Project Report on Credit Rating - Copy

8/12/2019 Project Report on Credit Rating - Copy

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PROJECT REPORT ON

WORKING AND MANIPULATION OF CREDIT RATING IN INDIA



1. Declaration

2. Introduction

3. Executive summary

4. Sector overview

5. Literature review

6. Objectives and need for the study

7. Types of credit rating

8. Factors involved in credit rating

9. Credit rating process

10. Rating methodology

A. Business risk analysis

B. Financial analysis

C. management evaluation

D. geographical analysis

E. regulatory and competitive environment

F. fundamental analysis

11. Rating Criteria

A. Rating Criteria Commercial Banks

B. Rating Criteria Financial Institutions

C. Rating Criteria Life Insurance Companies

D. Rating Criteria General Insurance Companies

E. Rating Criteria Manufacturing Companies



F. Rating Criteria Telecom Companies

G. Rating Criteria Corporate

H. Rating Criteria Securitizations

11. Credit rating companies in India



INTRODUCTION

The account information compiled by a credit information company incorporating there in

loan/s or credit card facilities availed from one or many banks/institutions, re-payment record,

current balance on each of the facility, new credit facilities obtained, number of new enquiries

from lenders., default/s in repayment of dues, suit filed information etc is referred to as credit

history of a borrower or a consumer.

A credit score is a number assigned by credit reporting companies based on information

available on credit report. Like a test score, the higher the score, the better your credit. A good

credit score shows that you have a high probability of repaying loans on time. Therefore, a

good credit score will help you take out loans more easily and even get better interest rates.

An assessment of the credit worthiness of a borrower in general terms 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, corporation, state or provincial authority, or sovereign

government. Credit assessment and evaluation for companies and governments is generally

done by a credit rating agency such as Standard & Poor’s or Moody’s. These rating agencies are

paid by the entity that is seeking a credit rating for itself or for one of its debt issues. For

individuals, credit ratings are derived from the credit history maintained by credit-reporting

agencies such as Equifax, Experian and trans Union.

Credit ratings for borrowers are based on substantial due diligence conducted by the rating

agencies. While a borrower will strive to have the highest possible credit rating since it has a

major impact on interest rates charged by lenders, the rating agencies must take a balanced

and objective view of the borrower’s financial situation and capacity to service/repay the debt.

The credit rating has an inverse relationship with the possibility of debt default. In the opinion

of the rating agency, a high credit rating indicates that the borrower has a low probability of

defaulting on the debt; conversely, a low credit rating suggests a high probability of default.



Credit rating agencies typically assign letter grades to indicate ratings. Standard & Poor’s, for

instance, has a credit rating scale ranging from AAA (excellent) and AA+ all the way to C and D.

A debt instrument with a rating below BBB- is considered to be speculative grade or a junk

bond.

Credit rating changes can have a significant impact on financial markets. A prime example of

this effect is the adverse market reaction to the credit rating downgrade of the U.S. federal

government by Standard & Poor’s on August 5, 2011. Global equity markets plunged for weeks

following the downgrade.

For individuals, the credit rating is conveyed by means of a numerical credit score that is

maintained by Equifax, Experian and other credit-reporting agencies. A high credit score

indicates a stronger credit profile and will generally result in lower interest rates charged by

lenders.

A credit rating is an evaluation of the credit worthiness of a debtor, especially

a business (company) or a government, but not individual consumers. The evaluation is made

by a credit rating agency of the debtor's ability to pay back the debt and the likelihood

of default. Evaluations of individuals credit worthiness is known as credit reporting and done

by credit bureaus, or consumer, which issue credit scores.

Credit ratings are determined by credit ratings agencies. The credit rating represents the credit

rating agency's evaluation of qualitative and quantitative information for a company or

government; including non-public information obtained by the credit rating agencies' analysts.

Credit ratings are not based on mathematical formulas Instead, credit rating agencies use their

judgment and experience in determining what public and private information should be

considered in giving a rating to a particular company or government. The credit rating is used

by individuals and entities that purchase the bonds issued by companies and governments to

determine the likelihood that the government will pay its bond obligations.



A poor credit rating indicates a credit rating agency's opinion that the company or government

has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis

of long term economic prospects.



Executive summary

Credit rating agencies are placed as intermediate between investors and issuers of fixed

income securities. Their most important role is to minimize the existence of asymmetric

information in the marketplace. The role is central in operating the financial markets. The

globalization process and development of complex financial products has provided the credit

rating agencies with a tremendous power.

Despite the powerful position, is the credit rating industry subject to very weak regulation. The

credit rating agencies are by them self supposed to manage potential pitfalls in the rating

process and rating system. They are said to be self-controlled as no authority control how the

agencies manage to avoid potential pitfalls. The weak regulation and self-control provides the

agencies with a high level of freedom.

