CHAPTER - 1

INTRODUCTION
A financial system, comprising of financial institutions, financial
services, financial markets and financial instruments, aims at
establishing and providing a regular, smooth, efficient and cost
effective linkage between depositors and investors. All the components
of a financial system work in connection with each other as financial
institutions operate in financial market by generating, purchasing and
selling financial instruments and rendering various financial services.
Thus, financial institutions allocate savings of the economy to useful
investments.
The financial markets on the other hand facilitate buying and
selling of financial claims, assets, services and securities. These
financial claims, assets, services and securities are the financial
instruments which are periodical payments of certain sum of money
by way of principal, interest or dividend. The financial services, dealt
within the financial system, not only help in raising the required
funds but also in ensuring their efficient distribution. Financial
services are at heart of every economy. They are regarded as an engine
of growth since financial globalization can contribute significantly to
promote growth both in developing countries and countries in
transition by augmenting domestic savings, reducing cost of capital,
transferring technology, developing domestic financial sector and
fostering human capital formation. Two characteristics of financial
services must be emphasized at the outset. One is that the financial
services involve the creation, dissemination and use of information.
This is an information-based industry that has been transformed by
the information revolution. The second common characteristic is
that financial services require huge amounts of high quality labour to
deal with information and communication with the market. Financial
services involve at least two people or firms, the service provider and
the user. Often financial relationships will involve many parties as

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with securities offerings. It is the differences in these parties that
make financial services valuable (Bhalla, 2005).
The financial services industry serves the primary sectors of the
economy by intermediating the flow of funds and providing financial
services. Nationally and internationally, this industry is huge, growing
and of critical significance to the health of global economy as well as
that of individual business, investors, consumers and employees. The
industry dominated the commanding heights of the Indian economy in
the 1990s. Financial services are provided by stock exchanges,
specialized and general financial institutions, banks and insurance
companies. Each of the financial services can be defined to include the
provision of a financial service or the sale of a financial product or
both. The products and services can be grouped under the sections:
banking and credit; insurance and securities and brokerage.
Historically, there are four classes of financial services firms: 1)
deposit taking firms; 2) insurance type firms; 3) investment
companies; and 4) securities firms (Bhalla, 2005). Following are some
of the examples of financial services:
1. Leasing, credit cards, factoring, portfolio management, technical
and economic consultancy, credit information.
2. Underwriting, discounting and rediscounting of bills
3. Acceptances, brokerage and stock holding
4. Depository, housing finance and book building
5. Hire-purchase and instalment credit
6. Deposit insurance
7. Financial and performance guarantee
8. E-commerce and securitization of debts
9. Loan syndicating and credit rating (Gurusamy, 2004).
Among the other financial services, credit rating is of most
recent origin. Credit rating is a financial service which is helpful to
investors in taking their investment related decisions. As the investors
in search of profitable investment avenues have recourse to various

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sources of information, such as research reports of market
intermediaries, offer documents of the issuer(s), media reports, etc.
but in addition they can also base the investment decision on the
grading offered by Credit Rating Agencies. Rating agencies are
independent third parties that are consulted in the course of a market
transaction. Their goal is to assess the probability whether an issuer
will meet its debt services obligations in time by overcoming
asymmetric information between both market sides by evaluating
financial claims according to standardized quality categories
(Christoph, 2001).

1.1 CREDIT RATING: AN OVERVIEW

The expansion of financial markets and ever increasing number
of financial instruments provide both borrowers and investors with
large number of funding and investing options. As the number of
companies borrowing directly from the capital market increases and
as the industrial environment becomes more and more competitive
and demanding, it is difficult for investors to make a right choice
among the multiplicity of instruments and fund raisers particularly
where all the borrowers have a good name and reputation. Further,
the growing number of cases of defaults and frauds in payment of
interest and repayment of principal sum borrowed has increased the
importance of credit rating. Therefore, investors feel a growing need
for an independent and credible agency which judges impartially, the
credit quality of debt obligations of different companies and assist
investors, individuals and institutions in making investment decisions
(Singh, 1996). Thus, Credit Rating Agencies fulfil this need of
investors as the main purpose of credit rating is to provide investors
with comparable information on credit risk based on standard rating
scales regardless of the specifics of the companies. According to
Roman Kraussl, Professor of Economics at University of Crete, The
historical logic underlying the existence of credit rating agencies has

