing share (role) of private sector in the national
economy or GDP of a certain country indicates the level of strength and development of
an economy. Referring to data from the world Bank, an economic measure of so-called
domestic credit to private sector (percentage to GDP) means that financial resources like
loans and non-equity securities are provided to the private sector by financial institutions
like banks and other financial corporations all measured as percentages with respect to
GDP (or national size of economy). The higher this measure is, the higher financial
resources or financing is to private sector in a country and so the greater opportunity and
space for the private sector to develop and grow. The better the private sector gets and
bigger role it has in national economy, the better is generally the health and development
of the economy of this country is. To illustrate taking examples from statistics done by
World Bank, China in 2013 has the ratio of domestic credit to private sector / GDP at a
rate of 133.7 %. This explains why China has succeeded in high economic growth because
it allowed a space and opportunity for private sector to get financing and as a result
emerge and grow leading to a mixed economy instead of just communism. Another
examples in 2013, Australia, USA, and UK have indications of 122.4%, 183.6 % and 176.8
% respectively, which is one measure that these countries have well developed and
advanced economies because private companies have great financing as US companies for
example have 13,000 billion $ of loans. In contrast, with all respect to developing countries
like Algeria in North Africa and Argentina in Latin America have this ratio of 14.5 % and
14.6 % respectively (although both rich in minerals and natural resources like oil, metals
and agricultural products) means that private sector have less role. (These countries in
one way or another have recently military regimes with governmental dominance for some
decades). In general, this is a one of the important indicator or measure of economic degree
of development and success because it shows the well-being and goodness of private sector
working hand in hand with public or governmental sector especially nowadays.

As far as the scenario of India is concern, we are way back in the ratio of private sector to
GDP. India’s GDP rank is 7th in the world and 3rd in Asia (as per Mar. 2021 statistics)
and we are almost at par with the United Kingdom in terms of GDP ranking. But the fact
is our per capita GDP ranking in the world is 147, which is far back from 23, per capita
raking of UK, we are just ahead of Bangladesh which is ranked at 148 per capita GDP
Ranking. Domestic credit to GDP percentage in our country is just over 50%, which is far
behind from the other developed countries. Our neighboring country china had achieved
50% rate of domestic credit to GDP way back in the year 1977. Presently China provides
about 165% of domestic Credit of GDP. Other Asian country Japan had over 100%
domestic credit of GPD more than 50 years back. Now their ratio of credit to private sector
of GDP is almost 175%. Japan is world’s largest economy after USA and China.
Above analysis has some other important dynamics also, but our purpose of bring this
analysis here just to understand the potential of rising rate of credit market in India and
the Credit Rating Agencies will be playing a major role of development of the Credit
Market in India.

Conclusion:

CRAs are the forensic department of the financial world. They analyse the data of
companies that are not available to others. People trust their verdict before investing.
They are not directly part of the business but are inseparable with it. Hence, their
credibility is paramount not just for their business but for the health of the entire
financial system. The murky issues should be sorted in favour of everyone.

In short, besides all the criticism, deprecation and discontentment, the relevance of the
Credit Rating Agencies is invincible in the current financial world. But the investors
seek a complete unbiasedness more transparency and more accuracy in the out come of
the CRA’s. There could be more effective and more accurate players can come into the
market of rating if SEBI’s liberates the entry barriers to increase the competition.