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Advantages and Disadvantages of Credit Rating

Credit Rating is a way to assess creditworthiness. It's a simple tool that can be understood by both the lender and investor to determine the risk associated with a loan amount or financial obligation. It uses alphanumeric symbols and can be used to describe an individual, company or country's financial assets.

Credit rating gives an opinion on the creditworthiness and reliability of the instrument. It does not guarantee repayment of the instrument rating. The rating represents the financial history, current assets and liabilities of rated instruments. A credit rating is not a recommendation to purchase, hold, or sell any debt instrument.

This guideline is intended to assist lenders and investors in making investment decisions. A good investment that has a low chance of default has a high credit rating. At the same time, investments with a high level of risk have poor credit ratings. Investors look for a risk-reward trade-off. Investors who seek high returns will invest in low-rated instruments to get compensated for the high risk.

Credit rating does not guarantee a fixed credit rate. The rating is subject to continuous review and can change periodically depending on new information. Recently, the reliance on communication ratings for its bonds was decreased with the information that the company cannot pay interest in the timeframe. Credit rating can be done for different debt instruments such as bonds, debentures and fixed deposits, Bank loans, commercial papers, etc.

Credit rating is defined by SEBI as "an opinion about securities, expressed as a standard symbol or any other standardized way, and assigned by credit rating agency. It is mandatory that an issuer of such securities must comply with a requirement specified by SEBI regulations and provide credit rating to the investors of bonds".

Origin and Development of Credit Rating

Advantages and Disadvantages of Credit Rating

It was in the 1840s in the USA that credit rating was first developed. Louis Tappan, a New York merchant and trader, established the first mercantile bank credit agency in 1841. This agency rated traders' and merchants' ability to meet their financial obligations. It was set up in response to the great financial crisis that hit the USA in 1837. Robert Dun later acquired the mercantile agency. It published its first rating guide back in 1859.

John Brad Street founded another credit rating agency, Dun & Bradstreet, in 1849. He published a rating guide in 1857. These two rating agencies merged to create Dun & Bradstreet in 1933. This became Moody's Investors Service, Inc. in 1962. Moody's history goes back over 100 years. Moody's Investors Service was founded by John Moody in 1900.

It published the "Manual of Railroad Securities" in 1909. In 1914, it published the Manual of Railroad Securities. In the 1920s, U.S. cities and municipalities were able to rate bonds.

Another credit rating company was created in 1916 by Poor's Publishing Company. It published its first ratings in 1916, followed closely by the standard statistics firm in 1922 and Fitch Publishing Company (1924).

In 1941, the Standard Statistics Company and the Poor's Publishing Company merged to create standard & Poor's. This company was then taken over by McGraw Hill. Numerous credit rating agencies were established all over the globe in the 1970s.

Canadian Bond Rating Service was established in 1972. Thomson Bank Watch was founded in 1974. Later, many countries established their own credit rating agencies.

India was the first country among the developing countries to establish a credit rating agency. It did so in 1987. CRISIL was the first credit rating agency to be established in 1988. It was sponsored by UTI, ICICI and other financial institutions, as well as public sector banks. Later on, many other agencies emerged, leading to a boom in this sector.

In 1991 and 1993, it was followed by the establishment of credit rating agencies ICRA and CARE, respectively. OCR India (P) Ltd was established in 1996 by a joint venture of international credit rating agencies Duff and Phelps and J.M. Financial and Alliance Group.

DCR India (P) Ltd., an International Credit Rating Agency, acquired DCR India(P) Ltd. in 2000. It changed its name to Fitch Ratings India Pvt. Ltd. ONIDA promoted ONICRA, India's first credit rating agency for individuals, in 1993.

Credit Information Bureau (INDIA), Ltd. (CIBIL), was established in 2000 to provide credit information on consumers and commercial borrowers to credit granting agencies.

Brickwork Ratings India Private Limited Ltd, another rating agency, was established in 2007. It offers rating and grading for various instruments issued by corporations, governments, local bodies, international agencies, etc. SAMERA, an SME rating agency, is another newcomer to the industry. There are currently 5 SEBI-registered credit rating agencies.

The Top 6 Objectives of Credit rating

These are the goals of credit rating:

i. Rate the debt instruments objectively to increase market confidence.

ii. To encourage the growth of the capital market and primary market;

iii. Because of the insufficient subscription, it is important to ensure capital absorption by investors.

iv. Protect the interests of investors, especially small and gullible investors, by providing adequate clues in the form of ratings concerning the safety and/or profitability of investments.

v. To maximize capital allocation as the market absorbs high-rated credit instruments

vi. To minimize flotation costs as high-rated securities do their own advertising. These securities are not expensive for corporates.

