CREDIT RATING AGENCIES ANDCREDIT RATING METHODOLOGY Submitted by: BHAVIN KARIA Roll: FS 11- 020 Nalsar University

of Law and Institute of Insurance and Risk Management Submitted to: V. RAMAMURTHY VISITING FACULTY Subject name: Risks In Financial Institution (MFS-303)

CHAPTER 1 - INTRODUCTION
Credit ratings provide individual and institutional investors with information that assists them in determining whether issuers of debt obligations and fixed-income securities will be able to meet their obligations with respect to those securities. Credit rating agencies provide investors with objective analyses and independent assessments of companies and countries that issue such securities. Globalization in the investment market, coupled with diversification in the types and quantities of securities issued, presents a challenge to institutional and individual investors who must analyze risks associated with both foreign and domestic investments. Historical information and discussion of three companies will facilitate a greater understanding of the function and evolution of credit rating agencies. The removal of strict regulatory framework in recent years has led to a spurt in the number of companies borrowing directly from the capital markets. There have been several instances in the recent past where the "fly-by-night operators have cheated unwary investors. In such a situation, it has become increasingly difficult for an ordinary investor to distinguish between 'safe and good investment opportunities' and 'unsafe and bad investments'. Investors find that a borrower's size or names are no longer a sufficient guarantee of timely payment of interest and principal. Investors perceive the need of an independent and credible agency, which judges impartially and in a professional manner, the credit quality of different companies and assist investors in making their investment decisions. Credit Rating Agencies, by providing a simple system of gradation of corporate debt instruments, assist lenders to form an opinion on -the relative capacities of the borrowers to meet their obligations. These Credit Rating Agencies, thus, assist and form an integral part of a broader programme of financial disintermediation and broadening and deepening of the debt market. Credit rating is used' extensively for evaluating debt instruments. These include long-term instruments, like bonds and debentures as well as short-term obligations, like Commercial Paper. In addition, fixed deposits, certificates of deposits, inter-corporate deposits, structured obligations including non-convertible portion of partly Convertible Debentures (PCDs) and preferences shares are also rated.

MEANING OF CREDIT RATING Credit Rating Agencies rate the aforesaid debt instruments of companies. They do not rate the companies, but their individual debt securities. Rating is an opinion regarding the timely repayment of principal and interest thereon; it is expressed by assigning symbols, which have definite meaning. A rating reflects default risk only, not the price risk associated with changes in the level or shape of the yield curve. It is important to emphasize that credit ratings are not recommendations to invest. They do not take into account many aspects, which influence an investment decision. They do not, for example, evaluate the reasonableness of the issue price, possibilities of earning capital gains or take into account the liquidity in the secondary market. Ratings also do not take into account the risk of prepayment by the issuer, or interest rate risk or exchange rate risks. Although these are often related to the credit risk, the rating essential is an
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opinion on the relative quality of the credit risk.. It has to be noted that there is no privity of contract between an investor and a rating agency and the investor is not protected by the opinion of the rating agency. Ratings are not a guarantee against loss. They are simply opinions, based on analysis of the risk of default. They are helpful in making decisions based on particular preference of risk and return. A company, desirous of rating its debt instrument, needs to approach a credit rating agency and pay a fee for this service. There is no compulsion on the corporate sector to obtain or publicize the credit rating except for certain instruments. A company can use the rating as another publicity exercise if it is a good one and to obliterate it

from its prospectus and publicity, if it is not good. The Credit Rating Agencies regularly analyses the financial position of corporations and assign and revise the ratings for their securities. The different rating agencies.~ seldom give different ratings for the same security. If two rating agencies do give the same security different ratings, it is called split rating; the few differences that occur are rarely more than one rating grade level apart. Accepted ratings are published in media, every week. In tune with the industrial practice in India, rating agencies do not publish ratings which are not accepted by issuers.

