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SASMIRA’S INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH FINAL PROJECT ON A study on CREDIT RATINGS IN BANKS BY Kapil Ramesh Prabhu MMS 2011-13 SEMESTER 4 SPECIALISATION: Finance ROLL NO - 108

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Page 1: Kapil final project sem 4.doc

SASMIRA’S INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

FINAL PROJECT

ON

A study on CREDIT RATINGS IN BANKS

BY

Kapil Ramesh Prabhu

MMS 2011-13 SEMESTER 4

SPECIALISATION: Finance

ROLL NO - 108

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CREDIT RATING IN BANKS

A

PROJECT REPORT

ON

A Study on CREDIT RATING IN BANKS

IN PARTIAL FULFILLMENT OF THE REQUIREMENT OF

MASTER OF MANAGEMENT STUDIES

CONDUCTED BY

UNIVERSITY OF MUMBAI

THROUGH

SASMIRA’S INSTITUTE OF MANAGEMENT STUDIES AND RESEARCH

UNDER THE GUIDANCE OF

Dr. Amit Oak

SUBMITTED BY

Kapil Ramesh Prabhu

MMS/Finance

BATCH: 2011-2013

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DECLARATION

I, Mr. Kapil.Ramesh.Prabhu hereby declare that this project report is the record of

authentic work carried out by me during the period from January 2013 to April

2013 and has not been submitted to any other university or institute for the award of

any degree/diploma etc.

Signature

Name of the student

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CERTIFICATE OF THE GUIDE

This is to certify that Mr. Kapil.Ramesh.Prabhu of SASMIRA’s Institute of Management Studies

and Research has successfully completed the project work titled A Study on Credit Rating in

Banks in partial fulfillment of the requirement for Master in Management Studies as prescribed

by Mumbai University.

This project report is the record of authentic work carried out by him/her during the period from

January 2013 to April 2013 under my guidance.

Signature

Name of Faculty Guide

Date

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ACKNOWLEDGEMENT

It is my privilege to express my gratitude and respect to those who guided and inspired me in the

completion of this project.

A great deal of appreciation goes to the contribution of my faculty guide Dr.Amit Oak for his

guidance in writing this research project.

I am grateful to the Director, Faculties, Administrative staff and the Librarian of SASMIRA’s

Institute of Management Studies and Research for providing me with all the support required for

the successful completion of this project.

- Kapil Ramesh Prabhu.

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RESEARCH METHODOLOGY

The research work for this project was done by the secondary source.

SECONDARY SOURCES:

It was done through the extensive use of

Websites

Various Books

Reference papers

Articles

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EXECUTIVE SUMMARY

Credit rating is the overall credit worthiness of a borrower measured on predefined scale accessed by

independent agencies and inform to lender.

The role of credit rating has taken a front seat in the current scenario where companies are crashing

and economies are collapsing.

This has pushed me to pursue the subject of CREDIT RATING IN BANKS.

The credit rating aroused in the U.S out of desire by the growing number of investing classes, to

have more information on financial market.

The credit rating establishes the link between risk and return. The need is because of the factors

affecting an economy. There are many advantages of credit rating, both to the borrowers, investor’s

and the rating company.

CRISIL and ICRA are the both engaged in rating of banks on the parameter known as CAMEL.

The credit rating process is highly quantitative and qualitative.

The credit has large economic impact on developing nations as they are procyclical.

The observation is that rating service serves a purpose in financial market.

Improvement can be made by encouraging more accurate ratings and more timely ratings.

There should be more stringent criteria for frequency of rating updates, disclosure, transparency

and ethical practices.

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INDEX

Sr. No Particulars Pg. No

1 INTRODUCTION 09

2 DEFINITIONS 10

3 ORIGIN OF CREDIT RATING 13

4 IMPORTANCE OF CREDIT RATING 15

5 NATURE OF CREDIT RATING 17

6 ADVANTAGE OF CREDIT RATING 20

7 CREDIT RATING OF BANKS 23

8 DISADVANTAGES OF CREDIT RATING 24

9 CREDIT RATING AGENCIES 26

10 CREDIT RATING AGENCIES OF FINANCIAL SYSTEM 28

11 FUNCTIONS OF CREDIT RATING AGENCIES 30

12 CREDIT RATING PROCEDURES & METHODS 32

13 CREDIT RATING AGENCIES IN INDIA 35

14 CRISIL 38

15 CREDIT RATING PROCESS 49

16 ECONOMIC IMPACT OF RATING 50

17 CONCLUSION 53

18 RECOMMENDATIONS 54

19 BIBLOGRAPHY 55

INTRODUCTION

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Overall credit worthiness of a borrower measured on a predefined scale assessed by an

independent agency and informed to lenders is called Credit Rating. Thus credit rating is

an evaluation of the likelihood of a borrower to default on a loan. It is an expression of

credit worthiness based upon present financial condition and past credit history.

Borrowers are rated by lenders according to the borrower’s credit-worthiness or risk

profile. Credit ratings are expressed as later grades such as A-, B or C+. These ratings are

based on various factors such as borrower’s payment history, foreclosures, bankruptcies

and charge-offs. There is no exact science to rating a borrower’s credit, and different

lenders may assign different grades to the same borrower.

DEFINITIONS

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As per (SEBI):- “Rating” means an opinion regarding securities, expressed in

the form of standard symbols or in any other standardized manner, assigned by a

credit rating agency and used by the issuer of such securities, to comply with a

requirement specified by SEBI regulations.

A credit rating estimates the credit worthiness of an individual, corporation, or even

a country. It is an evaluation made by credit bureaus of a borrower’s overall credit

history. A credit rating is also known as an evaluation of a potential borrower's ability

to repay debt, prepared by a credit bureau at the request of the lender

ORIGIN OF CREDIT RATING

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The use of credit ratings arose in the U.S. out of the desire by the growing

investing class to have more information about the many new securities – especially

railroad bonds – that were being issued and traded. In the middle of the 19th century, the

U.S. railroad industry began expanding across the continent and into undeveloped

territories. The industry’s demand for capital exceeded the ability or willingness of

banks and direct investors to provide it. In order to reach a broader and deeper capital

market, railroads

and other corporations began raising new capital through the market for private corporate

bonds. The growth in the sale of many different corporate bonds to a broad investing

public generated the need for better, cheaper and more readily available information

about these debtors and debt securities. In response to this development, Henry Varnum

Poor first published in 1868 the “Manual of the Railroads of the United States”. His

publication contained operating and financial statistics for the major railroad companies,

and provided an independent source of information on the business conditions of these

corporate borrowers. John Moody took the process another step forward in 1909 by

issuing the first credit ratings in the United States

The first mercantile credit agency was set up in New York in1841 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 Moody’s Investor’s Service in1962. The

history of Moody’s can be traced back about 100 years ago. In 1900, John Moody laid

stone of Moody’s Investors Service and published his ‘Manual of Railroad Securities’

.

