What is a Credit Rating?

Introduction

 

The Basel Committee on Banking Supervision is the international supervisory committee to improve the quality of banking worldwide. For this purpose, the Basel Committee set up three norms- Basel 1, Basel 2, and Basel 3, together known as the Basel Accords. These norms are policy recommendations that govern the banks' operations all over the world. Even though they are non-binding, all the members of the Basel Committee and a lot of other countries follow these guidelines.  

 

The Basel accords have divided financial risk into five basic categories: Credit Risk, Operational Risk, Liquidity Risk, Market Risk, and Systemic Risk. The financial risk faced by an institution needs to be analyzed and managed for the economic well-being of the financial institution. 

 

In this blog, we'll be focussing on credit risk, which was the chief catalyst of the 2007-08 financial crisis.

 

Credit Risk is the first risk introduced in the Basel accords. It is the possibility of loss resulting from a borrower not repaying a loan due to some reason or the other. 

 

Credit Rating

 

A credit rating is a measure of the credit quality of an organization's or an individual's obligations. 

 

These obligations could be in the form of debt raised by issuing debt instruments' like bonds. In which case, the credit quality of the corporation or the country would be dependent on the credit quality of the issued corporate bonds or the sovereign bonds, respectively. 

 

Investors use credit ratings to gauge the credit risk prevalent in a security and then take buying or selling decisions accordingly. 

 

What do Credit Ratings measure?

 

A credit rating is a quantitative measure of the creditworthiness of an organization. It is an evaluation of the credit risk of a prospective debtor. Analysts give enormous regard to this parameter to calculate the intrinsic value of a financial institution.

 

Since credit rating is inversely proportional to credit risk, an analyst usually measures 

the Expected Loss (EL), which is a function of Loss Given Default (LGD), Exposure At Default (EAD), and Probability of Default (PD). There are various statistical methods available to model these three parameters. Once these parameters are determined, an analyst can model the expected loss, and then he/she can evaluate the credit rating.

 

We won't be going into detail in the statistical aspects of credit rating in this blog but will soon put up a blog.

 

Types of credit ratings:

 

Credit Ratings could either be internal or external:

 

1. Internal: Done by the institution themselves. Most banks have models for rating the creditworthiness of their corporate and retail clients. Also, there is an internal-ratings-based (IRB) approach in the Basel 2 norms used by banks to gauge their own credit risk and proceed accordingly.

 

2. External: Certain organizations called Credit Rating Agencies have professional analysts who provide credit ratings on a contractual basis. Credit ratings, however, are mainly done for companies that have publicly traded debt and are usually paid for by institutional investors. 

 

Therefore, most small and medium-sized companies do not have credit ratings from such organizations and need to have internal credit rating measures in place for this purpose.

 

Credit Rating Agencies 

 

Credit rating agencies provide information that financial market participants widely use for the management of credit risks. They form the external source of credit ratings and are widely accepted all over the world.

 

• Types of financial instruments rated: 

 

1. Bonds (Corporate, Sovereign, etc.)

2. Debentures

3. Asset-Backed Securities (ABS)

4. Mortgage-Backed Securities (MBS)

5. Convertible bonds

6. Medium-Term Notes

7. Derivatives, etc. (From)

 

• Sources of Information:

 

1. Publicly available data (e.g., annual reports, investor presentations, etc.)

2. Prospectuses, offering circulars, offering memorandum, trust deeds, or indentures of particular securities.

3. Market data (e.g., stock price trends, trading volume, data on bond price spreads, etc.)

4. Economic data from industry groups, associations, or bodies (e.g., World Bank, International Monetary Fund, etc.)

5. Data from agencies, such as central banks, ministries, or regulators

6. Books or articles from academic sources, financial journals, news reports (e.g., Reuters, Bloomberg)

7. Discussions with expert sources in industry, government, or academia

8. Data that may come from meetings or conversations with the debt issuer

 

• Rating process:  

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Rating Process

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1. Contract: The issuer of an obligation (e.g., a bond) requests a rating from the rating agencies and signs an engagement letter with them.