CHAPTER 2 - ORIGIN
The first mercantile credit agency was set up in New York in 1841 to rate the ability of merchants to pay their financial obligations. Later on, it was taken over by Robert Dun. This agency published its first rating guide in 1859. The second agency was established by John Bradstreet in 1849 which was later merged with first agency to form Dun & Bradstreet in 1933, which became the owner of Moodys Investors Service in 1962. The history of Moodys can be traced back about 100 years ago. In 1900, John Moody laid stone of Moodys Investors Service and published his Manual of Railroad Securities. Early 1920s saw the expansion of credit rating industry when the Poors Publishing Company published its first rating guide in 1916. Subsequently Fitch Publishing Company and Standard Statistics Company were set up in 1924 and 1922 respectively. Poor and Standard merged together in 1941 to form Standard and Poors which was subsequently taken over by McGraw Hill in 1966. Between 1924 and 1970, no major new rating agencies were set up. But since 1970s, a number of credit rating agencies have been set up all over the world including countries like Malaysia, Thailand, Korea, Australia, Pakistan and Philippines etc. In India, CRISIL (Credit Rating and Information Services of India Ltd.) was setup in 1987 as the first rating agency followed by ICRA Ltd. (formerly known as Investment Information & Credit Rating Agency of India Ltd.) in 1991,\ and Credit Analysis and Research Ltd. (CARE) in 1994. All the three agencies have been promoted by the All-India Financial Institutions. The rating agencies have established their creditability through their independence, professionalism, continuous research, consistent efforts and confidentiality of information. Duff and Phelps has tied up with two Indian NBFCs to set up Duff and Phelps Credit Rating India (P) Ltd. in 1996.

INDIA FACTOR With the increasing market orientation of the Indian economy, investors value a systematic assessment of two types of risks, namely business risk arising out of the open economy and linkages between money, capital and foreign exchange markets and payments risk. With a view to protect small investors, who are the main target for unlisted corporate debt in the form of fixed deposits with companies, credit rating has been made mandatory. India was perhaps the first amongst developing countries to setup a credit rating agency in 1988. The function of credit rating was institutionalized when RBI made it mandatory for the issue of Commercial Paper (CP) and subsequently by SEBI. when it made credit rating compulsory for certain categories of debentures and debt instruments. In June 1994, RBI made it mandatory for Non-Banking Financial Companies (NBFCs) to be rated. Credit rating is optional for Public Sector Undertakings (PSUs) bonds and privately placed non-conve11ible debentures up to Rs. 50 million. Fixed deposits of manufacturing companies also come under the purview of optional credit rating. The High level Coordination Committee on Financial Matters (HLCCFM) in its meeting held on 11th January 2008, inter alia, decided that the legal and policy framework for regulating the

activities of CRAs should be revisited in order to take a larger view of the entire policy with respect to banking , insurance and securities market. Credit rating agencies play an important role in assessing risk and its location and distribution in the financial system. By facilitating investment decisions they can help investors in achieving a balance in the risk return profile and at the same time assist firms in accessing capital at low cost. CRAs can thus potentially help to allocate capital efficiently across all sectors of the economy by pricing risk appropriately. However, in view of the fact that CRAs that rate capital market instruments are regulated by SEBI and that entities regulated by other regulators (IRDA, PFRDA and RBI) predominantly use the ratings, it was felt necessary to institute a comprehensive review of the registration, regulatory and supervisory regime for CRAs. The major motivation for the exercise was to look at inter regulatory coordination so that all interested stake holders have an institutional mechanism for providing inputs feedback to ensure realization of the objective behind the regulation of CRAs. Adding a further dimension to this enquiry, the subprime crisis has attracted considerable adverse attention worldwide on the role of CRAs enhancing the need for this review. Given that rating is only an opinion, albeit a very influential one, and regulation of gatekeeper business models is a border line ethical regulatory issue, the committee has examined wide ranging steps to improve the functioning and accountability of CRAs including the suggestion that in the medium run regulators may move away from the mandatory rating practice at least in the capital market. Based on the examination of the CRA business models, current regulatory activities, global experiments and the Indian context, this report aims to lay out a broad framework for strengthening the existing regulatory architecture for CRAs in India and incorporates the Committees vision for new arrangements and practical steps required in this direction.