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clearly resided within the basic problems of financial markets:
Asymmetric information. Credit Rating agencies supply market
participants with a system of relative creditworthiness of all bond
issues by incorporating all the components of default risk into a single
code: The credit rating (Jutur, 2005).
Further, the following developments also contributed to
emergence of credit rating industry all over the world.
The increasing role of capital and money markets consequent to
disintermediation;
Increased securitization of borrowing and lending consequent to
disintermediation;
Globalization of credit market;
Continuing growth of information technology;
Growth of confidence in the efficiency of the open market
mechanism;
Withdrawal of Government safety nets and the trend towards
privatization (Arora, 2003).
Thus, in the changed scenario where corporates are increasingly
dependent on public, the removal of restrictions on interest rates and
stipulation of a mandatory credit rating of a number of instruments
since 1991 by the government / SEBI, credit rating has emerged as a
critical element in the functioning of Indian debt or financial markets.
It is useful to safeguard the interest of investors by guiding them
towards the right path. Credit rating is desirable and mandatory for
certain instruments worldwide to caution the investors in advance
about the strength and weaknesses of a fund raising company.
Credit rating is the symbolic indicator of the current opinion of
rating agencies regarding the relative capability of issuer of debt
instrument, to service the debt obligations as per contract. Rating is
an independent, professional and impartial assessment of default risk
in debt obligation. It is a qualified assessment and formal evaluation
of companys credit history and capability of repaying obligations. This

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assessment is based on an objective analysis of the information and
clarifications obtained from different sources including the issuer.
One of the leading Indian Credit Rating Agency CRISIL defines credit
rating as an unbiased, objective and independent opinion as to an
issuers capacity to meet financial obligations. It is the current
opinion as to the relative safety of timely payment of interest and
principal on a particular debt instrument. Thus, rating applies to a
particular debt obligation of the company and is not a rating for the
company as a whole. According to USA based internationally reputed
credit rating agency, Standard and Poors, credit ratings are
judgments of borrowers creditworthiness based on relevant risk
factors, expressed by letter grade rating symbol, which markets have
come to depend on as reliable, user friendly tool for differentiating
credit quality. Thus a rating, according to credit rating agencies
definition, is an opinion on creditworthiness of an obligator with
respect to a particular debt. In other words, the rating is designed to
measure the risk of a debtor defaulting on a debt. Credit rating
establishes a link between risk and return. It provides a yardstick
against which one can measure the risk inherent in an instrument.
The investor uses the rating to assess the risk level and compares the
offered rate of return with his risk return trade off and takes his
investment decision accordingly. Risk evaluation is only one factor
amongst various other factors, which also counts in taking investment
decisions.
Thus, the credit rating agencies evaluate the intrinsic worth of a
company and assign ranks to the companies accordingly. These
agencies have become important in view of the increasing number of
companies going to the public for funds and also due to government
stipulating that corporate bodies wanting to raise funds from the
market should have their debt instrument rated. The main objective
of these agencies is to restore the confidence in the capital market
and to provide unbiased assessment of credit worthiness of the

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companies issuing debt instruments. Credit Rating Agencies are
essentially corporations with specialized functions, namely,
assessment of the likelihood of the timely payments by an issuer on a
financial obligation (known as credit rating). Thus, credit rating is
essentially the task of determining the strength and prospects of a
security offered in the market and thereupon place it amongst a band
having predetermined standards called grades (typically these
grades are symbolically represented, viz. A, AA, AAA, etc.) (Jain and
Sharma, 2008).
In underdeveloped markets credit quality is often evaluated by
Name Recognition, which cannot be used as an effective tool for
systematic risk evaluation since it suffers from numerous avoidable
limitations. Because it is not necessary that every venture promoted
by a well-known name will be successful and free from default risk.
Credit rating has eliminated or at least minimized the role of Name
Recognition and replaces it with well researched and scientifically
analyzed opinions as to the relative ranking of different debt
instruments in terms of credit quality. Now, lesser known companies
can also approach market on the basis of their ratings. As a rated
security is placed higher in the estimation of investors than an
unrated security irrespective of better financial standing or reputation
of the Issuer or Sponsor Company or the business house (Verma,
2000). Credit rating reforms the isolated function of credit risk
evaluation and reflects borrowers accountability, expected capability
and inclination to pay interest and principal in a timely manner.
Credit rating provides indicative guidance to the prospective investors
on the degree of risk involved in the timely repayment of principal and
interest thereof. The agencies most important job is evaluation of
various instruments including debentures, bonds, preference shares,
fixed deposits, certificates of deposit, loans, commercial papers, bank
deposits, IPOs, mutual funds and insurance claims, etc. Normally,
Credit Rating Agencies focus their evaluation on the creditworthiness

