Bbs Credit Ratings

Credit RatingCredit Rating

Whenever an investor desires to invest in a debt Whenever an investor desires to invest in a debt instrument like a corporate debenture, Public instrument like a corporate debenture, Public Deposit or bond he normally has Deposit or bond he normally has two things in two things in his mind:his mind:

A. A. Whether the Company where he is putting Whether the Company where he is putting money money will pay the stated returnswill pay the stated returns regularly. regularly.

B. B. Whether or not the Company shall honour Whether or not the Company shall honour its commitment on maturityits commitment on maturity..

Now with so many companies in the market it Now with so many companies in the market it becomes difficult for the investor to decide becomes difficult for the investor to decide where he should put his money. where he should put his money. At this point credit rating comes to his rescue. At this point credit rating comes to his rescue.


• Credit rating is a symbolic Credit rating is a symbolic ( ( alphanumeric alphanumeric ) indicator of the ) indicator of the current opinion of the issuer to current opinion of the issuer to service the debt issued by a Company service the debt issued by a Company in timely fashion i.e. whether the in timely fashion i.e. whether the Company shall be Company shall be timely and regular timely and regular in payment of interest and also the in payment of interest and also the payment of principal on maturity. payment of principal on maturity.

Credit RatingCredit Rating• Points to be notedPoints to be noted• 1. The rating agency rates the debt or the instrument of the 1. The rating agency rates the debt or the instrument of the

Company and Company and not the Companynot the Company as a whole.as a whole.• 2. Rating given by a rating agency 2. Rating given by a rating agency cannotcannot be considered as a be considered as a

recommendation for the purchase or sale of the security of the recommendation for the purchase or sale of the security of the Company rated.Company rated.

• The probability that the rating given by the rating agency does The probability that the rating given by the rating agency does not comes out to be true is not comes out to be true is not zeronot zero. i.e. rating cannot be . i.e. rating cannot be foolproof)foolproof)

• 4. Rating agency carries out a detailed analysis of the Company 4. Rating agency carries out a detailed analysis of the Company from various angles only on the basis of the from various angles only on the basis of the published published informationinformation and and also information provided by the also information provided by the Company.Company.

• 5. It is left to the Company concerned whether it accepts the 5. It is left to the Company concerned whether it accepts the rating of the rating agency or not.rating of the rating agency or not.

Credit RatingCredit Rating• Method of Rating: The request has to come from

the Company

• After the request is made the employees of the rating agency visit the Company

• Obtain the necessary data & make a detailed study of following:-

• a. Business Angle : The assessment includes• Market Position of the Company’s products: • Demand for the Company’s products today and

their likely demand in future, • number of players • existing distribution channels, etc.

Credit RatingCredit Rating• b. Financial Angleb. Financial Angle: The financial angle is assessed by : The financial angle is assessed by

examining the financial statements. examining the financial statements. • Assessment of the Company is normally from the three Assessment of the Company is normally from the three

different angles; different angles; • the the present profitabilitypresent profitability and operating efficiency of the and operating efficiency of the

Company, Company, • the the liquidity positionliquidity position of the company and of the company and • thirdly the Company’s thirdly the Company’s long term solvencylong term solvency. The technique . The technique

of ratio analysis is normally employed for this purposeof ratio analysis is normally employed for this purpose

• Upon completion of this exercise the agency can get some Upon completion of this exercise the agency can get some idea about the idea about the strengths and weaknessesstrengths and weaknesses of the Company of the Company which is very useful in arriving at the final rating for the which is very useful in arriving at the final rating for the Company. Company.


• Operational Efficiency of the Company : Prospects of expansion and modernisation

• Availability of required raw material throughout the year

• Location of the plant• Plant’s proximity to various critical

inputs, • Capacity Utilisation etc.


• c. Management Angle:c. Management Angle: • The The track recordtrack record of the promoters of the promoters • Performance of the Performance of the other Companiesother Companies of the of the

same group.same group.• Corporate governance Assessment : Corporate governance Assessment :

Whether the Company is following Whether the Company is following such such practicespractices which are consistent with the which are consistent with the norms laid down by the regulator and takes norms laid down by the regulator and takes care of interests of investors, employees, care of interests of investors, employees, customers and general public at large. customers and general public at large.

• Assessment about the Assessment about the average age of the average age of the staffstaff of the Company and their of the Company and their trainingtraining

• NO FIXED FORMULA • There is no fixed mathematical formula where we can

put the results obtained from above and obtain a final rating.