The mixture of power and freedom is a dangerous combination, if not managed well. The

agencies need to be fully aware of the responsibilities that naturally follow power and freedom.

If they don’t act as a responsible intermediate and perform trustworthy, the market will lose its

faith to the system.

The credit rating agencies have through the years been subject to criticism in relation to the

management of their responsibility. The criticism has evolved in the wrong direction after focus

had been pointed to the agencies role in the corporate scandals of Enron, WorldCom and

Pharmalat. The criticism has reached a new high level under the current financial crisis. Many

players at the financial scene look upon the credit rating agencies as a direct scapegoat of the

current crisis. The criticism has been concentrated on numerous conflicts of interest and the

dependence of issuers.

It is expected that the criticism have a negative influence on the image of the credit rating

agencies and the investor’s confidence in the credit rating system. The credit rating agencies

can only exist if they have a strong reputation and enjoy great confidence. The credit rating



agencies has realized the problem and declared that improvements are needed to restore the

confidence and image.

This situation motivates an investigation of the nature of the criticism and the influence on

investor’s reactions on changes in long-term corporate credit rating. Have the investors as a

result of low confidence ignored the changes or are they reacting on information from criticized

credit rating agencies. Agencies who, by them self, have admitted the many problems the critics

have pointed out.

The main findings reveal that investors only react significant on downgrades during the current

crisis. There is no significant reaction in the months before the crisis. This is seen as an expected

result of the criticism and an erosion of the investors trust in the credit rating system. The

sudden reaction during the crisis is much more significant, than results in earlier studies. The

investor reaction measured as negative abnormal stock returns can be characterized as a

“panic-drop”. It is believed to be a psychological reaction and not a sudden rebuild trust in the

credit rating system. In the case of upgrades, no significant reaction was found.



CONCEPT OF CREDIT RATING

Ratings, usually expressed in alphabetical symbols, are a simple and easily understood tool

enabling the investor to differentiate between instruments on the basis of their credit quality.

Credit rating is the symbolic indicator of the current opinion of the service debt obligations in a

timely fashion with specific reference to the instrument being rated. It is focused on

communicating to investors the relative ranking of the different loss probability for a given

fixed income investment, in comparison with other rated instruments.

The term “Credit Rating” comprises two words: “credit” and “rating”. Credit is trust in a

person’s ability and intention to pay or reputation of solvency and honesty. Rating means to

classify a person’s position with reference to a particular subject matter. In other words, credit

is an act of assigning values by estimating worth or reputation of solvency and honesty so as to

repose trust in a person’s ability and intention to repay. Thus, credit rating could be defined as

an expression of an opinion through symbols about credit quality of the issuer of securities or

company with reference to sell that security. It provides risk which is one of the several factors

in investor decision making. It does not indicate market risk or forecast future market price. It is

always a specific evaluation done for a particular instrument. The rating process is itself based

on certain “givens”. The agency, for instance, does not perform an audit. Instead its required

information and opinion provided by the issuer and collected by analysts from different

sources, including personal interaction with various entities. In determining rating, both

quantitative and qualitative analyses are employed. The judgment is qualitative it nature and

the use of quantitative analysis is to make the best possible overall qualitative judgment

because ultimately the rating is an opinion.



LITERATURE REVIEW

Credit rating serves as a valuable input in the decision-making process of different participants

in the capital market including regulators, issuers and investors. Therefore, it has been

attracting the attention of thinkers in the field of finance to study various dynamics of this fast

emerging subject. Various studies have been conducted in India as well as in different parts of

the world by different bodies and individuals and thus contributing a lot to explore new insights

into the concept of credit rating. The area of concern of the studies conducted so far has been



mainly to find out the relevance of credit rating in the Indian context as well as at the global

level and the extent of awareness among the investors, about the concept of credit rating. The

present chapter provides a brief review of the research studies conducted on credit rating at

the national and international level.

Czarnitzki and Kraft (2007), in their study, tested whether the credit ratings give more specific

information about creditworthiness of the firms as compared to the publicly available

information (which is available to the potential investors without any substantial cost). They

selected a sample of about 8000 firms of German manufacturing sector for the purpose of

study and the time period of study was 1999-00.They compared the ratings given by leading

German credit rating agency „Credit Reform‟ with the publicly available information. The study

revealed that the young firms were more likely to default than the established ones. Further,

the lower the productivity the more would be the probability of default. They further inferred

that credit rating has some additional informational value for lenders but the rating agencies

overemphasized the factor „firm size‟ in construction of rating index.

Jain and Sharma (2008), in their paper, attempted to examine the working of credit rating

agencies in the light of role played by them in the capital market as information disseminators.