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of a debtor. In most cases, agencies act on the request of the
evaluated firm. A rating mandate is valid for several years, during
which the rating agency monitors the client firm and corrects the
rating decision if there is any significant change in the clients
financial situation (Christoph, 2001).
Credit rating reflects financial, sectoral, operational, legal and
organizational sides of companies which characterize ability and
willingness duly and in full amount to repay debt obligations. Further,
credit rating is a published ranking based on detailed financial
analysis by a credit bureau. Rating is a complex activity requiring
examination and appraisal of seemingly complex factors and
attributes involving a diverse mix of variables ranging from
accounting to financial analysis and risk ascertainment and many
more (Jain and Sharma, 2008). The rating process is a fairly detailed
exercise. It involves among other things, analysis of published
financial information, visits to 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 the degree of environment scanning. It is,
therefore, in human terms, rather impossible for a solo investor to
undertake to rate a security for chiefly two reasons; (i) lack of effective
access to the information required to make an effective rating, and (ii)
being not in possession of the complex tools required to translate the
data available into effective information required for decision-making
(Jain and Sharma, 2008).
The question Whats in a bond rating? has been asked for at
least since 1909 when such ratings were started in the United States.
Informed persons who answer this question typically admit that
ratings depend in part on readily available statistics on a firms
operations and financial condition. But these individuals also
emphasize that an important, if not the most important, determinant
of corporate bond rating is the raters judgement about the firms

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ability to make the scheduled interest and principal or sinking fund
payments on time. This judgement, it is asserted, is based on much
more information than that contained in readily available statistics
(Pogue and Soldofsky, 1969). Bond ratings are the principal source of
investor information about the quality and marketability of various
bond issues (Pinches and Singleton, 1978). Better credit ratings lead
to better capital market access, both in terms of the cost of borrowing
and the amount of debt issued (Tang, 2006). Bond ratings have a
direct and often dramatic impact on the debt market. The cost of the
firm and even the marketability of the issue is in large part,
determined by assigned ratings. The investment community tends to
regard the bond rating as an indication of the firms overall
investment quality; thus bond ratings may influence both the cost of
debt and cost of equity to the firm (Pinches and Mingo, 1975). The
impact of credit rating on capital market can easily be visualized from
the fact that it becomes easier for investors to distinguish the
investment opportunities with different issuers both rated and not
rated going public for raising funds. Investors are prepared about the
risk, whereas the issuers are also free and enthusiastic to go to the
market with confidence created through rating grade. Thus, capital
market is driven to efficiency in true sense where there remains no
place for rumours and fancies of brand names (Verma, 2000).
Further, credit rating has proven itself to be effective instrument of
risk assessment in countries with advanced economies since it
demonstrates transparency of an enterprise. Credit rating facilitates
the company in raising funds in the capital market and helps the
investors to select their risk return trade off (Sarkar, 1994).
Credit ratings are commonly used by lenders to assess the
default risk because every credit is connected with a possible loss. If
the probability of a default is above a certain threshold a credit will
not be provided (Czarnitzki and Kraft, 2007). Thus, bond ratings are
used extensively in the investment community as a surrogate

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measure for the riskiness of bonds (Robert and Gabriel, 1979). Rating
evaluates only a specific instrument and indicates risk associated
with such instrument only. Therefore, credit rating is neither a
general purpose evaluation of a corporate entity nor an overall
assessment of credit risk likely to be involved in all the debts or
financial instruments. A credit rating is a rating agencys credit
quality assessment of a debt issuer or a specific debt obligation. A
credit rating consists of both a letter rating (credit category) and (if
provided) commentary. The commentary can include a credit watch
and/or credit outlook modifier, assumptions, criteria and methods
used in determining the rating opinion, conditions under which the
rating may or will be changed and descriptions of the rated company
and its lines of business (Frost, 2006). The involvement of a
specialized agency in this task of rating increases the creditability of
the process, so ratings serve as objective criteria for the market
players to base their self-purchase decision on (Jain and Sharma,
2008).
Credit rating essentially indicates the credit worthiness of the
borrowers and the probability that the borrowers will pay the interest
and principal on due dates. A credit rating system is considered of
good quality if debtors with a lower credit rating default more often
than debtors with a higher credit rating (Lehman, 2003). Here are
some important features/facts about credit rating:
(a) Rating can be revised.
(b) Rating is not based on audit.
(c) Rating only helps in investment decision-making.
(d) Rating is based on current information.
(e) Rating is assigned to specific instrument (Sarkar, 1994).
(f) Rating aims at guiding the investors.
(g) Rating does not provide any recommendation to buy, hold or
sell any instrument.