• Some experts have tried to develop some kind of formula but such formulas cannot be applied to all situations

• Now after the final rating is arrived it is shown to the Company and it is only after the Company accepts the rating is made public.

• However the work of the rating agency does not end with that and it has to periodically monitor the rating of the Company.

• This is because new developments keep on taking place and hence it is the job of the rating agency to monitor these developments to enable it to revise the original rating. The revision can be upwards, downwards or no change from the original rating.

Is lower rating badIs lower rating bad

• What if a Co gets lower rating: Is it a bad What if a Co gets lower rating: Is it a bad signalsignal

• Many times the Many times the ambitious growth plansambitious growth plans of of Companies do result in lower credit rating. Companies do result in lower credit rating.

• To fund the expansion plans many companies To fund the expansion plans many companies resort to resort to more of debtmore of debt , and as debt increases , and as debt increases the credit profiles tend to weaken resulting in the credit profiles tend to weaken resulting in lower rating. lower rating.

• Globally companies like Unilever and Philip Globally companies like Unilever and Philip Morris have been comfortable with lower ratings. Morris have been comfortable with lower ratings.

• That is why there is a That is why there is a good business for Junk good business for Junk MarketMarket in the world or in developed markets in the world or in developed markets there is great interest in low rate papers. there is great interest in low rate papers.

Retail Loans and Credit Retail Loans and Credit RatingRating

• Credit Rating and Individual Credit ScoresCredit Rating and Individual Credit Scores• The retail loan segment has grown exponentially in The retail loan segment has grown exponentially in

the recent past.the recent past. From a 19 % growth rate in 1999 , From a 19 % growth rate in 1999 , the growth rate climbed up to 51 % in just five the growth rate climbed up to 51 % in just five yearsyears

• Retails loans mainly comprise of hosing loans, Retails loans mainly comprise of hosing loans, consumer durables loan, personal loan etc. consumer durables loan, personal loan etc.

• A study by FICCI on housing loans found that the A study by FICCI on housing loans found that the average borrower’s age was in mid thirties.average borrower’s age was in mid thirties.

• Another study with respect to auto loans has shown Another study with respect to auto loans has shown that almost 60 % of the new Car purchases are that almost 60 % of the new Car purchases are from bank loans and 35 % of the two wheelers are from bank loans and 35 % of the two wheelers are financed from bank loans. financed from bank loans.

• The percentage of housing loans financed through The percentage of housing loans financed through bank loans may still be higher.bank loans may still be higher.

Credit Rating and Individual Credit Rating and Individual Credit ScoresCredit Scores

• There is an urgent need for giving individual loan seekers a credit score.

• Such credit score helps to determine whether the individual in question should be advanced loan or not.

• According to ICRA the competition in the retail segment especially the housing segment is increasing amongst the lenders which can lead to the danger of lending to sub prime borrowers.

• Moreover certain changes have taken place in the Indian retail loan markets which have actually resulted in increase of default risk like :-


• (i) relaxation in the eligibility criteria whereby one can borrow much more with the same income that he would have done it a few years ago.

• (ii) introduction of floating interest rates also increase the risk of default. The risk however is the failure of the borrower to pay the installment when the rates of interest go up as the floating rates would also rise. So the bank’s should assess amongst other things the individual’s current and potential capacity to pay in both normal and abnormal conditions.


• Banks in India have been assessing the repayment capacity in the past too but such an exercise was being carried out without a sequential research.

• However the mounting NPAs, competition and pressures from RBI have forced many banks to rework their entire loan giving process is carried out.

• Questionnaire Method is quite popular• Bank has been using this method in

screening personal loan applicants. .

A simplified version of a questionnaire . Parentheses A simplified version of a questionnaire . Parentheses indicates the percentage of borrowers in each who indicates the percentage of borrowers in each who

subsequently defaultedsubsequently defaulted

Do you have?Do you have?• 1 or more telephones:1 or more telephones: (0.7)(0.7)• No telephone?No telephone? (7.0)(7.0)• Do you:Do you:• Own your home?Own your home? (0.7)(0.7)• Rent a House?Rent a House? (2.2)(2.2)• Rent a room?Rent a room? (7.3)(7.3)• How long did you spend in your last job?How long did you spend in your last job?