CHAPTER 3 - Systemic Importance of Rating and Rating Agencies

The institution of credit rating as a mechanism for addressing the considerable degree of information asymmetry in the financial markets has travelled a long way from the times of the US rail road companies in the mid-19th century. The need for an independent rating agency capable of assessing creditworthiness of borrowers was felt when corporates started mobilizing resources directly from savers instead of accessing it through banks which hitherto assumed the credit risk in such cases. The history of systematic credit rating, however, is a century old beginning with rating of US railroad bonds by John Moody in 1909. During this one century of growth and adaptation, CRAs progressed from rating simple debt products to rating complex derivatives to national economies and altered their business models to cover a range of activities/products. There are three major credit rating agencies operating internationally Fitch, Standard and Poors, Moodys Investor Services: between them they share the bulk of the $5 billion rating business globally relegating other 60 plus local/regional players into just competitive fringes. In India, credit ratings started with the setting up of The Credit Rating Information Services of India (now CRISIL Limited) in 1987. CRISIL was promoted by premier financial institutions like ICICI, HDFC, UTI, SBI, LIC and Asian Development Bank. Now CRISIL is an S&P company with a majority shareholding. Apart from CRISIL four more rating agencies have been registered by SEBI in India. These are ICRA, promoted by IFCI and now controlled by Moodys, CARE promoted by IDBI, Fitch India a 100% subsidiary of Fitch, and a new born Brickworks. In India, CRAs that rate capital market instruments are governed by Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999. The regulation provides detailed requirements that a rating agency needs to fulfill to be registered with SEBI.

