Simply put, credit rating indicates a business’s creditworthiness. For a lender, a higher credit rating implies no default repays and for an investor, it bespeaks safer investment. Credit rate often gets mixed up with credit score. Though both assist in credit approval process, the former pertains to corporates and the latter is for the individuals. Corporate credit rating is mandated to credit rating agencies (CRA) duly regulated by SEBI in India. It is no secret that CRA’s globally are facing a fair share of controversies. False ratings, flawed methodology, political bias, the allegations are many. Credit rating has a crucial role in credit decisions. But it fits the bills only if the assessment is independent and transparent.
What are Credit Rating Agencies (CRA)?
A Credit rating agency is a corporate that provides credit ratings which indicate the timely repayment of the principal and interest payments by the debtor & the likelihood of a debtor defaulting. Some of the debt instruments for which credit ratings provided are the corporate bonds, Commercial Paper, Certificate of deposits, Municipal bonds & Mortgage backed securities. A few of the credit rating companies operating in India are CARE, CRISIL, and ICRA & Brickwork Rating. The credit rating determines the interest payments on debt instruments, the higher the credit ratings of an instrument issued by the debtor, the lesser would be the net interest outgo. A sovereign credit rating is an independent assessment of the creditworthiness of a country or sovereign entity. Sovereign credit ratings can give investors’ insights into the level of risk associated with investing in the debt of a particular country, including any political risk.
How are the Credit ratings arrived at?
Credit ratings are arrived at after looking at the past history of a company’s borrowings and the timely repayment of debt. Delay in payment of debt severely downgrades the credit rating. The future growth potential of a company is also factored in the credit rating. The CRA provides credit score to individuals while the corporations and Government are provided with credit rating (1).
Importance of Credit ratings to Banks in lending activities
Credit ratings helps the banks to make sound investment decision by taking into account the risk aspects of the company which are factored in the credit ratings. The lenders get assurance that the debtor would pay back the loan money. Loan origination and disbursement is faster. The interest rates are fixed depending on the credit rating assigned to corporates.
Conflict of interest in CRA
The conflict of interest arises between the CRA’s and corporates for whom they provide credit ratings while receiving fees from the corporates. The CRAs ability for providing unbiased ratings gets undermined in the process of garnering higher fees. The CRAs may allot higher ratings to continue receiving fees. They also provide consulting services to the corporate to raise their offerings to meet the standards as set by CRAs, while receiving fees for the advice rendered (2).
CRA failures in predicting corporate collapses
The Credit rating agencies were not able to predict the defaults of corporates like IL&FS, DHFL, Cox& Kings and Altico Capital. The corporates defaulted while their long-term ratings had indicated low to moderate risk of non-payment (3). The lack of more forewarning on payment problems has fueled questions about the quality of ratings, and could keep some investors away from corporate bonds, hindering market development. The “Big Three” global credit rating agencies—U.S.-based Standard and Poor’s (S&P), Moody’s, and Fitch Ratings—had come under intense scrutiny in the wake of the global financial crisis. The CRA’s were expected to provide investors with reliable information on the riskiness of various kinds of debt, instead CRA’s were accused of exacerbating the financial crisis by offering overly favourable evaluations of insolvent financial institutions and approving extremely risky mortgage-related securities.
Why increased Disclosure requirements for CRA’s- RBI/ SEBI
The securities market regulator, Securities and Exchange board of India (SEBI) had strengthened disclosure norms in 2019 after rating firms failed to give adequate warning on IL&FS group’s defaults from 2018, which triggered a prolonged cash squeeze in the nation. The CRAs now have to reveal annual default rates among the corporates they evaluate. The capital markets regulator mandated that independent directors should constitute one-third of the board of the rating agency. SEBI had further said that the board of a CRA will have to constitute ratings sub-committee, nomination and remuneration committee and the chief ratings officer would directly report to the ratings sub-committee of the board. SEBI in October 2022 came out with guidelines to facilitate orderly migration of credit ratings of debt securities following cancellation of licence of a credit rating agency (CRA). The Reserve Bank of India in August 2022 had advised CRA companies to either downgrade or withdraw bank loans ratings that were propped up through arrangements that the regulator thought were diluted or non-prudent support structures.
How will enhanced disclosures by CRA’s help lenders?
The enhanced disclosures would desist CRA’s from providing a higher credit rating to debts that later turn out to be high-risk investments. Increased scrutiny by regulators would result in elimination of flawed methodologies which CRAs had adopted for rating financial products.
The disclosures would enable investors and other stakeholders to properly make use of such disclosures before making investment decisions (4). The disclosures would ultimately lead to improvement in the quality of ratings provided by the Credit rating agencies.
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Do you think firms manage their Credit Ratings? Why?
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2. UK Diss. (05/10/2021). Problems of the Credit Rating Agencies
3. Rahul Satija. (01/10/2019). Business standard. Why do credit rating agencies keep missing big Indian company defaults?
4. Economic Times- 27/08/2022 Sebi enhances disclosure norms for rating companies