• 6 months?6 months? (3.2)(3.2)• 7 to 60 months?7 to 60 months? (1.5)(1.5)• More than 60 months?More than 60 months? (0.9)(0.9)• What is your marital status:What is your marital status:• Single?Single? (1.6)(1.6)• Married?Married? (1.0)(1.0)• Divorced?Divorced? (2.9)(2.9)

A simplified version of a questionnaire cont…A simplified version of a questionnaire cont…

• What is your monthly income:What is your monthly income:• Below 20,000 Below 20,000 (2.3)(2.3)• 20000 to 5000020000 to 50000 (1.1)(1.1)• More than 50000More than 50000 (0.7)(0.7)• What is your age:What is your age:• 25 or under?25 or under? (1.5)(1.5)• 26 to 39?26 to 39? (1.8)(1.8)• More than 40?More than 40? (1.0)(1.0)• How many members are there in your familyHow many members are there in your family::• OneOne (1.6)(1.6)• Two to seven?Two to seven? (1.1)(1.1)• Eight or more?Eight or more? (2.6)(2.6)• (Source: P.F. Smith, ‘Measuring Risk on Consumer (Source: P.F. Smith, ‘Measuring Risk on Consumer

Instalment Credit’ Management Science No.11, PP 327-Instalment Credit’ Management Science No.11, PP 327-340) 340)

A simplified version of a questionnaireA simplified version of a questionnaire

• The first question asks ‘Do you have: one of more The first question asks ‘Do you have: one of more telephone (0.7) or No Telephone (7). Figure given in telephone (0.7) or No Telephone (7). Figure given in the parenthesis show the percentage of loan defaulters. the parenthesis show the percentage of loan defaulters.

• Clearly the past data tells us that those individual Clearly the past data tells us that those individual borrowers who owned telephone had a much lesser borrowers who owned telephone had a much lesser chance of default than those who did not have a chance of default than those who did not have a telephone. telephone.

• Now suppose a borrower says ‘No Telephone’ to this Now suppose a borrower says ‘No Telephone’ to this question we give him a score of 7%. question we give him a score of 7%.

• In the same way a number of questions are asked and In the same way a number of questions are asked and their corresponding probabilities of default are noted. their corresponding probabilities of default are noted.

• For every loan seeker a total of these probabilities are For every loan seeker a total of these probabilities are calculated and then the bank can work out its calculated and then the bank can work out its own own index of default.index of default.

• Say an index of default for a particular bank can be not Say an index of default for a particular bank can be not to lend money to any borrower to lend money to any borrower if his score crosses x % if his score crosses x % (default risk).(default risk).

Analysis of data collectedAnalysis of data collected• Some banks go a step further and they putSome banks go a step further and they put weight on weight on

each of the parameterseach of the parameters too. too. • In India traditionally banks have relied more on the In India traditionally banks have relied more on the

income income of the individual and on the of the individual and on the age of the age of the borrowerborrower and therefore weightage given to these and therefore weightage given to these parameter must be higher in the Indian Context. parameter must be higher in the Indian Context.

• Let us now suppose a bank has only two parameters Let us now suppose a bank has only two parameters whereby it has to decide whether a borrower should whereby it has to decide whether a borrower should be given a loan or not. be given a loan or not.

• The first parameter being the The first parameter being the monthly income of loan monthly income of loan seeker ( say ‘a’)seeker ( say ‘a’) and second the and second the number of months number of months the loan seeker stayed in his last job ( say ‘b’)the loan seeker stayed in his last job ( say ‘b’)

• Let us now try to plot a graph between the two Let us now try to plot a graph between the two parameters on the basis of historical data parameters on the basis of historical data

• Every single individual who had taken the loan in the Every single individual who had taken the loan in the past, whether defaulting or not shall be represented past, whether defaulting or not shall be represented by a point on the graph. by a point on the graph.

Analysis of data collectedAnalysis of data collected• We then try to draw an arbitrary line, which We then try to draw an arbitrary line, which

separates the defaulters from non-defaulters;separates the defaulters from non-defaulters;• we may not be able to draw the dividing line we may not be able to draw the dividing line

exactly exactly • but roughly we may get the divider which but roughly we may get the divider which

represents an equation which shall be in our represents an equation which shall be in our case 4 a + b = X ; case 4 a + b = X ;

• where ‘a’ is the monthly income of the where ‘a’ is the monthly income of the borrower and ‘b’ is the number of months he borrower and ‘b’ is the number of months he spends in his last job. (Note take any two spends in his last job. (Note take any two values on this line say a= 4, then b shall be 8, values on this line say a= 4, then b shall be 8, the equation gives X= 4 x4 + 8 = 24) the equation gives X= 4 x4 + 8 = 24)

• Thus we can safety say that if X> 24 for any Thus we can safety say that if X> 24 for any borrower he/she is not likely to default borrower he/she is not likely to default

Analysis of data collectedAnalysis of data collected• This technique is called Multiple Discriminate This technique is called Multiple Discriminate

Analysis and is one of the many techniques used Analysis and is one of the many techniques used for rating purposes. for rating purposes.