Early 1920’s saw the expansion of credit rating industry when the Poor’s Publishing

Company published its first rating guide in 1916. Subsequently Fitch Publishing

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Company and Standard Statistics Company were set up in 1924 and 1922 respectively.

Poor and Standard merged together in 1941 to form Standard and Poor’s which was

subsequently taken over by McGraw Hill in 1966. Between 1924 and 1970, no major

new rating agencies were set up. But since 1970’s, 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 credit- ability 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.

IMPORTANCE OF CREDIT RATING

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Credit ratings establish a link between risk and return. They thus provide a yardstick

against which to measure the risk inherent in any instrument. An investor uses the

ratings to assess the risk level and compares the offered rate of return with his expected

rate of return (for the particular level of risk) to optimise his risk-return trade-off.

The risk perception of a common investor, in the absence of a credit rating system,

largely depends on his familiarity with the names of the promoters or the

collaborators. It is not feasible for the corporate issuer of a debt instrument to offer

every prospective investor the opportunity to undertake a detailed risk evaluation. It is

very uncommon for different classes of investors to arrive at some uniform conclusion

as to the relative quality of the instrument. Moreover they do not possess the requisite

skills of credit evaluation.

Thus, the need for credit rating in today’s world cannot be over- emphasised. It is

of great assistance to the investors in making investment decisions. It also helps the

issuers of the debt instruments to price their issues correctly and to reach out to new

investors. Regulators like Reserve Bank of India (RBI) and Securities and Exchange

Board of India (SEBI) use credit rating to determine eligibility criteria for some

instruments. For example, the RBI has stipulated a minimum credit rating by an

approved agency for issue of commercial paper. In general, credit rating is expected to

improve quality consciousness in the market and establish over a period of time, a

more meaningful relationship between the quality of debt and the yield from it. Credit

Rating is also a valuable input in establishing business relationships of various types.

However, credit rating by a rating agency is not a recommendation to purchase or sale

of a security.

Investors usually follow security ratings while making investments. Ratings are

considered to be an objective evaluation of the probability that a borrower will default

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on a given security issue, by the investors. Whenever a security issuer makes late

payment, a default occurs. In case of bonds, non-payment of either principal or

interest or both may cause liquidation of a company. In most of the cases, holders of

bonds issued by a bankrupt company receive only a portion of the amount invested by

them.

Thus, credit rating is a professional opinion given after studying all available

information at a particular point of time. Such opinions may prove wrong in the

context of subsequent events. Further, there is no private contract between an investor

and a rating agency and the investor is free to accept or reject the opinion of the

agency. Thus, a rating agency cannot be held responsible for any losses suffered by the

investor taking investment decision on the basis of its rating. Thus, credit rating is an

investor service and a rating agency is expected to maintain the highest possible level

of analytical competence and integrity. In the long run, the credibility of rating agency

has to be built, brick by brick, on the quality of its services provided, continuous

research undertaken and consistent efforts made. The increasing levels of default

resulting from easy availability of finance, has led to the growing importance of the

credit rating. The other factors are:

i. The growth of information technology.

ii. Globalization of financial markets.

iii. Increasing role of capital and money markets.

iv. Lack of government safety measures.

v. The trend towards privatization.

vi. Securitization of debt.

NATURE OF CREDIT RATING

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1. Rating is based on information: Any rating based entirely on published

information has serious limitations and the success of a rating agency will depend, to a

great extent, on its ability to access privileged information. Cooperation from the

issuers as well as their willingness to share even confidential information are important

pre-requisites. The rating agency must keep information of confidential nature

possessed during the rating process, a secret.

2. Many factors affect rating: Rating does not come out of a predetermined

mathematical formula. Final rating is given taking into account the quality of

management, corporate strategy, economic outlook and international environment. To

ensure consistency and reliability a number of qualified professionals are involved in

the rating process. The Rating Committee, which assigns the final rating, consists of

specialised financial and credit analysts. Rating agencies also ensure that the rating

process is free from any possible clash of interest.

3. Rating by more than one agency: In the well developed capital markets, debt

issues are, more often than not, rated by more than one agency. And it is only natural

that ratings given by two or more agencies differ from each other e.g., a debt issue, may

be rated ‘AA+’ by one agency and ‘AA’ or ‘AA-’ by another. It will indeed be unusual

if one agency assigns a rating of AA while another gives a ‘BBB’

4. Monitoring the already rated issues: A rating is an opinion given on the basis

of information available at particular point of time. Many factors may affect the debt

servicing capabilities of the issuer. It is, therefore, essential that rating agencies

monitor all outstanding debt issues rated by them as part of their investor service. The

rating agencies should put issues under close credit watch and upgrade or downgrade

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the ratings as per the circumstances after intensive interaction with the issuers.

5. Publication of ratings: In India, ratings are undertaken only at the request of the

issuers and only those ratings which are accepted by the issuers are published. Thus,

once a rating is accepted it is published and subsequent changes emerging out of the

monitoring by the agency will be published even if such changes are not found

acceptable by the issuers.

6. Right of appeal against assigned rating: Where an issuer is not satisfied with

the rating assigned, he may request for a review, furnishing additional information, if

any, considered relevant. The rating agency will undertake a review and thereafter give

its final decision. Unless the rating agency had over looked critical information at the

first stage chances of the rating being changed on appeal are rare.

7. Rating of rating agencies: Informed public opinion will be the touchstone on

which the rating companies have to be assessed and the success of a rating agency is

measured by the quality of the services offered, consistency and integrity.

8. Rating is for instrument and not for the issuer company: The important thing

to note is that rating is done always for a particular issue and not for a company or the

Issuer. It is quite possible that two instruments issued by the same company carry

different ratings, particularly if maturities are substantially different or one of the

instruments is backed by additional credit reinforcements like guarantees. In many

cases, short-term obligations, like commercial paper (CP) carry the highest rating.

9. Rating not applicable to equity shares: By definition, credit rating is an

opinion on the issuers capacity to service debt. In the case of equity there is no pre-

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determined servicing obligation, as equity is in the nature of venture capital. So, credit

rating does not apply to equity shares.

10. Credit vs. financial analysis: Credit rating is much broader concept than

financial analysis. One important factor which needs consideration is that the rating is

normally done at the request of and with the active co-operation Of the issuer. The

rating agency has access to unpublished information and the discussions with the

senior management of issuers give meaningful insights into corporate plans and

strategies. Necessary adjustments are made to the published accounts for the purpose

of analysis. Rating is carried out by specialised professionals who are highly qualified

and experienced. The final rating is assigned keeping in view the number of factors.

