Credit Rating Agencies, Credit Scoring, and Credit Information Companies - Explained | MODULE D: FINANCIAL PRODUCTS AND SERVICES
Credit Rating Agencies and Their Functions
Credit Rating refers to an evaluation made by a credit rating agency regarding the creditworthiness of an entity (such as a corporation or government) or a financial instrument (such as a bond). It reflects the probability of timely repayment of debt obligations.
What is Credit Rating?
Credit rating is a symbolic representation of an entity's ability to repay its debts, based on historical and projected data, financial health, and market conditions. Ratings help investors make informed decisions about risk.
Credit Rating Agencies (CRAs)
Credit Rating Agencies are independent organizations that assess and assign ratings to entities and their financial instruments. Notable CRAs include:
- Standard & Poor's (S&P)
- Moody's Investors Service
- Fitch Ratings
- CRISIL (India)
- ICRA (India)
- CARE Ratings (India)
History of Credit Rating
The concept of credit rating began in the 19th century. Henry Varnum Poor published financial statistics about railroads in the USA, which evolved into formal rating agencies in the early 20th century.
Characteristics of Credit Rating
- Independent and objective
- Based on extensive research and analysis
- Subject to periodic review
- Not a recommendation to buy or sell securities
Importance of Credit Rating
Credit ratings build investor confidence, help companies raise funds easily, and promote transparency in the financial system.
Benefits of Credit Rating
- Lower cost of borrowing
- Better marketability of instruments
- Benchmark for investment decision-making
- Reputation enhancement
Factors Considered While Rating Companies/Instruments
- Financial Statements and Ratios (e.g., debt-equity ratio)
- Industry Characteristics
- Management Quality
- Past Performance and Track Record
- Macroeconomic Environment
Mathematical Example:
Altman's Z-Score Formula (commonly used for predicting bankruptcy risk):
Z = 1.2X₁ + 1.4X₂ + 3.3X₃ + 0.6X₄ + 1.0X₅ Where: X₁ = Working Capital / Total Assets X₂ = Retained Earnings / Total Assets X₃ = Earnings Before Interest and Tax / Total Assets X₄ = Market Value of Equity / Total Liabilities X₅ = Sales / Total Assets
Example Calculation:
- Working Capital = ₹5,00,000; Total Assets = ₹20,00,000
- Retained Earnings = ₹3,00,000; EBIT = ₹2,00,000
- Market Value of Equity = ₹8,00,000; Total Liabilities = ₹10,00,000
- Sales = ₹15,00,000
Now,
X₁ = 5,00,000 / 20,00,000 = 0.25 X₂ = 3,00,000 / 20,00,000 = 0.15 X₃ = 2,00,000 / 20,00,000 = 0.10 X₄ = 8,00,000 / 10,00,000 = 0.8 X₅ = 15,00,000 / 20,00,000 = 0.75 Thus, Z = (1.2×0.25) + (1.4×0.15) + (3.3×0.10) + (0.6×0.8) + (1.0×0.75) Z = 0.30 + 0.21 + 0.33 + 0.48 + 0.75 Z = 2.07
Interpretation: A Z-score below 1.8 indicates a high risk of bankruptcy, while a score above 3.0 is considered safe. A score of 2.07 suggests a moderate financial health.
Process of Credit Rating
- Request for rating
- Data Collection and Analysis
- Meeting with Management
- Rating Committee Review
- Assignment of Rating
- Publication and Monitoring
Credit Rating Symbols
Examples:
- AAA: Highest Safety
- AA: High Safety
- A: Adequate Safety
- BBB: Moderate Safety
- BB and below: High Risk
Ratings Outlook
The outlook indicates the direction of a potential rating change and is usually classified as:
- Positive
- Stable
- Negative
Regulations for CRAs in India
- Regulated by Securities and Exchange Board of India (SEBI)
- Mandatory registration with SEBI
- Disclosure norms for methodology, fee structure
Fees for Credit Rating
Fees vary depending on the complexity, size, and tenure of the instrument. It includes initial rating fees and annual surveillance fees.
What is Credit Scoring?
Credit scoring is a numerical expression based on a level analysis of a person's credit files, representing the creditworthiness of an individual.
Credit Information Companies (CICs) in India
- CIBIL (TransUnion CIBIL)
- Equifax
- Experian
- CRIF High Mark
Membership to CICs
Banks, NBFCs, and financial institutions must become members of CICs and regularly submit customer credit data.
Regulatory Guidelines Governing CICs
- Regulated by the Reserve Bank of India (RBI)
- Guidelines on data security, customer consent, dispute resolution
- Fair practices for reporting and updating data
Credit Scores
Credit Scores range between 300 to 900. A score above 750 is generally considered good for approving loans and credit cards.
Mathematical Example for Credit Score Calculation:
Assume the following factors and weights:
- Payment History: 35%
- Credit Utilization: 30%
- Credit History Length: 15%
- New Credit: 10%
- Credit Mix: 10%
Suppose a person scores:
- Payment History: 90/100
- Credit Utilization: 80/100
- Credit History Length: 70/100
- New Credit: 85/100
- Credit Mix: 75/100
Final Score = (0.35×90) + (0.30×80) + (0.15×70) + (0.10×85) + (0.10×75)
= 31.5 + 24 + 10.5 + 8.5 + 7.5
= 82
Scaling to a 300–900 range:
Score = 300 + (82/100 × 600)
= 300 + 492
= 792
Interpretation: A credit score of 792 is excellent.
Difference Between Credit Ratings and Credit Scores
| Basis | Credit Rating | Credit Score |
|---|---|---|
| Entity | Companies, Governments | Individuals |
| Purpose | Debt instrument evaluation | Personal creditworthiness |
| Scale | Letter Grades (AAA, BB, etc.) | Numerical Scores (300-900) |
| Regulators | SEBI | RBI |
Chapter List: MODULE D: FINANCIAL PRODUCTS AND SERVICES
- Overview of Financial Markets
- Money Markets and Capital Markets
- Fixed Income Markets - Debt / Bond Markets
- Forex Markets
- Interconnection of various markets/Market Dynamics
- Merchant Banking Services
- Derivatives Market including Credit Default Swaps
- Factoring, forfaiting & Trade Receivables Discounting System (TReDS)
- Venture capital
- Leasing and Hire Purchase
- Credit Rating agencies & their functions
- Mutual Funds
- Insurance Products
- Pension Funds (include APY, NPS)
- Guidelines on Para Banking & Financial Services provided by Banks
- Real Estate Investment Funds / Infrastructure Investment Fund (concept)
Comments