Role and Rationale A credit rating is technically an opinion on the relative degree of risk associated with timely Payment of interest and principal on a debt instrument. It is an informed indication of the likelihood of default of an issuer on a debt instrument, relative to the respective likelihoods of default of other issuers in the market. It is therefore an independent, easy-to-use measure of relative credit risk. Given the universal reliance on rating, and hence the power of the opinion, credit rating is expected to increase the efficiency of the market by reducing information asymmetry and lowering costs for both borrowers and lenders. A simple alphanumeric symbol is normally used to convey a credit rating. Ordinarily the Company which issues the debt instrument is not rated. It is the instrument which is rated by the rating agency. But the issuer company which has issued the debt instrument gets strength and credibility with the grade of rating awarded to the credit instrument it intends to issue to the public for raising funds. Though the purpose of rating is to rate instruments, a general perception may be gathered that the organization issue a highly rated instrument is also sound and a highly rated entity. Thus, credit rating is a mechanism whereby an independent third party makes an assessment, based on different sources of information on the credit quality of the assessed. Given the systemic superstructure position that the CRAs have come to occupy as information and
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insight gate keepers, they play an important role in the of modern capital markets. Their importance to various stakeholders is as follows. Investors CRAs typically opine on the credit risk of issuers of securities and their financial obligations. Given the vast amount of information available to investors today- some of it valuable, some of it not CRAs can play a useful role in helping investors and others sift through this information, and analyze the credit risks they face when lending to a particular borrower or when purchasing an issuers debt and debt like securities. CRAs also provide investors with rating reports, giving detailed information and analytical judgments on the issuers business and financial risk profile. This assists investors in taking more informed investment decisions, calibrated to their own riskreturn preferences. Securitized instruments are among the most complex instruments in the debt market. Securitized instruments backed by retail assets are classified as Highly Complex by some Indian rating agencies. Given the inherent complexity in these instruments, an independent assessment of the risks involved in the instruments by a credit rating agency acts as an important input to an investors decision-making. Unlike most corporate bonds, where an investor can independently assess a borrowers creditworthiness, In a securitization transaction there will normally be little or no information in the public domain for an Investor to carry out such an assessment. Understanding the nuances of different pools and analysis of the past behavior of asset classes are areas where CRAs can play an important role. Tracking the performance of the transaction and the corresponding impact on the riskiness of the instruments is a feature where CRAs play an important monitoring role. These aspects have also been recognized by Indian regulators. As required by Basel capital accord risk weights are assigned to all rated and unrated bank exposures. Issuers Issuers rely on credit ratings as an important tool to access investors and also to reach a wider Investor base than they otherwise could. In most cases, successful placement of a significant bond issuance needs at least one rating from a recognized CRA; without a rating, the issue may be undersubscribed or the price offered by investors may not be appropriate. Further, they enable issuers to price their issues competitively. In financial markets, the price of debt is determined primarily by the rating of the debt issue. Banks/ Bank loan rating Although credit rating is not mandatory under Basel II, banks are likely to save capital if they get their loan rated. If a bank chooses to keep some of its loans unrated, it may have to provide, as per extant RBI instructions, a risk weight of 100 per cent for credit risk on such loans. As provided under Basel II, supervisors may increase the standard risk weight for unrated claims where a higher risk weight is warranted by the overall default experience in their jurisdiction. Further, as part of the supervisory review process, the supervisor may also consider whether the credit quality of corporate claims held by individual banks should warrant a standard risk weight higher than 100%. In terms of RBI instructions on the 'New Capital Adequacy Framework (Basel II)' issued in April 2007, banks were required to initially assign a risk weight of 100 per cent in
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respect of unrated claims on corporates with the caveat that such claims would be assigned higher risk weights over time. To begin with, for the financial year 2008-09, all fresh sanctions or renewals in respect of unrated claims on corporates in excess of Rs.50 crore were to attract a risk weight of 150 per cent, and with effect from April 1, 2009, all fresh sanctions or renewals in respect of unrated claims on corporates in excess of Rs. 10 crore were to attract a risk weight of 150 per cent. This higher risk weight of 150 per cent for unrated corporate claims was equivalent to the risk weight to be assigned to exposures rated BB and below. However, in November 2008, as a counter cyclical measure, RBI relaxed the regulatory prescription of 150 percent risk weight for unrated claims. Accordingly, all unrated claims on corporates, irrespective of the amount currently attract a uniform risk weight of 100 percent. This relaxation is temporary and will be reviewed at an appropriate time. A large number of Indian companies, hitherto unrated by rating agencies, have now come forward to get their bank facilities rated. Basel-II norms hold significant potential for further development of the domestic debt markets, by introducing into the public domain easily accessible credit information about a large pool of mid-sized companies. This will not only allow these companies to explore alternative sources of funds, but, through greater visibility, also facilitate healthy competition among fund providers. For banks and other investors, it creates an information base that can be used for efficient portfolio selection. The acceptance of credit ratings by the investor community has led to investors showing increasing interest in the bank loan rating portfolio. Investors have also begun to consider offering a suite of market-linked borrowing products (including non-convertible debentures, commercial paper, and MIBORlinked short-term debt instruments) to rated mid-sized companies. Regulators Regulatorstypically banking regulators and capital market regulatorsuse credit ratings, or permit ratings to be used, for regulatory purposes. For example, under the Basel II capital framework of the Basel Committee on Banking Supervision, banking regulators can accredit credit rating agencies based on specified criteria. The ratings assigned by these accredited External Credit Assessment Institutions or ECAIs are used to assign risk weights to various bank exposures in calculating capital charge for credit risk. Further, some regulators (such as IRDA and PFRDA) have incorporated ratings into the investment guidelines for the entities they regulate. Rating thus provides an additional layer of comfort to the regulators in their assessment of product risks and overall systemic risks.