Concept of credit rating

Credit rating is the process of evaluating credit risk. It does not reflect market risk nor predict the prices or yields for credit instruments. It provides an expert opinion about the relative ability and willingness to make timely payments on debtor-related instruments.

It measures the likelihood of a borrower paying interest and principal on time. It gives a ranking of the credit quality of various debt instruments.

Ratings are often expressed in either alphabetic or alphanumeric symbols. These ratings allow the investor to distinguish between different debt instruments based on their credit quality. Credit rating is therefore a symbol of an investor's current opinion about the issuer's ability to pay its debt obligations on time. Ratings are indicators of safety, liquidity, and profitability for debt instruments.

This function is performed by independent rating agencies. This is based on various factors like past performance, the market, competitors, and the risk associated with the project.

There are many rating options, such as high safety, adequate safety and substantial risk, in default. These ratings are used to do this. These documents provide sufficient information to investors about the debt instruments that the entities have arranged.

In simple terms, credit rating is a measure of the capability of the issuer of debt security, performed by an independent agency to pay interest and to repay the principal according to the conditions of the issue of the debt.

The rating agency could not use a formula to guide its work. It is subject to various subjective factors such as asset quality, management quality, accounting accuracy, etc. A credit-rating agency evaluates the instruments alone and not the business. It's only a guideline for investors and not a recommendation for any particular debt instrument.

Key Qualities of Credit Rating

The following are the characteristics of credit rating:

  1. The credit rating system is essentially designed to inform non-professional investors about corporate entities.
  2. Ratings are calculated exclusively to help grade bonds, debentures, Government municipal bonds, bonds for commercial paper, public deposits and so on, depending on their investment quality.
  3. Rating is an assessment of the reliability of the issuer of securities with regard to particular obligations.
  4. Credit rating offers lenders a straightforward system of gradation.
  5. The credit rating represents the judgment of the credit rating organizations that indicates the security of timely payment of principal and interest on a debenture, preference share or fixed deposit. It can also be a short-term instrument issued by a business.
  6. The credit rating can be displayed either in alphabetical form or in alphanumerical format for easy comprehension by laypeople and potential investors.
  7. Credit rating isn't a general assessment of the organization issuing it but rather a specific declaration expressing the view on the capacity to repay the body that issued the credit card.
  8. Ratings are not solely based on the results of an audit.
  9. Ratings are able to be adjusted either upwards or downwards, looking at various aspects and conditions of an organization. Therefore, credit ratings are adjustable in nature.
  10. Rating aid in making investment decisions for the investors.
  11. Rating is based upon current information on the issuer of securities and obligations.

The significance of a credit rating

In an open market, a variety of businesses, both from the country and abroad, join the capital market using their financial instruments to raise funds. Investors are often in a dark place to assess the company's debt instruments.

A third party that is knowledgeable about studying the financial condition of the business and is creditworthy can assist the investor in making his decision. A credit rating agency can take responsibility for this.

Rating agencies offer an instrument to gauge the risk that comes with the instrument. Investors who are considering investing make use of this yardstick to determine the level of risk associated with the anticipated returns.

Therefore, credit ratings are utilized to improve the risk-return tradeoff. Since the average investor does not have the knowledge required for the process of evaluating credit and rating, credit rating agencies offer a similar service.

Credit ratings also allow issuers to have a wide variety of investors spread across different areas across the nation. If the instruments have a high rating, people are likely to purchase them. Additionally, regulators such as SEBI make it mandatory to obtain certain credit instruments to be evaluated. This creates a high-quality awareness in markets for capital.

Globalization of the market for financial services and the absence of effective control by the government on the financial market make the role of credit rating companies more crucial in the current world.

The Merits of Credit Rating

Merits to Investors:

i. Security against Bankruptcy:

The rating of a credit instrument, performed by the Credit Rating Agency gives an indication to investors about the financial strength of the company that issued the instrument. This helps him decide regarding the investment. Instruments that are highly rated by the company assure investors of the security of the instruments and a low chance of bankruptcy.

ii. A Simple Understanding of Risk:

Credit rating offers investors rating symbols that convey information in a way that is easily recognized. It helps investors see the potential risks associated with investing. It's easier for investors to gauge the worth of the company that is the issuer through symbolism.

iii. Credibility of Issuers:

The symbol of a rating associated with an instrument of credit provides an indication of the reliability of the company that issues the credit instrument. It is independent of the issuer and has no business or other connections with it. The lack of connections to business between the rating agency and the company being rated gives credibility to the rating agency and draws investors.

iv. The Saving of Resources:

Investors depend on credit ratings. This eliminates the hassle of understanding the basic aspects of a business and its strength, financial standing, management information and more. The credit score, which is provided by the experts from this credit rating agency, gives the investor confidence to trust the credit rating to make the right investment decisions.

