Before we go about on how credible the credit ratings are, allotted by the rating companies, it is important to have a clear understanding of what these credit ratings are? How do they function? And who actually assigns these ratings to companies?
Let us start by answering the above questions one by one and then finally discuss on ‘credibility of credit ratings’.
What is a credit rating?
Credit ratings are assessment of credit risks that are associated with prospective borrowers and assuming their ability to repay the loan and forecasting the conditions under which the debtor might default.A credit rating can be allotted to any entity that want to borrow money, i.e., an individual, a corporation, state or provincial authority, or the government.
How do credit ratings work?
Credit ratings depict the likelihood of repayment of debt/loan by the borrower and his/her willingness to pay. Higher credit ratings shows higher possibility of repayment by borrower without any problem while a poor credit rating shows that the debtor might default in payment and could repeat the same pattern in future.
Short and long term ratings
Short term credit ratings are becoming very popular in the current scenario reflects the possibility that a borrowers might default in less than a year. Long term credit ratings are used to predict if the borrower would default in payment anytime in an extended future.
Credit rating companies/agencies
These credit-rating agencies basically judge the repaying capacity of the borrower and refer to financial statements, previous debt history, level and type of debt request, etc. These credit ratings that are allotted to the entities serve as a benchmark for market regulations.
The big three agencies of the world are:
- Standard & Poor’s (S&P)
- Fitch group
While S&P and Moody’s are both based at US, Fitch group has dual-headquarters at US and London. These big three companies have around 95% of the global market share (as of 2013).
A few of the major rating agencies in India are:
Now that we know about the credit ratings, we must know how to ensure the credibility of these ratings so that while investing with any company we are sure that we receive the money back and are able to mitigate the risk factor.
Since there have been many cases like the IL&FS, Zee group and DHFL where these ratings were forged and defaulted in recent times, it makes it even more crucial for an investor to rightly access the credit ratings on how credible they are and give their money in the right place.
The factors that affect the ratings given by the agencies are an important aspect which determines on how minutely the agency is studying the issuer and hence affect the credibility of their decisions.
Some of the factors that these credit rating agencies keep in mind are:
1. Entities past history
The past financial records of profits, repayments and default are studied by the agencies to reach on a conclusion of how well the borrower entity is able to manage its operations.
2.Entity’s future economic potential
If the economic potential of a company seems to be bright with high growth opportunities, higher credit ratings are allotted to them and vise-a-versa.
3.Amount already owed
The amount with which the company is already indebted is a very important aspect to be considered as it shows the repaying capacity of the company.The credibility of the credit ratings often go hand in hand with the challenges faced by the agencies during the time of allotment of these ratings
1. Barriers to entry and lack of competition
There are very limited number of agencies which are in the market and also the majority of the marker share is held by just 2/3 companies as specified above. This creates monopoly in the market and may also sometimes provide no choice to the users.
Lack of transparency on the methods followed for allotting these ratings, their procedures etc. creates doubts in the minds of investors. A few of the agencies do publish reports on processes followed by them but still do not satisfy the users of the information.
There is no exact method available to safeguard investors/borrowers from inaccurate data published and assigned by the agencies and any abuse of the powers in their hands.
4. The issuer pays model and investor pays model
The issuer has an advantage that he could go to as many agencies as he wants for evaluation and select the one which provides him with the best rating. This is a predominant model used by the majority, whereas on an average only 3 out of 10 agencies apply the investor pays model.
5.Dependency and behavior of analysts
The ratings are based on different quantitative and qualitative methodologies followed by the agencies which are usually kept secret to maintain secrecy. However, it largely depends on the behavior of analyst who works on it. If the analyst is optimistic he might provide with higher ratings and if he is pessimistic the ratings might even be lower than it should actually be. This leads to bias on the behavior of the analyst and can lead to serious consequences.
6.Frequent changes in regulations
Due to the skepticism that these credit agencies face, the regulations are regularly updated which make it difficult and stressful on their part. For example the Dodd-Frank Act increased the liability of the credit rating agencies for issuing inaccurate ratings.
At an international level, the main initiative has been the publication by IOSCO of its Code of Conduct. SEBI is the member of IOSCO. This Code aims at improving governance rules for CRAs to ensure the quality and integrity of the rating process, the independence of the process and avoidance of conflict of interest and to provide greater transparency. Thus, CRAs plays a key role in the financial markets by providing information to users at both end, the investors as well as the issuers.