11. Time taken in rating process: T The rating process is a fairly detailed

exercise. It involves, among other things analysis of published financial

information, visits to the issuers offices and works, ‘intensive discussion with the

senior executives of issuers, discussions with auditors, bankers, creditors etc. It also

involves an in-depth study of the industry itself and a degree of environment

scanning. All this takes time, a rating agency may take 6 to 8 weeks or more to

arrive at a decision. For rating short-term instruments like commercial paper (CP),

the time taken may vary from 3 to 4 weeks, as the focus will be more on short-term

liquidity rather than on long-term fundamentals. Rating agencies do not

compromise on the quality of their analysis or work under pressure from issuers for

quick results. Issuers are always advised to. approach the rating agencies sufficiently

in advance so that issue schedules can be adhered to.

ADVANTAGES OF CREDIT RATING

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Different benefits accrue from use of rated instruments to different class of investors or

the company. These are explained as under:

A. Benefits to Investors

1. Safety of investments. Credit rating gives an idea in advance to the investors about

the degree of financial strength of the issuer company. Based on rating he decides

about the investment. Highly rated issues gives an assurance to the investors of safety

of Investments and minimizes his risk.

2. Recognition of risk and returns. Credit rating symbols indicate both the returns

expected and the risk attached to a particular issue. It becomes easier for the investor to

understand the worth of the issuer company just by looking at the symbol because the

issue is backed by the financial strength of the company.

3. Freedom of investment decisions. Investors need not seek advise from the stock

brokers, merchant bankers or the portfolio managers before making investments.

Investors today are free and independent to take investment decisions themselves.

They base their decisions on rating symbols attached to a particular security. Each

rating symbol assigned to a particular investment suggests the creditworthiness of the

investment and indicates the degree of risk involved in it.

4. Wider choice of investments. As it is mandatory to rate debt obligations for every

issuer company, at any particular time, wide range of credit rated instruments are

available for making investment. Depending upon his own ability to bear risk, the

investor can make choice of the securities in which investment is to be made.

5. Dependable credibility of issuer. Absence of any link between the rater and rated

firm ensures dependable credibility of issuer and attracts investors. As rating agency

has no vested interest in issue to be rated, and has no business connections or links

with the Board of Directors. In other words, it operates independent of the issuer

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company, the rating given by it is always accepted by the investors.

6. Easy understanding of investment proposals. Investors require no analytical

knowledge on their part about the issuer company. Depending upon rating symbols

assigned by the rating agencies they can proceed with decisions to make investment in

any particular rated security of a company.

7. Relief from botheration to know company. Credit agencies relieve investors from

botheration of knowing the details of the company, its history, nature of business,

financial position, liquidity and profitability position, composition of management

staff and Board of Directors etc. Credit rating by professional and specialised analysts

reposes confidence in investors to rely upon the credit symbols for taking investment

decisions.

8. Advantages of continuous monitoring. Credit rating agencies not only assign

rating symbols but also continuously monitor them. The Rating agency downgrades or

upgrades the rating symbols following the decline or improvement in the financial

position respectively.

B. Benefits of Rating to the Company

A company who has got its credit instrument or security rated is benefited in the

following ways.

1. Easy to raise resources. A company with highly rated instrument finds it easy to

raise resources from the public. Even though investors in different sections of the

society understand the degree of risk and uncertainty attached to a particular security

but they still get attracted towards the highly rated instruments.

2. Reduced cost of borrowing. Investors always like to make investments in such

instrument, which ensure safety and easy liquidity rather than high rate of return. A

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company can reduce the cost of borrowings by quoting lesser interest on those fixed

deposits or debentures or bonds, which are highly rated.

3. Reduced cost of public issues. A company with highly rated instruments has to

make least efforts in raising funds through public. It can reduce its expenditure on

press and publicity. Rating facilitates best pricing and timing of issues.

4. Rating builds up image. Companies with highly rated instrument enjoy better

goodwill and corporate image inthe eyes of customers, shareholders, investors and

creditors. Customers feel confident of the quality of goods manufactured, shareholders

are sure of high returns, investors feel secured of their investments and creditors are

assured of timely payments of interest and principal.

5. Rating facilitates growth. Rating motivates the promoters to undertake expansion

of their operations or diversify their production activities thus leading to the growth of

the company in future. Moreover highly rated companies find it easy to raise funds

from public through new issues orthrough credit from banks and FIs to finance their

expansion activities.

6. Recognition to unknown companies. Credit rating provides recognition to

relatively unknown companies going for public issues through wide investor base.

While entering into market, investors rely more on the rating grades than on ‘name

recognition’.

C. Benefits to Intermediaries

Stock brokers have to make less efforts in persuading their clients to select an

investment proposal of making investment in highly rated instruments. Thus rating

enables brokers and other financial intermediaries to save time, energy costs and

manpower in convincing their clients.

CREDIT RATING OF BANKS

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CRISIL and ICRA both are engaged in rating of banks based on the following six

parameters also called CAMELS.

C - C stands for capital adequacy of banks. A bank need to maintain at least 10 %

capital against risky assets of the bank. A - A stands for asset quality. The loan is

examined to deter- mine non-performing assets. An asset/loan is considered non-

performing asset where either interest or principal is unpaid for two quarters or more.

Ratios like NPA to Net Advances, Adequacy of Provision & Debt Service Coverage

Ratio are also calculated to know exact picture of quality of asset of a bank.

M - M stands for management evaluation. Here, the efficiency and effectiveness of

management in framing plans and policies is examined. Ratios like RO!, Return on

Capital Employed (ROC E), Return on Assets (ROA) are calculated to comment upon

bank’s efficiency to utilise the assets.

L - L indicates liquidity position. Liquid and current ratios are determined to find out

banks ability to meet its short-term claims.

S - S stands for Systems and Control. Existing systems are studied in detail to

determine their adequacy and efficacy. Thus, the above six parameters are analysed in

detail by the rating agency and then final rating is given to a particular bank. Ratings

vary from A to D. Where A denotes financial, manage- rial and operational soundness

of a bank, and D denotes that bank is in financial crisis and lacks managerial expertise

and is facing operational problems.

DISADVANTAGES OF CREDIT RATING

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Credit rating suffers from the following limitations

1. Non-disclosure of significant information. Firm being rated may not provide

significant or material information, which is likely to affect the investor’s decision as to

investment, to the investigation team of the credit rating company. Thus any decisions

taken in the absence of such significant information may put investors at a loss.

2. Static study. Rating is a static study of present and past historic data of the

company at one particular point of time. Number of factors including economic,

political, environment, and government policies has direct bearing on the working of a

company. Any changes after the assignment of rating symbols may defeat the very

purpose of risk indicativeness of rating.