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(h) Rating process is based on broad parameters of information
supplied by the issuer and collected from various other sources.
(i) The rating furnished by the agency does not provide any
guarantee for the completeness or accuracy of information on
which it is based.
(j) In rating business, the users of the rating services such as
investors, financial intermediaries and other end users, do not
pay for it but the issuers, of the financial instrument, who do
not use rating, pay for it. This is one of the most peculiar
feature of credit rating.
(k) A key feature of rating is that they contain a limited number of
categories. Hence, equally rated bonds are not claimed to be of
identical quality and rating cannot be inverted into unique
default probabilities (Kliger and Sarig, 2000).
Thus, Credit rating is expected to improve the 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 (Vepa, 2006). Nowadays, the outlook of credit rating
industry appears to be positive but the industry has to continuously
strive to improve the professional capabilities and sustain credibility.
The credit rating agencies today have ample opportunities to play a
unique role in strengthening the capital market and building the
investors confidence in the financial system. Clearly, accurate
assessment of the credit worthiness of obligators is an important
precondition for the stability of a financial system since inadequately
high exposure to credit risk has been one of the leading sources for
problems in financial institutions worldwide for many decades (Hornik
et al., 2006).

DEFINITIONS
Some important definitions of credit rating given by various
national and international rating agencies are as under:

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Moodys Investor Service
Ratings are designed exclusively for the purpose of grading
bonds according to their investment qualities.
Investment Information and Credit Rating Agency of India Ltd.
(ICRA)
Credit rating is a simple and easy to understand symbolic
indicator of the opinion of a credit rating agency about the risk
involved in a borrowing programme of an issuer with reference to the
capability of the issuer to repay the debt as per terms of issue. This is
neither a general purpose evaluation of the company nor a
recommendation to buy, hold or sell a debt instrument.
Credit Analysis and Research Ltd. (CARE)
Credit rating is, essentially, the opinion of the rating agency on
the relative ability and willingness of the issuer of a debt instrument
to meet the debt service obligations as and when they arise.
1.2 IMPORTANT DETERMINANTS OF CREDIT RATING
The ratings are so devised that they provide investors with a
simple and easily understood indicator expressing the underlying
credit quality and the risk associated with an instrument of debt (Rao
et al., 1996). Each rating assigned to a security issue is a reflection of
various factors. Rating does not come out of a pre-determined
mathematical formula, which fixes the relevant variables as well as
the weights attached to each of them. Rating agencies do a great
amount of number crunching, but the final outcome also takes into
account factors like quality of management, corporate strategy,
economic outlook and international environment.
While assigning ratings the credit rating agencies principally
focus on the following determinants:
(i) The character and terms of the particular security being issued;
(ii) The probability that the issuer will default on the security and
the ability and willingness of the issuer to make timely

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 payments as specified in the indenture (contract) accompanying
the security;
(iii) The degree of protection granted to the investors if the security
issuer is liquidated, reorganized, and/or declares bankruptcy.
The past and probable future cash flows of the security issuer;
(iv) The volume and composition of outstanding debt;
(v) The stability of the issuers cash flows over time;
(vi) The value of asset pledged as collateral for a security and
securitys priority of claim against the issuing firms assets; and
(vii) The interest coverage ratios and the liquidity of the issuing firm
(Bhalla, 2005).
Thus, credit rating agencies use their understanding of
companies business and operations and their expertise in building
frameworks for relative evaluation, which are then applied to arrive at
performance grading of various instruments of the companies, without
disclosing the private information of the issuer companies. Therefore,
issuers willing to dissolve some of the asymmetric information risk
with respect to their credit worthiness and yet not wishing to disclose
private information can use rating agencies as certifiers. In such a
case, ratings are supposed to convey new information to investors.
Ratings can also be used as regulatory licences that do or do not
convey any new information (Galil, 2003).
1.3 ESSENTIALS OF A GOOD CREDIT RATING SYSTEM
Credit rating serves as a valuable input in the decision-making
process of different market participants in the capital market
including the regulators. A good credit rating system is one which
serves the interests of all such market participants and the regulators
in an effective way. So, in order to fulfil this requirement and the
rating system to function effectively existence of the following
ingredients is necessary.
1. Credible and Independently Derived Credit Ratings: Ratings
should be credible and the credibility arises only if the rating