2. Pre-Evaluation: A team of analysts reviews the pertinent information.

3. Management Meeting: Analysts have a meeting with the management to discuss information and further steps.

4. Analysis: The analysts then evaluate the information, prepare a rating and propose it to the rating committee.

5. Review: Rating committees review the work of the analysts and vote on the credit rating.

6. Notification: The issuer is contacted with the credit rating along with the rationale behind it.

7. Publication: There is a press release and website release of the rating.

8. Surveillance: There is constant surveillance, and any good/bad market development is regularly taken into account for changes in the rating. (Source)

 

The three major global credit rating agencies are Moody’s, S&P, and Fitch: 

 

These credit rating agencies  provide ratings both on the national and the global scale.

 

1. Moody’s

 

Moody's is the holding company that owns: Moody's Investor Service and Moody's Analytics. Moody's Investor Service provides credit ratings to its customers, and Moody's Analytics provides financial analysis software and services to its customers.

 

Moody's was founded by John Moody in 1909 to provide reports of statistics about stocks and bonds and their ratings. It is headquartered in New York and is one of the Nationally Recognized Statistical Rating organizations (NRSRO). NRSRO is a credit rating agency approved by the U.S. Securities and Exchange Commision.

 

The primary goal of Moody’s rating is the evaluation of the projected losses in case of a default.

 

The rating scale used by Moody's is:

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Rating Scale of Moody

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2. S&P Global 

 

S&P Global or Standard and Poor's Global is the parent company of S&P Global Ratings, S&P Global Market Intelligence, S&P Global Platts, and CRISIL. CRISIL is the most popular credit rating agency in India.

 

Founded in 1860 and headquartered in New York, S&P is considered the largest credit rating agency in the world today.

 

The primary goal of the S&P credit rating is to gauge a security’s probability of default.

 

The rating scale used by S&P is:

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Rating scale of S&P Global

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Examples of Indian companies rated by S&P Global on a global scale: Tata Consultancy Services (TCS)- A, Infosys- A-, Reliance Industries- BBB+, ICICI Bank, HDFC Bank, Axis Bank, State Bank of India- BBB-. (Source)

 

The ‘+’ and ‘-’ sign in front of the credit ratings above signify the rating outlook. The rating outlook is an opinion of the credit rating agency (in this case, S&P Global) on the likely direction of the movement of rating in the medium term which is usually the period comprising the next six months to two years. Economic and fundamental business conditions at present are taken into consideration to determine the rating outlook.

 

3. Fitch Ratings 

 

Fitch Ratings is the last constituent of the three biggest credit rating agencies in the world. Dual-headquartered in New York and London, Fitch Ratings was founded in 1913.

 

Fitch Ratings uses the same rating scale as the one used by S&P. And similar to S&P, Fitch’s ratings also focus on a security’s probability of default.

 

Usually, these three credit rating agencies have a similar rating for a particular financial institution and therefore, similarly scale them according to their respective scales.

 

Credit Rating Agencies in India:

 

Securities and Exchange Board of India (SEBI) reserves the right to authorize and regulate credit rating agencies according to SEBI Regulations, 1999 of the SEBI Act, 1992.

 

The three most popular rating agencies in India are:

1. CRISIL (Credit Rating Information Services of India Limited): CRISIL was set up in 1987 and is one of India's oldest credit rating agencies. It has a global presence. CRISIL offers a wide variety of ratings in India.

 

2. CARE (Credit Analysis & Research Limited): CARE was established in 1991 and is headquartered in Mumbai. It primarily offers corporate governance ratings, mutual funds ratings, etc.

 

1. ICRA (Investment Information and Credit Rating Agency of India Limited): ICRA was established in 1993 and is headquartered in Mumbai as well. It primarily offers short-term and long-term bank loan ratings.