3. Rating is no certificate of soundness. Rating grades by the rating agencies are

only an opinion about the capability of the company to meets its interest obligations.

Rating symbols do not pinpoint towards quality of products or management or staff

etc. In other words rating does not give a certificate of the complete soundness of the

company. Users should form an independent view of the rating symbol.

4. Rating may be biased. Personal bias of the investigating team might affect the

quality of the rating. The companies having lower grade rating do not advertise or use

the rating while raising funds from the public. In such a case the investors cannot get

the true information about the risk involved in the instrument.

5. Rating under unfavorable conditions. Rating grades are not always

representative of the true image of a company. A company might be given low grade

because it was passing through unfavorable conditions when rated. Thus, misleading

conclusions may be drawn by the investors which hampers the company’s interest.

6. Difference in rating grades. Same instrument may be rated differently by the two

rating agencies because of the personal judgment of the investigating staff on

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qualitative aspects. This may further confuse the investors.

CREDIT RATING AGENCIES

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Credit rating agencies (subsequently denoted CRAs) specialize in analysing and

evaluating the creditworthiness of corporate and sovereign issuers of debt

securities. In the new financial architecture, CRAs are expected to become more

important in the management of both corporate and sovereign credit risk. Their role has

recently received a boost from the revision by the Basel Committee on Banking

Supervision (BCBS) of capital standards for banks culminating in Basel II.

The logic underlying the existence of CRAs is to solve the problem of the informative

asymmetry between lenders and borrowers regarding the creditworthiness of the

latter. Issuers with lower credit ratings pay higher interest rates embodying larger risk

premiums than higher rated issuers. Moreover, ratings determine the eligibility of debt

and other financial instruments for the portfolios of certain institutional investors

due to national regulations that restrict investment in speculative-grade bonds.

The rating agencies fall into two categories: (i) recognized; and (ii) non-recognized. The

former are recognized by supervisors in each country for regulatory purposes. In the

United States, only five CRAs of which the best known are Moody’s and Standard and

Poor’s (S&P) are recognized by the Security and Exchange Commission (SEC). The

majority of CRAs such as the Economist Intelligence Unit (EIU), Institutional Investor

(II), and Euromoney are "non- recognized". There is a wide disparity among CRAs.

They may differ in size and scope (geographical and sectorial) of coverage. There

are also wide differences in their methodologies and definitions of the default risk,

which renders comparison between them difficult.

Regarding their role vis-à-vis developing countries, the rating of country and sovereign is

particularly important. As defined by Nagy (1984), "Country risk is the exposure to a

loss in cross-border lending, caused by events in a particular country which are – at least

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to some extent – under the control of the government but definitely not under the control

of a private enterprise or individual". Under this definition, all forms of cross-border

lending in a country

i. whether to the government, a bank, a private enterprise or an individual – are

included. Country risk is therefore a broader concept than sovereign risk. The

latter is restricted to the risk of lending to the government of a sovereign nation.

ii. However, sovereign and country risks are highly correlated as the government is

the major actor affecting both. Rare exceptions to the principle of the sovereign

ceiling – that the debt rating of a company or bank based in a country cannot

exceed the country’s sovereign rating – do occur.

The failure of big CRAs to predict the 1997–1998 Asian crisis and the recent

bankruptcies of Enron, WorldCom and Parmalat has raised questions concerning the

rating process and the accountability of CRAs and has prompted legislators to scrutinize

rating agencies. This report gives an overview of the sovereign credit rating

industry: (i) analyses its impact on developing countries; and (ii) assesses some of the

CRAs' shortcomings in the context of concerns that have recently been raised.

CREDIT RATING AGENCIES IN THE FINANCIAL SYSTEM

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A. Asymmetry of information and CRAs as "opinion" makers

A credit rating compresses a large variety of information that needs to be known about

the creditworthiness of the issuer of bonds and certain other financial instruments. The

CRAs thus contribute to solving principal agent problems by helping lenders "pierce the

fog of asymmetric information that surrounds lending relationships and help borrowers

emerge from that same fog"1.

CRAs stress that their ratings constitute opinions. They are not a recommendation to buy,

sell or hold a security and do not address the suitability of an investment for an investor.

Ratings have an impact on issuers via various regulatory schemes by determining the

conditions and the costs under which they access debt markets. Regulators have

outsourced to CRAs much of the responsibility for assessing debt risk. For investors,

ratings are a screening tool that influences the composition of their portfolios as well as

their investment decisions.

B. Credit ratings and Basel II

Directive Regulatory changes in banks’ capital requirements under Basel II have resulted

in a new role to credit ratings. Ratings can be used to assign the risk weights

determining minimum capital charges for different categories of borrower. Under the

Standardized Approach to credit risk, Basel II establishes credit risk weights for each

supervisory category which rely on "external credit assessments" . Moreover, credit

ratings are also used for assessing risks in some of the other rules of Basel II.

The importance of ratings-based regulations is particularly visible in the United States,

where it can be traced back to the 1930s. These regulations not only affect banks but

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also insurers, pension funds, mutual funds and brokers by restricting or prohibiting the

purchase of bonds with "low" ratings. Examples are:

(i) non-investment grade or speculative-grade ratings easing the issuance

conditions or disclosure requirements for securities carrying a "satisfactory"

rating; and

(ii) an investment-grade rating.While ratings-based regulations are less common in

Europe, they are part of the new Capital Requirements through the EU that will

implement Basel II.

FUNCTIONS OF CREDIT RATING AGENCY

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A credit rating agency serves following functions:

1. Provides unbiased opinion: An independent credit rating agency is likely to

provide an unbiased opinion as to relative capability of the company to service debt

obligations because of the following reasons:

i. It has no vested interest in an issue unlike brokers, financial intermediaries

ii. Its own reputation is at stake.

2. Provides quality and dependable information:. A credit rating agency is in a

position to provide quality information on credit risk which is more authenticate and

reliable because:

i. It has highly trained and professional staff who has better ability to assess risk.

ii. It has access to a lot of information which may not be publicly available.

3. Provides information at low cost: Most of the investors rely on the ratings

assigned by the ratings agencies while taking investment decisions. These ratings are

published in the form of reports and are available easily on the payment of negligible

price. It is not possible for the investors to assess the creditworthiness of the

companies on their own.

4. Provide easy to understand information: Rating agencies first of all gather

information, then analyse the same. At last these interpret and summarise complex

information in a simple and readily understood formal manner. Thus in other words,

information supplied by rating agencies can be easily understood by the investors.

They need not go into details of the financial statements.

5. Provide basis for investment: An investment rated by a credit rating enjoys

associated with a particular rated issue while investing money in them.