CHAPTER 4 - Functions and Approaches of Credit Rating Agencies

Rating related products and activities
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CRAs in India rate a large number of financial products: 1. Bonds/ debentures- [the main product] 2. Commercial paper 3. Structured finance products 4. Bank loans 5. Fixed deposits and bank certificate of deposits 6. Mutual fund debt schemes 7. Initial Public Offers (IPOs) CRAs also undertake customized credit research of a number of borrowers in a credit portfolio, for the use of the lender. CRAs use their understanding of companiesbusiness and operations and their expertise in building frameworks for relative evaluation, which are then applied to arrive at performance grading. For example developer gradings are carried out to assess the ability of the developers to execute projects on a timely basis and promised quality while maritime institute gradings are carried out to assess quality of education imparted to the students vis a vis DGS (Directorate General of Shipping) objectives. Non-rating related activities CRAs often undertake a variety of non-rating related activities. These include the following: 1. Economy and Company Research: Some Indian CRAs have set up research arms to complement their rating activities. These arms carry out research on the economy, industries and specific companies, and make the same available to external subscribers for a fee. In addition, they disseminate opinions on the performance of the economy or specific industries, available through releases to the media. The research would also be used internally by the rating agencies for arriving at their rating opinions. SEBI permits CRAs to carry out this activity subject to relevant firewalls. 2. Risk consulting: With the application of Basel II regulations for banks, there is considerable demand for tools and products that will allow banks to compute their capital adequacy ratios under the revised guidelines. The risk consulting groups of credit rating agencies would leverage the agencies understanding of credit risk to develop and provide the tools and data that banks would require. The products in this area include tools for internal ratings, operational risk evaluation, and overall capital calculation. 3. Funds research: Some CRAs have diversified from mutual fund ratings into mutual fund research. The services that are available under this head include fund rankings, performance attribution tools (to help users understand the reasons for funds performance), desktop tools, and fixed income research.

4. Advisory services: CRAs offer various kinds of advisory services, usually through dedicated advisory arms. Most of this is in the nature of developing policy frameworks, bid process management, public private partnership consulting, and creating an enabling environment for
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business in India and globally. 5. Knowledge Process Outsourcing: Some Indian CRAs (CRISIL and ICRA) have KPO arms that leverage their analytical skills and other process and manpower capabilities. These arms provide services to the CRAs affiliates in developed markets, and also to other clients outside India.

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CHAPTER 5-THE RATING PROCESS

Rating is a multilayered decision making process. The process of rating starts with a rating request from the issuer, and the signing of a rating agreement. The rating agreement has important clauses like confidentiality, agreement by the issuer to share information with the CRA for the purpose of assigning the rating and thereafter on an ongoing basis when the rating is under surveillance. The rating agency undertakes discussion with the management of the issuing entity. Discussions during a management meeting are wide-ranging, covering competitive position, strategy, financial policy, historical performance, and near- and long-term financial and business outlook. Discussions with company managements help rating analysts evaluate management capability and risk appetite, which is an important aspect of the evaluation. After discussion with the issuer's management, a report is prepared detailing the analyst teams assessment of the business risk, financial risk, and management risk associated with the issuer. 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. Drawing on the knowledge and expertise of the participants, the rating committee determines the rating. The process is an attempt to ensure objectivity of the rating, since the decision results from the collective thinking of a group of experts analysing the risks pertaining to the issuer vis-a-vis its competitors in the industry and markets in which they operate. On finalisation of a rating at the rating committee meeting, the rating decision is communicated to the issuer. As the decision to get an initial rating is at the issuer's discretion (except, in India, for public issues of debt), the global best practice is to allow the issuer to decide whether to accept the rating. If the issuer disagrees with the rating, it can also appeal for a fresh look at the rating assigned. The rating committee then discusses the information submitted; it may or may not decide to modify the rating, Depending on the facts of the case. If the rating is not changed and the issuer continues to disagree with the rating, it can choose not to accept the rating, which then does not get published. ANALYTICAL FRAMEWORK USED BY CRAS A credit rating is an opinion on the relative credit risk (or default risk) associated with the instrument being rated, where a failure to pay even one rupee of the committed debt service payments on the due dates would constitute a default. For most instruments, the process involves estimating the cash generation capacity of the issuer through operations (primary cash flows) in relation to its requirements for servicing debt obligations over the tenure of the instrument. The analysis is based on information obtained from the issuer, and on an understanding of the business environment in which the issuer operates; it is carried out within the framework of the rating agencys criteria. The analytical framework involves the analysis of business risk, technology risk, operational risk, industry risk, market risk, financial risk and management risk. Business risk analysis covers industry analysis; operating efficiency, market position of the company whereas financial risk covers accounting quality, existing financial position, cash flows and financial flexibility. Under management risk analysis an assessment is made of the competence and risk appetite of the management. In addition to the basic framework, rating agencies also have detailed criteria/methodologies for various industries which take into account the specific features of that industry. The CRA might also look at the sufficiency of other means of servicing debt in case the primary cash flows are insufficient: for instance, in a securitized instrument, the credit enhancement and structure will
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be examined, while in case of a guaranteed bond the credit strength of the guarantor could drive the rating. The quality of ratings is also affected by the timeliness of adjustment of the ratings. The issue is whether there should be aggressive rating changes such as downgrading a rating by several notches immediately in reaction to adverse news rather than responding to a fundamental change in creditworthiness. CRAs need to balance between the dual objectives of accuracy of ratings and their stability.