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 agency is independent of issuers business, holds high degree of
professionalism and relevant expertise across the industry.
Further, the ratings will be credible if there exists impartiality of
opinions, strict rules of confidentiality relating to sensitive and
confidential information of the issuer, timeliness of rating reviews
and announcement of changes, ability to reach a wide range of
investors by means of press reports, print and electronic
publications and research services. In the words of Wilson(1994),
Every time a rating is assigned, the agencys name, integrity and
credibility are on line and subject to inspection by whole
community (Gurusamy, 2004).
2. The Meaning and Use of Ratings should be Clear, including the
Level of Risk Inherent in the Rating: Rating agencies should be
transparent about the meaning and limitations of their ratings.
Further the rating agencies should use warning signals whenever
possible, such as credit rating watch and rating outlook, in order
to make the ratings more important to investors. Thus, rating
users might understand that ratings can change suddenly based
on market or industry-specific events.
3. Disclosure Requirements: One of the essential requirements of a
good rating system is to make the adequate corporate disclosures
and to publish all the essential information required by the
investors.
4. Investor Education: Along with the task of rating a particular
instrument, the rating agencies should also ensure that such
information should not only reach the investors, but they should
enable investors to make meaningful interpretations also. The
investors should also be aware of the limitations of credit rating.
Regulation should require the rating firms to provide publicly
detailed explanations about the nature of their opinions and
pertinent information used in the rating process in order to
enhance the investor knowledge.

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5. Transparency and Soundness of Credit Rating Analysis: There
should be transparency in ratings process, including criteria and
methodologies for assigning and updating ratings, which would
give investors critical information they need to make informed
decisions, to compare ratings, and to form their own opinions on
the soundness of an agencys analytics.
6. Existence of Active Debt Market: An active primary and
secondary debt market is crucial for rating agencies to continue to
provide their services.
1.4 IMPACT OF CREDIT RATING: POSITIVES Vs NEGATIVES
Credit ratings have a direct and dramatic impact on the bond
market and various parties related directly or indirectly to credit
rating since credit rating is a source of reliable information for many
users as rated instruments speak themselves about the soundness of
the company and the strength of the instrument rated by the credit
rating agency.
As suppliers, corporate bond issuers rely on credit ratings to
ensure the best possible interest rate for their securities; as
consumers, bond investors depend on credit ratings to determine the
credit worthiness of companies in which they invest (Mansi and
Baker, 2001). As both pros and cons always exist, so credit rating also
has both positive and negative impact on the related parties in the
form of advantages and disadvantages as discussed below:
1.4.1 Advantages of Credit Rating
Ratings provide great advantages to issuers and investors. To
the investors, it communicates the relative ranking of the default loss
probability for a given fixed income investment in comparison to other
instruments. To the issuers, it is a marketing tool which provides
greater access to a much wider investor base as compared to unrated
securities (Vepa, 2006). As name recognition is replaced by objective
rating the lesser known companies are also able to access the money
market and capital market. The companies have the advantage of

14
mobilizing resources at low-coupon rate and easy market accessibility
of fund mobilization.
- Rating helps investor to compare the issues by providing them a
short and clear guide.
- Fair, honest and impartial rating motivates the public to invest their
savings in company debentures, deposits, etc.
- Credit ratings are guide posts to investors (Rao et al., 1996).
Thus, credit rating is beneficial to various parties like issuers,
investors, regulators, brokers and financial intermediates. They all
have lot to gain from credit rating. Various benefits derived from credit
rating by different parties include:
To Issuers:
The benefit of credit rating for issuers stems from the faith
placed by the market on the opinions of credit rating and widespread
use of ratings as a guide for investment decision (Arora, 2003). Credit
rating facilitates the borrower company or the issuer of securities to
mobilize savings from a wider section of interested investing public at
a lower cost for the highly rated company and helps a lesser known
company to have easy access to the capital market (Verma, 2000).
1. Rating provides access to international pool of capital as it creates
a tendency amongst the rated corporate units to maintain higher
corporate standards and to remain healthy in the business
environment. This creates better image of the business class of the
country as a whole in the international market.
2. Rating reduces the cost of borrowing for the companies as
companies with high rating can quote lesser interest rate on fixed
deposits or debentures or bonds. The investors with low risk
preferences would like to invest in such safe securities.
3. The wider access to investor base and investing instruments
increase the financial flexibility of the company.
4. Rating leads the companies to self-discipline as it encourages
them to come out with more disclosures about their accounting