6. Healthy discipline on corporate borrowers: Higher credit rating to any credit

investment enhances corporate image and builds up goodwill and hence it induces a

healthy/ discipline on corporate.

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7. Formation of public policy: Once the debt securities are rated

professionally, it would be easier to formulate public policy guidelines as to the

eligibility of securities to be included in different kinds of institutional port-folio.

CREDIT RATING PROCEDURES AND METHODS

A. Quantitative and qualitative methods

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The processes and methods used to establish credit ratings vary widely among

CRAs. Traditionally, CRAs have relied on a process based on a quantitative and

qualitative assessment reviewed and finalized by a rating committee. More recently,

there has been increased reliance on quantitative statistical models based on publicly

available data with the result that the assessment process is more mechanical and

involves less reliance on confidential information. No single model outperforms all

the others. Performance is heavily influenced by circumstances.

A sovereign rating is aimed at "measuring the risk that a government may default on its

own obligations in either local or foreign currency. It takes into account both the ability

and willingness of a government to repay its debt in a timely manner.3" The key

measure in credit risk models is the measure of the Probability of Default (PD) but

exposure is also determined by the expected timing of default and by the Recovery Rate

(RE) after default has occurred:

• Standard and Poor's ratings seek to capture only the forward-looking probability of

the occurrence of default. They provide no assessment of the expected time of default or

mode of default resolution and recovery values;

• By contrast, Moody's ratings focus on the Expected Loss (EL) which is a function of

both Probability of Default (PD) and the expected Recovery Rate (RE). Thus EL = PD

(1- RE); and

• Fitch's ratings also focus on both PD and RE (Bhatia, 2002). They have a more

explicitly hybrid character in that analysts are also reminded to be forward-looking and

to be alert to possible discontinuities between past track records and future trends.

The credit ratings of Moody's and Standard and Poor's are assigned by rating committees

and not by individual analysts. There is a large dose of judgement in the committees’

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final ratings. CRAs provide little guidance as to how they assign relative weights to each

factor, though they do provide information on what variables they consider in

determining sovereign ratings. Identifying the relationship between the CRAs' criteria

and actual ratings is difficult, in part because some of the criteria used are neither

quantitative nor quantifiable but qualitative. The analytical variables are interrelated and

the weights are not fixed either across sovereigns or over time. Even for quantifiable

factors, determining relative weights is difficult because the agencies rely on a large

number of criteria and there is no formula for combining the scores to determine ratings.

In assessing sovereign risk, CRAs highlight several risk parameters of varying

importance:

(i) economic; (ii) political; (iii) fiscal and monetary flexibility; and (iv) the debt burden .

Economic risk addresses the ability to repay its obligations on time and is a function of

both quantitative and qualitative factors. Political risk addresses the sovereign's

willingness to repay debt. Willingness to pay is a qualitative issue that

distinguishes sovereigns from most other types of issuers. Partly because creditors have

only limited legal redress, a government can (and sometimes does) default selectively on

its obligations, even when it possesses the financial capacity for debt service. In

practice, political risk and economic risk are related. A government that is unwilling to

repay debt is usually pursuing economic policies that weaken its ability to do so.

Willingness to pay, therefore, encompasses the range of economic and political factors

influencing government policy. Broadly speaking, the economic variables aim at

measuring three types of performance:

(i) measures of domestic economic performance; (ii) measures of a country's external

position and its ability to service its external obligations; and (iii) the influence

of external developments. Bhatia (2002), notes that CRAs’ analyses prior to the Asian

financial crisis focused on traditional macroeconomic indicators with limited emphasis

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on contingent liability and international liquidity considerations. Moreover, private

sector weaknesses were not included in the analyses of sovereign rating.

In practice, a small number of variables such as: (i) GDP per capita; (ii) real GDP growth

per capita; (iii) the Consumer Price Index (CPI); (iv) the ratio of government fiscal

balance to GDP; and (v) government debt to GDP have a large impact on credit ratings.

The relationship between these indicators and Standard and Poor's ratings are illustrated

in figures 1-5 of Annex 1. By and large: (i) higher GDP per capita leads to higher

ratings; higher CPI inflation to lower ratings, the lower the rating, the lower the

government balance as a ratio to GDP; and

(ii) higher fiscal deficits and government debt in relation to GDP to lower ratings.

CREDIT RATING AGENCIES IN INDIA

CREDIT RATING AGENCIES IN INDIA In India, at present, there are four

credit Rating Agencies:

i) Credit Rating and Information Services of India Limited (CRISIL).

ii) Investment Information and Credit Rating Agency of India Limited

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(ICRA).

iii) Credit Analysis and Research Limited (CARE).

iv) Duff and Phelps Credit Rating of India (Pvt.) Ltd. CRISIL : This

was set-up by ICICI and UTI in 1988, and rates debt instruments.

Nearly half of its ratings on the instruments are being used. CRISIL's

market share is around 75%. It has launched innovative products for credit

risks assessment viz., counter party ratings and bank loan ratings.

CRISIL rates debentures, fixed deposits, commercial papers,

preference shares and structured obligations. Of the total value of

instruments rated, debentures' accounted for 31.196, fmed deposits for

42.3% and commercial paper 6.6%. CRISIL publishes CRISIL rating in

SCAN that is a quarterly publication in Hindi and Gujarati, besides English.

CRISIL evaluation is carried out by professionally qualified persons and

includes data collection, analysis and meeting with key personnel in

the company to discuss strategies, plans and other issues that may

effect ,evaluation of the company. The rating ,process ensur ensures

confidentiality. , Once . - the company decides to use rating, CRISIL is

obligated to monitor the rating over the life of the debt instrument.

ii) ICRA : ICRA was promoted by IFCI in 1991. During the year 1996-

97, ICRA rated 261 debt instruments of manufacturing companies,

finance companies and financial institutions equivalent to Rs. 12,850 crore

as compared to

293 instruments covering debt volume of Rs. 75,742 crore in 1995-96. This

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showed a decline of 83.0% over the year in the volume of rated debt

instruments. Of the total amount rated cumulatively until March-end 1997,

the share in terms of number of instruments was 28.5% for debentures

(including long ternr'instruments), 49.4% for Fixed Deposit programme

(including medium- term instruments), and

22.1% for Commercial Paper Programme (including short- term

instmments). The corresponding figures of amount involved for these

three broad rated categories was 23..8% for debentures, 52.2% for fixed

deposits, and 24.0% for

Commercial Paper.

The factors that ICRA takes into consideration for rating depend on

the nature of borrowing entity. The inherent protective factors,

marketing strategies, competitive edge, competence and effectiveness

of management, human resource development policies and practices,

hedging of risks, trends in cash flows and potential liquidity, financial

flexibility, asset quality and past record of servicing of debt as well as

government policies affecting the industry are examined.