THE DETERMINANTS OF RATINGS

The default-risk assessment qnd quality rating assigned to an issue are primarily determined by three factors i) The issuer's ability to pay, ii) The strength of the security owner's claim on the issue, and iii) The economic significance of the industry and market place of the issuer..
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Ratio analysis is used to analyze the present and future earning power of the issuing corporation and to get insight into the strengths and weaknesses of the firm. Bond rating agencies have suggested guidelines about what value each ratio should have within a particular quality rating. Different ratios are favored by rating agencies. For any given set of ratios, different values are appropriate for each industry. Moreover, the values of every firm's ratios vary in a cyclical fashion through the ups and downs of the business cycle. To assess the strength of security owner's claim, the protective provisions in the indenture (legal instrument specifying bond owners' rights), designed to ensure the safety of bondholder's investment, are considered in detail. The factors considered in regard to the economic significance and size of issuer includes: nature of industry 'in which issuer is, operating (specifically issues like position in the economy, life cycle of the industry, labor situation, supply factors, volatility, major vulnerabilities, etc.), and the competition faced by the issuer (market share, technological leadership, production efficiency, financial structure, etc.)
RATING METHODOLOGY

Rating is a search for long-term fundamentals and the probabilities for changes in the fundamentals. Each agency's rating process usually includes fundamental analysis of public and private issuer-specific data, 'industry analysis, and presentations by the issuer's senior executives, statistical Institutions 'in India classification models, and judgement. Typically, the rating agency is privy to the issuer's short and long-range plans and budgets. The analytical framework followed for rating methodology is divided into two interdependent segments. D The first segment deals with operational characteristics and the second one with the financial characteristics. Besides, quantitative and objective factors; qualitative aspects, like assessment of management capabilities play a very
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important role in arriving at the rating for an instrument. The relative importance of qualitative and quantitative components of the analysis varies with the type of issuer. Key areas considered in a rating include the following: Business Risk : To ascertain business risk, the rating agency considers Industry's characteristics, performance and outlook, operating position (capacity, market share, distribution system, marketing network, etc.), technological aspects, business cycles, size and capital intensity. ii) Financial Risk : To assess financial risk, the rating agency takes into account various aspects of its Financial Management (e.g. capital structure, liquidity position, financial flexibility and cash flow adequacy, profitability, leverage, interest coverage), projections with particular emphasis on the components of cash flow and claims thereon, accounting policies and practices with particular reference to practices of providing depreciation, income recognition, inventory valuation, off-balance sheet claims and liabilities, amortization of intangible assets, foreign currency transactions, etc. iii) Management Evaluation: Management evaluation includes consideration of the background and history of the issuer, corporate strategy and philosophy, organizational structure, quality of management and management capabilities under stress, personnel policies etc. iv) Business Environmental Analysis : This includes regulatory environment, operating environment, national economic outlook, areas of special significance to the company, pending litigation, tax status, possibility of default risk under a variety of scenarios. i)