v. Capacity to Make Direct decisions:

Usually, investors need to get advice from financial intermediaries, merchant bankers, stock brokers and portfolio managers or financial advisors about the best investment options. But investors do not have to trust the recommendations provided by these brokers when it comes to assessed instruments because the rating symbol that is assigned to any instrument indicates the creditworthiness of the instrument as well as the level of risk associated with it. Therefore, investors are able to make investment decisions on their own.

vi. Choice of Investments:

Many alternative credit-rated instruments are readily available at a specific point in time for investing in the capital markets. Investors can choose according to their risk profile and their diversification strategy.

vii. Rating Surveillance:

Investors can benefit from the ongoing monitoring by the credit rating agency of the instruments that are rated and rating by various businesses. Credit Rating Agency downgrades the rating of any instrument when it is discovered that the strength of the business decreases or if any other incident occurs that requires disclosure of information regarding its financial condition to investors.

Merits to Company:

i. Lower Cost of Borrowing:

A company that has an instrument with a high rating is able to cut costs of borrowing money from public sources by quoting lower interest rates on fixed deposits, bonds or debentures. Investors typically prefer to invest in secure securities, even though they yield less return.

ii. Extensive Borrowing:

A company that has an instrument that is highly rated could approach investors frequently to mobilize resources using the media. Investors of all levels of society might be drawn to higher-rated instruments. Investors are aware of the level of confidence in the timely payments of principal and interest on debt instruments with higher ratings.

iii. Rating as a Marketing Tool:

Businesses with rated instruments boost their image and take advantage of rating as an advertising tool that creates an image that is more appealing when dealing with customers, lenders, creditors and constituents. Customers are confident about the utility products made by companies that have high scores for credit products.

iv. The Self-Discipline of Companies:

Ratings encourage businesses to make more information regarding their accounting system as well as financial reporting, management patterns and more. The company has the opportunity and incentive to enhance the practices it has in place to be comparable to the standard of competitors and to maintain the high standard of rating it has earned or improve its rating.

v. Reduction of Costs in Public Problems:

A company that has a better rating is able to draw investors and raise funds with minimal effort. So, the company that is rated can cut costs and reduce the cost of public matters by limiting the costs of conferences, coverage in the media and other publicity-related events.

vi. Motivation to grow:

Ratings provide confidence to the company's growth because the individuals who promote the company are confident about their efforts and are encouraged to pursue the expansion of their business or to develop new initiatives. With a more positive image by a higher credit score, it is able to access money from public banks and institutions.

8 Big Problems with Credit Rating

The different problems that arise with credit rating can be described as the following:

  1. Lack of accountability hinders the process of rating credit. The lack of skilled and experienced personnel may not be up to their job and can result in an inaccurate rating.
  2. There is a wide possibility of bias in rating since there is no standard mathematical formula to calculate the amount of rating.
  3. Ratings do not warrant any security for investors. It is subject to change over time.
  4. Ratings are based upon the current and past performance of a business and can be affected by future events of a company.
  5. Investors might be confused by the fact that different rating agencies give different ratings to the same financial instrument of the same entity.
  6. To give ratings to their instruments, the credit rating agency charges a substantial fee. This could lead to misleading or exaggerated ratings.
  7. Rating information is provided by the borrower/issuer and is subject to an error on the part of the company.
  8. Credit rating agencies are facing the problem of not having a large branch network, which could lead to limited rating skills.

Credit Rating: Top 5 Limitations

These are the limitations of credit rating:

i. Biased Ratings and Misrepresentations:

Credit rating is a curse in the capital market industry if it does not have a quality rating. The Rating Agency experts should not have any connections with the company or persons who are interested in the company in order to avoid biased ratings. This will allow them to make impartial and judicious recommendations to the rating committee. Rating committee members must be impartial and judicious in making decisions.

ii. Static Study:

The company's past and present historical data are used to rate the company. This is not a static study. There may be many changes in the political environment, economic situation, or government policy framework that directly impact the company's functioning. Ratings will be useless in the future if there are such changes.

iii. Concealed Material Information:

Rating Companies may conceal information from the credit rating company's investigating team. It means that the company may give only that information which goes in its favour. This can lead to a reduction in quality and render the rating unreliable. As is said, "there are loopholes everywhere."

iv. There is no guarantee of the soundness of the company:

Ratings are done for specific instruments to assess credit risk, but they should not be taken as a guarantee of matching quality or management. The rating symbol should not be used to form independent opinions. A good credit rating doesn't always indicate the soundness of an organization.

v. Downgrade:

After a company is rated, if the company fails to perform well or has poor working results, the credit rating agency will review the rating and downgrade it. The company's image will be affected. Therefore, it becomes important for companies to maintain a certain standard throughout.

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