Besides determining the credit risk associated with a debt instrument,

ICRA has also formed a group under Earnings Prospects and Risk

Analysis (EPRA). Its goal is to provide authentic information on the

relative quality of the equity. This requires examination of almost all

parameters pertaining to the fundamentals of the company including

relevant sectoral perspectives. This qualitative analysis is reinforced and

completed by way of the unbiased opinion and informed perspective of

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one analyst and wealth of judgement of committee members.

ICRA opinions help the issuing company to broaden the market for

their equity. As the name recognition is replaced by objective opinion,

the lesser know compapies are also able to access the equity market.

iii) CARE : CARE is a credit rating and information services company

promoted by IDBI jointly with investment institutions, banks and

finance companies. The company commenced its operations in October

1993. 'In January

1994, CARE commenced publication of CAREVIEW, a quarterly

journal of CARE ratings. In additioh to the rationale of all accepted

ratings, CAREVIEW often carries special features of interest to issuers of

debt instruments, investors and other market players.

CRISIL

CRISIL is India's leading Ratings, Research, Risk and Policy Advisory company.

At the core of CRISIL are its unimpeachable credibility and unmatched analytical rigour.

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Leveraging these core strengths CRISIL delivers opinions and solutions that:

» Make markets function better, and,

» Help clients mitigate and manage their business & financial risks

» Help shape public policy.

CRISIL offers domestic and international customers a unique combination of local

insights and global perspectives, delivering independent information, opinions and

solutions that help them make better informed business and investment decisions,

improve the efficiency of markets and market participants, and help shape infrastructure

policy and projects. Its integrated range of capabilities includes credit ratings; research

on India's economy, industries and companies; investment research outsourcing; fund

services; risk management and infrastructure advisory services more ».

CRISIL's majority shareholder is Standard & Poor's, the world's foremost provider of

independent credit ratings, indices, risk evaluation, investment research and data.

Values

Today, CRISIL inspires trust and confidence across industry for upholding values that

serve as tenets across the Group Companies. Epitomising the collective character of our

people, these core values have been instrumental in delivering us success.

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Our commitment, analytical rigour and passion for innovation are exemplified by the

thought leadership provided by our Centres of Excellence. Dedicated teams for

innovative products and methodologies across businesses repeatedly and regularly create

new industry standards.

At the core of our credibility, assiduously built over the years, are our unimpeachable

integrity and independence of individual thinking. Objectivity, neutrality of views and

opinions backed by rigour of analysis are encouraged and rewarded internally, and

appreciated by clients.

» Analytical Rigour

» Independence

» Integrity

» Innovation

» Commitment

Analytical Rigour

The service offerings are underlined by analytical rigour. We blend in-depth conceptual

understanding – the science of building analytical frameworks – with the art of

evaluation.

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CRISIL combines an extensive knowledge base, understanding of the dynamics of

business and the market place, expertise, judgment and experience to offer world-class

solutions to clients.

Policy level assignments in the area of Infrastructure Advisory are but one example of

this.

Independence

We pride on being non-partisan and unbiased.

culture fosters objectivity and neutrality of views and opinions.

Independence and objectivity are ingrained in our processes and call for a participatory

approach, individual thinking and transparency for arriving at logical conclusions.

Integrity

The credibility in the market place is the result of unimpeachable integrity, honesty and

transparency in our work and dealings.

The people are characterised by a strong sense of fairness and ethics. CRISIL seeks to

become the benchmark on integrity by adopting the best professional practices regarding

client confidentiality, integrity of analysis and lack of bias

Innovation

The dedicated Centres of Excellence provide thought leadership. The core teams lead the

way by developing and sharing insights from the extensive corpus available, building

innovative analytical frameworks and developing new methodologies and products in

line with requirements of the market place.

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Commitment

They are committed to…

» Setting standards for integrity, analytical rigour and best practices in the marketplace

» Consistently providing value to constituents through analytically relevant and reliable

opinions and solutions

» Upholding independent evaluation processes and a non-partisan, unbiased and fearless

approach to functioning

What they do?

At this important milestone, we reflect on our journey thus far and look into the horizon

beyond.

We began our journey as India's first rating agency. Today, we are a diversified global

analytical platform with leadership positions in the ratings, research and advisory

domains. Along the way, our growth has been closely intertwined with India's

development milestones.

We started in 1987 as a credit rating agency, at a time when lending rates in India were

fixed, and there was, therefore, little demand for credit ratings. We firmly established

ourselves as the country's leading rating agency, respected for our fiercely independent,

highly credible, and analytically rigorous views. Shouldering the mantle of a pioneer and

a market leader, we facilitated the development of India's credit market and built investor

confidence in our risk assessment capabilities.

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India's transformation into a market-led economy greatly increased its need for capital,

and required extensive reforms and institution building. Accordingly, we diversified into

the infrastructure advisory and business research domains, and quickly built up a

reputation for independent, reliable and incisive information, research, models and

advisory services. Today, our services are key inputs in informed decision-making and

the shaping of public policy in India.

With increasing globalisation, we also focused on making our income streams more

global. We acquired Irevna, a pioneer in the investment research outsourcing space;

Irevna has since been voted No.1 in highend investment research and analytics

outsourcing by the US-based Brown and Wilson Group two years in a row in 2006 and

2007. We have a thriving business that meets increasing global demand for better

understanding of the Indian business environment, through the services offered by our

research and advisory groups.

Guided by our core values of integrity, independence, innovation, analytical rigour and

commitment, we are proud to have built a globally-acknowledged institution of repute

over these 20 years. We have facilitated the setting up of credit rating agencies in several

countries around the world. Our association and integration with Standard & Poor's has

further enhanced our capabilities and opened up newer vistas of opportunity, for our

businesses and people.

The macro environment trends, both in India and globally, present myriad business

opportunities. At a youthful 20, we are ideally positioned to service the needs of our

expanding client base by maintaining our focus on our mission:

» Making markets function better

» Helping clients manage and mitigate business and financial risks

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» Shaping public policy

CRISIL GROUP businesses:

» Ratings

» Research

» Advisory

Ratings

CRISIL Ratings

CRISIL Ratings is the only ratings agency in India to operate on the basis of sectoral

specialisation. It reflects our sharpness of analysis, the responsiveness of the process and

the large-scale dissemination of opinion.

CRISIL Ratings plays a leading role in the development of the debt markets in India.

The Rating Criteria & Product Development Centre, responsible for policy research, new

product development and ratings' quality assurance, has developed new ratings

methodologies for debt instruments and innovative structures across sectors.

CRISIL Ratings provides technical know-how to clients worldwide. We have helped set

up ratings agencies in Malaysia (RAM), Israel (MAALOT) and in the Caribbean.