Rating is not based on a predetermined formula, which specifies the relevant variables as well as weights attached to each one of them. Further, the emphasis on different aspects varies from agency to agency. Broadly, the rating agency assures itself that there is a good congruence between assets and liabilities of a company and downgrades the rating if the quality of assets depreciates. The rating agency employs qualified professionals to ensure consistency and reliability. Reputation of the Credit Rating Agency creates confidence in the investor. Rating Agency earns its reputation by assessing the client's operational performance, managerial competence, management and organizational set-up and financial structure. It should be an independent company with its own identity. It should have no government interference. Rating of an instrument does not give any fiduciary status to the credit rating agency. It is desirqble that the rating be done by more than one agency for the same kind of instrument. This will attract investor's confidence in the rating symbol given. A rating is a quality label that conveniently summarizes the default risk of an issuer. The credibility of the issuer's , proposed payment schedule is complemented by
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the credibility of the rating agency. Rating agencies perform this certification role by exploiting the economies of scale in processing information and monitoring the issuer. There is an ongoing debate about whether the rating agencies perform an information role in addition to a certification role. Whether agencies have access to superior (private) information, or if agencies are superior processors of information; security ratings provide information to investors, rather than merely summarizing existing information. Empirical research confirms the information role of rating agencies by demonstrating that news of actual and proposed rating changes affects the price of issuer's securities. Most studies I document numerically larger price effects for downgrades than for upgrades, consistent with the perceived predilection,of management for delaying bad news.

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CHAPTER 6 - LIMITATIONS OF CREDIT RATINGS

Specifically, a credit rating, in the words of the CRAs, is: Not a recommendation to buy, hold or sell any shares, bonds, debentures or other instruments issued by the rated entity, or derivatives thereof. A rating is one of the many inputs that is used by investors to make an investment decision. Not Intended to measure many other factors that debt investors must consider in relation to risk - such as yield offered, liquidity risk, pre-payment risk, interest rate risk, taxation aspects, risk of secondary market loss, exchange loss risk, etc. Not a general-purpose credit or performance evaluation of the rated entity, unless otherwise specified. The rating is usually specific to the instrument and is not the rating of the issuer. Not an opinion on associate, affiliate or group companies of the rated entity, or on promoters, directors or officers of the rated entity. Not a statutory or non-statutory audit of the rated entity Not an indication of compliance or otherwise with legal or statutory requirements Not a guarantee against default of the rated instrument. Even the highest-rated instrument faces some risk of default, although the risks associated with this are lower than lowerrated instruments. 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 Agencies? 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 has suggested that markets do this information processing better
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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 e.g. 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 underpricing. 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 nonpublic 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.

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CHAPTER 7 - THE REGULATORY FRAMEWORK FOR CRAs IN INDIA

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. SEBIs 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: o Credible players enter this business (through stringent entry norms and eligibility criteria ) o CRAs operate in a manner that enables them to issue objective and fair opinions (through well-defined general obligations for CRAs) o There is widespread investor access to ratings (through a clearly articulated rating dissemination process). o The applicant should be registered as a company under the Companies Act, 1956 and possess a minimum network of Rs.5 crore. The following are some of the General Obligations specified in the CRA regulations. CRAs are amongst the very few market intermediaries for which such detailed operating guidelines have been prescribed under the regulations. 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 regulators right to inspect a CRA. An important feature of the regulation is that CRAs are prohibited from rating their promoters and associates. SEBI Code of conduct SEBIs code of conduct for CRAs addresses some of the basic issues relating to conflicts of interest. The Code of Conduct is designed to ensure transparent and independent functioning of CRAs. Some of the salient provisions of the Code of Conduct are: A CRA shall make all efforts to protect the interests of investors. A CRA shall at all times exercise due diligence, ensure proper care and exercise independent professional judgment in order to achieve and maintain objectivity and independence in the rating process. A CRA shall have in place a rating process that reflects consistent and international rating standards. A CRA shall keep track of all important changes relating to the client companies and shall develop efficient and responsive systems to yield timely and accurate ratings.

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Further a CRA shall also monitor closely all relevant factors that might affect the creditworthiness of the issuers. A CRA shall disclose its rating methodology to clients, users and the public. A CRA shall not make any exaggerated statement, whether oral or written, to the client either about its qualification or its capability to render certain services or its achievements with regard to the services rendered to other clients.