The authors identified conflicts of interest affecting the rating decisions and the manner in

which the regulations have attempted to address them. Further, they also studied the

regulatory framework for credit rating agencies in India. The authors revealed that credit rating

agencies play a central role in the capital markets through their informed and independent

analysis. The various conflicts of interest highlighted in the study were relating to the fee

charged, ancillary services of credit rating agencies, ownership interest of credit rating agencies

in client securities and the problem of notching. The study highlighted that despite the

significant role played by credit rating agencies in capital markets, they are not properly

regulated as not much responsibility is put on them in respect of their rating actions. Further, in

the Indian context too, the authors revealed certain loopholes in the regulatory system of credit



rating agencies. These included deficient disclosure regime, lack of private enforcement regime,

management conflict of interest and lack of rules for structured finance ratings, which need to

be corrected in a proper and timely manner.

Reddy and Gowda (2008), in their paper, explained the importance and problems of credit

rating in India. They also highlighted the basis of credit rating and credit rating practices

prevalent in India. For this purpose, the opinions of sample of investors from Hyderabad were

taken. The results of the study inferred that majority of the respondents were aware of the

existence of various credit rating agencies including CRISIL, CARE, ICRA, etc. About 40 per cent

(80 out of 200) of the respondents depend on credit rating for their investment in debt

instrument but more than 50 percent from them (94 out of 180) rely on CRISIL for their

investment than the other credit rating agencies. The study worked out that though there is

confusion among various investors due to existence of more than one credit rating agency but

majority of them are satisfied with the guidance of credit rating agencies.

Bhattacharyya (2009), in her paper, evaluated the issuer rating system in India with special

reference to ICRA‟s issuer rating model, since ICRA introduced the issuer rating services in India

in 2005. The author identified various quantitative variables having major impact on the issuer

rating along with their relative importance with the help of discriminant analysis. The time

period of the study is from the date when the issuer rating started in 2005 to March 2008 and

the sample consists of 17 companies which have been rated by ICRA during this period. The

study highlighted that out of the ten variables being used by ICRA for issuer rating the PBIT &

Debt plus net worth ratio, current ratio and net sales growth rate play an important role but the

qualitative factors can also affect the ratings at any time.

Bheemanagauda and Madegowda (2010) made an attempt to evaluate the performance of

credit rating agencies in India including CRISIL, ICRA, CARE and FITCH. Secondary data relating

to long-term debt instruments from time period 2000-08 has been used for the purpose of the

study. The analysis of the study brings out that during the given period there is a substantial

increase in the rating business in India. During the study period, the maximum percentage of

instruments rated is assigned the investment grade rating. As far as rating revisions are



quality, competitive position of the issuer and commitment to new projects etc. A detailed analysis of

the past financial statements is made to assess the performance and to estimate the future earnings.

The company’s ability to service the debt obligations over the tenure of the instrument being rated is

also evaluated. In fact, it is the relative comfort level of the issuer to service obligations that

determine the rating.

While assessing the instrument, the following are the main factors that are analyzed into detail by the

credit rating agencies.

1. Business Risk Analysis

2. Financial Analysis

3. Management Evaluation

4. Geographical Analysis

5. Regulatory and Competitive Environment

6. Fundamental Analysis

I. Business Risk AnalysisBusiness risk analysis aims at analyzing the industry risk, market position of the company, operating

efficiency and legal position of the company. This includes an analysis of industry risk, market position

of the company, operating efficiency of the company and legal position of the company.

a. Industry risk: The rating agencies evaluates the industry risk by taking into consideration various

factors like strength of the industry prospect, nature and basis of competition, demand and supply

position, structure of industry, pattern of business cycle etc. Industries compete with each other on

the basis of price, product quality, distribution capabilities etc. Industries with stable growth in

demand and flexibility in the timing of capital outlays are in a stronger position and therefore enjoybetter credit rating.

b. Market position of the company: Rating agencies evaluate the market standing of a company taking

into account:

i. Percentage of market share

ii. Marketing infrastructure

iii. Competitive advantages

iv. Selling and distribution channel

v. Diversity of products

vi. Customers base

vii. Research and development projects undertaken to Identify obsolete products

viii. Quality Improvement programs etc.



c. Operating efficiency: Favorable location advantages, management and labor relationships, cost

structure, availability of raw-material, labor, compliance to pollution control programs, level of capital

employed and technological advantages etc. affect the operating efficiency of every issuer company

and hence the credit rating.

d. Legal position: Legal position of a debt instrument is assessed by letter of offer containing terms of

issue, trustees and their responsibilities, mode of payment of interest and principal in time, provision

for protection against fraud etc.

e. Size of business: The size of business of a company is a relevant factor in the rating decision.

Smaller companies are more prone to risk due to business cycle changes as compared to larger

companies. Smaller companies operations are limited in terms of product, geographical area and

number of customers. Whereas large companies

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