Research

CRISIL Research is India's largest independent integrated research house providing

accurate and reliable research, analysis and forecasts on the Indian economy, industries

and companies to over 500 Indian and international clients across financial, corporate,

consulting and public sectors.

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CRISIL Research leverages on its unique, integrated research platform and capabilities

spanning the entire economy-industry-company spectrum to deliver superior perspectives

and insights to its clients, through both, subscription products and customised solutions.

CRISIL Research also offers consistent, high quality financial data analysis to users

within and outside the CRISIL group, enhancing the efficacy of the conventional

financial analysis frameworks adopted in the marketplace.

Fund Services

CRISIL FundServices is India's leading provider of fund evaluation services and risk

solutions to the mutual fund industry.

Through innovative analytics, benchmarks and analytical tools, CRISIL FundServices

plays a significant role in shaping investor confidence and facilitating the introduction of

best practices in the mutual fund industry.

Widely reputed as the industry standard, CRISIL Fund Services is the official provider of

valuation tools and market benchmarks.

Economic Research

The Centre for Economic Research is uniquely positioned to provide benchmarks and

analyses for India's policy and business decision makers.

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Manned by a team of senior economists, the Centre applies economic principles to live

business applications, creating conceptual and contextual linkages that are unique to

CRISIL.

The Centre also works with other CRISIL businesses, contributing to both the range and

depth of products, services and consulting assignments that CRISIL offers.

Investment Research Outsourcing

CRISIL added equity research to its wide canvas of work, by acquiring Irevna, a leading

global equity research and analytics company.

Irevna, a division of CRISIL, provides high-end customised equity research and

analytics, and knowledge process outsourcing, to the world's leading financial

institutions, investment banks, private equity firms and consulting companies, helping

them achieve sustainable competitive advantage.

Irevna offers investment research services to the world's leading investment banks and

financial institutions. Founded in 2001, Irevna pioneered the 'outsourced research'

concept, where the firm helps large financial institutions to carry out investment

research, at a time when accepted wisdom did not consider this possible.

Infrastructure Advisory

Our Infrastructure Advisory enhances CRISIL's franchise in the areas of policy-making

and economic development. Our spectrum of activities includes catalysing economic

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development through creation of appropriate policy frameworks, sector reforms,

regulatory support, project structuring and global competitive bid process management

for large and complex projects.

CRISIL Infrastructure Advisory blends the best global practices with analytical

excellence and a deep understanding of the local environment to provide policy,

regulatory and transaction level advice to governments and leading organisations across

sectors.

We work closely with our clients to facilitate an environment for public-private

partnerships and ensure the success of projects undertaken.

Investment and Risk Advisory

CRISIL Risk Solutions business provides integrated risk management solutions and

advice to Banks and Corporates by leveraging the experience and skills of CRISIL in the

areas of credit and market risk.

Taking cognisance of the market needs for integrated solutions that quantify and manage

complex risks, CRISIL Risk Solutions uses cutting-edge research and

methodologies. Also, the Group brings together the experience of all business teams to

offer modular or integrated solutions and advisory services that are customised to meet

client needs.

How they do it ?

At the core of our success are our unimpeachable credibility and unmatched analytical

rigour.

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CRISIL is a professionally managed company. It has adopted the best global practices

for corporate governance, under the active guidance of a visionary Board of Directors

comprising distinguished, independent professionals of proven competence and integrity.

» Focus on Human Capital

» Technologically oriented

Focus on Human Capital

Our people are our key assets. CRISIL has an unrivalled skill base spanning its business

areas. Functional skills include financial modeling, risk modeling, credit and equity

research, sector-specific research, policy and transaction advisory, and database

management, among others. A strong contextual understanding of business and markets

underpins the application of these skills. CRISIL encourages a value-driven and

performance-based culture, which attracts the best talent from the marketplace.

On a consolidated basis, total headcount in the CRISIL group increased to 1902 till July

2008. The growth in headcount was primarily to meet the growing demand for talented

people across CRISIL businesses.

As a Standard & Poor's Company, CRISIL faces the challenges of crosscultural

communication. The shift being an India-centric workforce to global workforce has

brought with several advantages as well, for its employees.

CRISIL is technologically oriented, with a view to

» Propel CRISIL to Leadership Position

» Mesh business areas and applications using IT capabilities to create a seamless end-

user experience

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» Empower Businesses to function anytime, anywhere

» Provide Business Process Efficiency to Clients of CRISIL

Our Technology Experience is diverse

» Infrastructure Management

» Management of heterogeneous infrastructure – Microsoft, Sun, Digital -- Management

of Wide Area Network – Voice & Data

-- Providing 24x365 access of Business Applications through Citrix

» Software Solutions -- Varied experience in application development ranging from

Work process automation to product development

-- Possess internal resources in varied technologies like VB, VC, ASP, Java, Oracle, SQL

Server, XML

-- Development and Management of diverse applications ranging from real-time news to

electronic desktop products

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ECONOMIC IMPACT OF RATINGS

Another major policy concern regards the impact of ratings on capital flows and the

overall economic performance of developing countries. Critics of the agencies argue that

ratings have a large economic impact because they are procyclical. They claim that

ratings increase the magnitudes of the business cycles because sovereigns are upgraded

during expansionary periods and downgraded contractionary periods. Moody’s,

Standard & Poor’s, and Fitch all claim to rate with a view across the business cycle, and

therefore their ratings are not significantly affected by purely cyclical influences.

The foundation for this policy concern is the economic relationship between credit

ratings

– plus changes in those ratings – and overall economic growth. If accurate ratings can

come out ahead of movements in the financial markets, the ratings can be very useful in

curbing or dampening the current direction of capital. During an economic expansion,

hot money can travel quickly into an emerging market country. A downgrade during this

expansionary period would have a sobering effect on exuberant expectations, and in turn

this would reduce the likelihood of a country experiencing a boom-bust cycle. The same

is true for a ratings upgrade during an economic contraction. The upgrade would likely

reduce capital outflows and help the country to finance their recession with lower interest

rates.

Conversely, if the ratings are inaccurate or are behind financial markets, the speed of

capital flows will likely increase and exacerbate the cycle. A downgrade during a period

of contraction in developing countries will hurt businesses from gaining trade credits.

Portfolio managers may be forced to shed their holdings of the downgraded debt due to

legal requirements or investment policies. These effects are greatly accelerated once the

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important threshold of investment grade rating has been crossed.

An upgrade during expansion will also speed up capital – this time an inflow – and may

create a dangerous level of over-lending to the sovereign. Over-lending is a possible

explanation to Mora’s (2001) conclusion that higher ratings have led to a higher

probability of a crash once other factors are controlled for.