• Other popular techniques are Linear Probability Other popular techniques are Linear Probability Method (LPM), Probit and Logit methods. Method (LPM), Probit and Logit methods.

• The LPM technique uses regression analysis with The LPM technique uses regression analysis with one of the variable being a dummy which is one of the variable being a dummy which is taken as dependent variable. Let us now examine taken as dependent variable. Let us now examine how the data on defaulters and non defaulter’s how the data on defaulters and non defaulter’s monthly income can be formulated into a model.monthly income can be formulated into a model.

• The following table borrowers with their monthly The following table borrowers with their monthly incomes. Out of these those which defaulted in incomes. Out of these those which defaulted in payment of loan are given number 0 and those payment of loan are given number 0 and those which did not default are given number 1. which did not default are given number 1.

• Monthly Income of the Borrower (X)Monthly Income of the Borrower (X)• Default (0) Default (0)

or Did Not Default (1) or Did Not Default (1)

• 80008000 00• 1600016000 11• 1800018000 11• 1100011000 00• 1200012000 00• 1900019000 11• 2000020000 11• 1500015000 11• 2200022000 11

Analysis of data collectedAnalysis of data collected

• We can now run a regression equation We can now run a regression equation with Dummy Variable ( 1 or 0) as with Dummy Variable ( 1 or 0) as dependent variable and monthly dependent variable and monthly income of the borrower as income of the borrower as independent variable and we get the independent variable and we get the following equation :following equation :

•

• Yi = - 0.808 + 0.00009412 XiYi = - 0.808 + 0.00009412 Xi• R2 = 0.75, ‘F’ as 21.33R2 = 0.75, ‘F’ as 21.33

Interpretation of data Interpretation of data collectedcollected

• InterpretationInterpretation: : • the Intercept is negative which is not possible we treat it the Intercept is negative which is not possible we treat it

as zero which shows that when the monthly income of the as zero which shows that when the monthly income of the borrower is zero, probability of his not defaulting is zero or borrower is zero, probability of his not defaulting is zero or he is sure to default. he is sure to default.

• The slope of 0.00009412 shows that with a unit (1 %) The slope of 0.00009412 shows that with a unit (1 %) increase in his monthly income the chance that he shall increase in his monthly income the chance that he shall not default in the payment rises by 0.009 %. not default in the payment rises by 0.009 %.

• R2 of 0.75 shows that monthly income explains the default R2 of 0.75 shows that monthly income explains the default characterstics of the borrower to the extend of 75 % or characterstics of the borrower to the extend of 75 % or only 25 % is the default probability not arising due to only 25 % is the default probability not arising due to monthly income and can be due to other factors like age, monthly income and can be due to other factors like age, marital status etc. marital status etc.

• F test of 21.33 shows that the relationship between the F test of 21.33 shows that the relationship between the two variables i.e. the default probability and the monthly two variables i.e. the default probability and the monthly income is statistically significant or we reject the null income is statistically significant or we reject the null hypothesis. hypothesis.

• Sensitivity AnalysisSensitivity Analysis : : • The method determines the likely probability of default by The method determines the likely probability of default by

the the corporate borrower. corporate borrower. • Here first the borrower is first asked to compute the Net Here first the borrower is first asked to compute the Net

Present Value( NPV) of his project. Present Value( NPV) of his project. • Then the banker usually estimates the sensitivity of the key Then the banker usually estimates the sensitivity of the key

variables or factors and if the sensitivity of the key factors is variables or factors and if the sensitivity of the key factors is found to be low, the bankers usually reject the loan. The found to be low, the bankers usually reject the loan. The following example makes it clear.following example makes it clear.

• Example : The proposed borrower has summarized his Example : The proposed borrower has summarized his proposal to the banker in the following manner : proposal to the banker in the following manner :

• Initial Outlay for the Project = Rs.12000 , Cash flows for Initial Outlay for the Project = Rs.12000 , Cash flows for four years = Rs.4500 p.a., four years = Rs.4500 p.a.,

• Cost of Capital which may be used as the discount rate = 14 Cost of Capital which may be used as the discount rate = 14 %. %.