Provisions relating to conflict of interest Credibility is the cornerstone of acceptability of credit rating services in the market. SEBI has prescribed certain provisions in the Code of Conduct to ensure credible rating devoid of conflict of interest. The important ones are as follows. A CRA shall, wherever necessary, disclose to the clients, possible sources of conflict of duties and interests, which could impair its ability to make fair, objective and unbiased ratings. Further it shall ensure that no conflict of interest exists among any member of its rating committee participating in the rating analysis, and that of its client. A CRA or any of its employees shall not render, directly or indirectly, any investment advice about any security in the publicly accessible media. A CRA shall not offer fee-based services to the rated entities, beyond credit ratings and research. A CRA shall maintain an arms length relationship between its credit rating activity and any other activity. A CRA shall develop its own internal code of conduct for governing its internal operations and laying down its standards of appropriate conduct for its employees and officers in the carrying out of their duties within the CRA and as a part of the industry. Such a code may extend to the maintenance of professional excellence and standards, integrity, confidentiality, objectivity, avoidance of conflict of interests, disclosure of shareholdings and interests, etc. Such a code shall also provide for procedures and guidelines in relation to the establishment and conduct of rating committees and duties of the officers and employees serving on such committees. Despite maintaining a Chinese wall between advisory services and rating services criticism persists as rating and non-rating entities have common ownership and top management. Recognizing the merit in such criticism, CAREs Board decided to discontinue its advisory service business and their activities are confined to only credit rating and research activities. CRAs in general maintain that while non-rating services do pose conflict of interest challenges on one hand, revenues from other services reduce dependence on rating service revenues thereby enabling them to maintain objectivity and independence.

International Regulations IOSCO has formulated a Code of Conduct Fundamentals for the working of CRAs. The Code Fundamentals are designed to apply to any CRA and any person employed by a CRA in either in full time or part time capacity. The Code of Conduct focuses on transparency and disclosure in relation to CRA methodologies, conflicts of interest, use of information, performance and duties to the issuers and public, the role of CRA in structured finance
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transactions etc. It does not dictate business models or governance but rather seeks to provide the market with information to judge and assess CRA activities, performance and reliability. The IOSCO Code of Conduct broadly covers the following areas; Quality and integrity of the rating process This includes the measures to ensure quality of the rating process and monitoring and updating by the CRAs. CRAs independence and avoidance of conflicts of interest The procedures and policies to ensure the same. CRAs responsibilities to the investing public and issuers These address issues such as transparency and timeliness of ratings disclosure and the treatment of confidential information. Disclosure of the code of conduct and communication with market participants This requires CRAs to disclose to the public, inter alia, its code of conduct, how the code of conduct is in accordance with the IOSCO Principles regarding the activities of Credit Rating Agencies and the IOSCO Code of Conduct Fundamentals for Credit Rating Agencies and in case of deviation, reasons for the same.

It is observed that all SEBI regulated CRAs in India have framed their internal code of conduct, which have provisions, inter alia, of conflict of interest management, avoidance and disclosures of conflict of interest situations etc. and such provisions prescribed are by and large in accordance with the IOSCO Code of Conduct Fundamentals for CRAs. The internal code of conduct formulated by the CRAs is in addition to the Code of Conduct prescribed under the SEBI (CRA) Regulations 1999.

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CHAPTER 8 CONCLUSION

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Contents
CHAPTER 1 - INTRODUCTION ................................................................................................................ 2 CHAPTER 2 - ORIGIN ................................................................................................................................ 4 CHAPTER 3 - SYSTEMIC IMPORTANCE OF RATING AND RATING AGENCIES ........................... 6 CHAPTER 4 - FUNCTIONS AND APPROACHES OF CREDIT RATING AGENCIES ......................... 8 CHAPTER 5-THE RATING PROCESS .................................................................................................... 11 CHAPTER 6 - LIMITATIONS OF CREDIT RATINGS........................................................................... 15 CHAPTER 7 - THE REGULATORY FRAMEWORK FOR CRAs IN INDIA ........................................ 17 CHAPTER 8 CONCLUSION .................................................................................................................. 20

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