Reisen (2002) believes that agencies are, in fact, behind markets because the agencies

primarily use publicly available data in making their ratings. By only using public

information, the agencies will remain behind the markets if the markets follow the

strong- form efficient market hypothesis. The transition matrices in Tables 8 and 9 show

the ratings movement after one year. The first matrix is during the 1991 recession while

the second matrix is during the 1998 expansion. Although not conclusive, we see a

greater percentage of downgrades during the recession, especially from ratings at and

below BBB.

The Asian Crises is one of the most frequently cited examples of rating agencies having

been procyclical. From June of 1997 to November of 1998 several Asian countries

received downgrades ranging from four to eight levels. Critics argue that the agencies

should have foreseen the economic problems and downgraded the countries before and

not during the crisis. The agencies responded by arguing that only after start of the crisis

did the ability and willingness of the countries deteriorate substantially.

Empirical evidence on whether ratings agencies are indeed procyclical have been mixed.

Ferri, Lui and Stiglitz (1999) concluded that rating agencies are procyclical. Based on

Cantor and Packer’s paper of sovereign rating determinants, Ferri, Lui and Stiglitz used a

sample of ten countries from 1989-1999 to create a model to explain ratings. The

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outcome was that before the crisis, ratings on the East Asian countries were on average

higher than those based on a model of economic fundamentals. After the crisis the

ratings were much worse than what their model predicted. Korea and Thailand which

were given ratings of Ba1 (the top speculative grade for Moody's) should have never

have fallen below investment grade (Baa3 lowest investment grade for Moody's)

according to the model. The authors concluded that the rating agencies must have given

more weight toward the qualitative factors in the agencies’ assessments and these

qualitative factors are what cause the procyclical nature.

CONCLUSION

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Ratings agencies do serve a purpose in financial markets. Their value in assessing

default risk and thereby affecting credit spreads plays a critical role in financial markets

and especially the flow of capital to developing countries. Improvements can be made

by encouraging more accurate ratings and requiring more timely ratings. Additional

improvement can come through investor education about the method and meaning of

credit ratings, and greater transparency by the agencies to level the playing field for all

investors. Increasing competition may be one strategy to increase investment and more

accurate ratings, but its potential negative consequences will need to be monitored and

supervised to prevent "rate shopping." Another strategy is to improve the NRSRO

designation process; a formal regulation for NRSRO status can provide more stringent

criteria for frequency of rating updates, disclosures, transparency and ethical practices.

RECCOMENDATION

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Not all problems dealing with rating agencies can be easily solved or reconciled. Ratings

from NRSRO agencies are still the best independent source of credit risk and thus have

value in capital markets. Consequently, more attention should be placed in modifying

the process to reduce unwanted side effects rather than eliminating them all together.

The effects of procyclical behavior in ratings can be reduced through more frequent

ratings updates. More frequent announcements will reduce the impact of downgrades

and will reduce the time-lag by which ratings fall behind market events. It will also

induce rating agencies to investment more in analysts and coverage. Additionally, a

more frequent approach to rating changes and announcements will reduce the tendency

of rating changes to cause yields to overshoot from a change in a stale rating. Investors

will know that ratings should reflect current economic fundamentals.

An additional measure to reduce the impact of ratings is more transparency and public

disclosures. Greater transparency on behalf of the agencies will let investors become

aware of the details that influence the agencies’ decisions.

Investor can then more accurately reconcile the agencies' ratings with their own opinion

and not have to be blindly led by the agencies. In addition to the benefits accruing to

investors, an increase in transparency will also assist banks and governments in planning

to prevent a downgrade or to reduce the impact of a downgrade. For example, a bank

can anticipate a ratings downgrade of its assets by issuing capital or reducing capital

charges elsewhere. This will hopefully reduce or prevent a capital crunch or a liquidity

crisis. Investors and institutions that have prepared for a downgrade will need to react

less when it occurs and this will mitigate the forces of contagion.

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Furthermore, the SEC and the rating agencies need to communicate with investors more

clearly that ratings do not indicate price risk or market risk of the security. Doing so will

reduce the weight investors place on ratings in their assessments. Ratings are merely a

forward looking assessment, based on current information, of the ability and willingness

of the debtor to fulfill its payment obligations – it is not a forecast of future performance.

For example, exogenous shocks that might occur in the future are not reflected in the

ratings. Investors should be informed through disclosures that unforeseen policy changes

in other countries can affect a sovereign’s ability to pay. Changes in U.S. monetary

policy, such as that in 1994 which had a strong impact on Mexico, can adversely affect

several countries but these countries' ratings do not incorporate forecasts of future U.S.

monetary policy.

Another policy recommendation concerns the need to assure equal access to information

by all investors while also protecting against the conflict of interest caused by debtors

and debt issuers paying for ratings. While charging an issuer for a rating is not ideal,

charging users creates other problems of asymmetric information between those with

more and less information about the rating decisions. It also can create problems with

free-riders since the ownership of the information cannot easily be protected and it is

easily disseminated to non-subscribers. The better policy is to charge the debtor or debt

issuer but require a "Chinese Wall" to separate marketing and sales from research and the

decision making process that assigns ratings. Also, rating agencies should not consult

and should have limits on other outside services to firms they are rating. Finally, senior

management of credit rating agencies should not be allowed to sit on boards of

companies that the agency rates.

The last recommendation is to formalize the NRSRO process. Although it is uncertain

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whether the process will in fact create more competition, a more formal procedure does

have benefits. Having the exact criteria laid out will have other agencies qualifying or

making changes that will eventually allow them to qualify. This can create competition

or at least present a credible threat of entry. A more credible threat of entry will force

the existing firms to invest more into methods and areas of coverage including

developing counties. In order to further stimulate competition, the SEC should modify

the NRSRO requirements to allow regional agencies, especially those located in

developing countries, and smaller, less recognized agencies that have a historically

validated record of judging creditworthiness. Along with a formal process should come

the authority to monitor and evaluate the behavior of credit reporting agencies.

Currently, the responsibility lies within the agencies to report changes in structure or in

the ratings process that affect their NRSRO status; the SEC needs to have a more

proactive and more formal role in this process.

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BIBLOGRAPHY

BOOKS AND REFERENCES

FINANCIAL SERVICE MANAGEMENT — DIPAK ABHYANKAR.

FINANCIAL POLICY FORUM— SPECIAL REPORT 6— GAUTAM SHETTY.

RANDALL DODD.

UNITED NATION CONFERENCE ON TRADE AND DEVELOPMENT(2008)

--DISCUSSION PAPER—MARWAN ELKHOURY .

IMF WORKING PAPER—AMADOU N.R.

WEBSITES

www.crisil.com/

www.cibil.com/

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