• Project Life = 4 years , Scrap Value is nil. Show how will the Project Life = 4 years , Scrap Value is nil. Show how will the banker react to the proposal.banker react to the proposal.

Analysis of data collectedAnalysis of data collected

• Solution :Solution :The project’s NPV is calculated as follows :-The project’s NPV is calculated as follows :-• ⇒ ⇒ NPV = -12000 + 4500 x PVIFA ( 14,4) =NPV = Rs.1112NPV = -12000 + 4500 x PVIFA ( 14,4) =NPV = Rs.1112

• The banker will then calculate the sensitivity of Project’s NPV to different factorsThe banker will then calculate the sensitivity of Project’s NPV to different factors• (i) (i) Sensitivity with respect to Annual Cash flowsSensitivity with respect to Annual Cash flows : What a banker is interested : What a banker is interested

in knowing at what cash flow the NPV of the project shall be zero. This can be in knowing at what cash flow the NPV of the project shall be zero. This can be known by taking annual cash flow as ‘A’ in the NPV equation given above i.e. known by taking annual cash flow as ‘A’ in the NPV equation given above i.e.

• NPV = -12000 + ‘A’ x PVIFA ( 14,4) = 0 or ‘A’ = Rs.4118. But since the projected NPV = -12000 + ‘A’ x PVIFA ( 14,4) = 0 or ‘A’ = Rs.4118. But since the projected cash flow is Rs 4500 , even if it falls by Rs 382 it shall still mean NPV is not cash flow is Rs 4500 , even if it falls by Rs 382 it shall still mean NPV is not negative, but a fall more than that shall make it negative and this is what the negative, but a fall more than that shall make it negative and this is what the bankers don’t want. In other words the Annual Cash Flow has a sensitivity of bankers don’t want. In other words the Annual Cash Flow has a sensitivity of 382/4500 or 8.5 %.382/4500 or 8.5 %.

• (ii) (ii) Sensitivity with respect to initial outlaySensitivity with respect to initial outlay : Again the banker may feel that : Again the banker may feel that initial outlay may escalate and may affect the NPV and therefore a margin on initial outlay may escalate and may affect the NPV and therefore a margin on Initial Outlay must be calculated which is 9.4 % i.e. x % on Rs12000 =1112 , x = Initial Outlay must be calculated which is 9.4 % i.e. x % on Rs12000 =1112 , x = 9.4 %.9.4 %. even if the initial outlay of the project increases by 9.4 %, still the NPV continues to even if the initial outlay of the project increases by 9.4 %, still the NPV continues to

be positive territory.be positive territory. • Now it is for the banker to decide what shall be the acceptable level of sensitivity Now it is for the banker to decide what shall be the acceptable level of sensitivity

with respect to various factors.with respect to various factors.

Analysis of data collectedAnalysis of data collected• Expected LossExpected Loss : The bankers also use the technique of : The bankers also use the technique of

expected loss which is nothing but the mean or average expected loss which is nothing but the mean or average loss and is given by the product of the following three loss and is given by the product of the following three factors ; the money lent, probability of default and factors ; the money lent, probability of default and percentage of recovery in case of default. This can be percentage of recovery in case of default. This can be explained with the following example : Calculate the explained with the following example : Calculate the expected loss for AA+ borrower who wants to borrow Rs expected loss for AA+ borrower who wants to borrow Rs 100 crores from the bank. The default probability for AA+ 100 crores from the bank. The default probability for AA+ borrowers in the past has been 0.25 % only and the borrowers in the past has been 0.25 % only and the recovery rate from the defaulters has been 50 %. The recovery rate from the defaulters has been 50 %. The expected loss on a loan of Rs. 100 crores shall be 100 x expected loss on a loan of Rs. 100 crores shall be 100 x 0.0025 x 0.5 = Rs.12,50,000 . Expected loss is considered 0.0025 x 0.5 = Rs.12,50,000 . Expected loss is considered as a normal loss and many banks while granting loan make as a normal loss and many banks while granting loan make provisions for it .Clearly the actual loss can be more or less provisions for it .Clearly the actual loss can be more or less than the expected loss, any loss higher than the expected than the expected loss, any loss higher than the expected loss is called unexpected loss and for covering such loss is called unexpected loss and for covering such unexpected loss banks usually use the statistical approach unexpected loss banks usually use the statistical approach of building up a confidence level of building up a confidence level

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Bbs Credit Ratings