15
 system, financial reporting and management pattern. Further, in
order to maintain the standard of rating attained, the companies
try to improve their existing practices to match the competitive
standards.
5. Rating facilitates best pricing and timing of issues.
6. The rating leads the companies to assess their own performance. It
provides motivation to the companies for growth as the promoters
of the companies feel confident in their own efforts and are
encouraged to undertake expansion of their operations or new
projects.
7. Companies with rated instruments avail of the rating as a
marketing tool to create better image in dealings with their
customers, lenders and creditors.
8. Credit rating provides recognition to some unknown or new
issuers as investors invest their money after considering the rating
grade given to them rather than just by their names. So, a
relatively new issuer with good credit rating can have a strong
standing in the financial market.
To Investors
A rating is one of the inputs that is used by investors to make
an investment decision. Rating exercise adds to the structure and
system of trading market as the debt securities can be classified
according to the ratings so that the investors can weigh the ratings
vis--vis advantages of securities (Khan and Akbar, 1993). Various
benefits available to the investors from credit rating include:
1. Credit rating gives superior information about the rated product
and that too at low cost, which the investor, otherwise, would not
be able to get so easily. Thus, the investor can easily recognize the
risk involved and the expected advantage in the instrument by
looking at the symbols. This helps the investors to take calculated
risk.

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2. With the help of credit rating the investors can take quick
decisions about the investment to be made in any particular
security of the company.
3. Credit rating reduces the dependence of investors on advice of
financial intermediaries, the stock brokers, merchant bankers, the
portfolio managers or financial consultants about the good
investment proposals. As the rating symbol assigned to a
particular instrument suggests the credit worthiness of the
instrument and indicates the degree of risk involved in it. Thus,
investors can make independent investment decisions.
4. Highly rated securities/instruments of the company give an
assurance to the investors of safety of the instrument, thus, this
safeguard the investors against bankruptcy as highly rated
securities are considered as safe ones.
5. Credit rating is done by the highly qualified analysts of the
agencies, who recognize all the quantitative and qualitative
variables of the company before assigning the rating. Thus, credit
rating gives the clue of credibility of the issuer company. It relieves
the investors from botheration of knowing about fundamentals of a
company, as such rating saves time and energy of investors.
6. As investors need not to see into the fundamentals of the
companies, so with the help of rating they can compare many
instruments of various companies at a time and they can make
choice depending upon their own risk profile and diversification
plan.
7. Investors can make the correct investment decisions after
considering or evaluating the rating of instruments, without just
relying on the criteria of name recognition. As the well-known or a
prominent groups companies often go sick and investors funds
deposited with them are rendered unsafe.
8. After rating the instruments, the rating agencies are involved in
the ongoing surveillance of the instrument being rated. The rating

17
 agencies downgrade or upgrade the instruments after considering
the subsequent financial strength of the company whose
instrument is rated by it. This ongoing surveillance gives a great
benefit to the investors as they can change their investment
decision accordingly.
9. Credit rating encourages the investors to invest in securities or
instruments of companies as rating gives them clear cut idea
about the financial strength of the company without putting any
extra efforts. Thus, rating induces/encourages habit of saving
among investors.
10. The investing community is also benefited from the allied services
provided by credit rating agencies such as research in the form of
industry reports, corporate reports, seminars and open access to
the analysis of agencies.
Thus, credit rating helps the investors in numerous ways by
safeguarding their interests. According to US Credit Rating Agency
Standard and Poors, Credit ratings help investors by providing an
easily recognizable, simple tool that couples a possibly unknown
issuer with an informative and meaningful symbol of credit quality.
To Brokers and Financial Intermediaries
The brokers and other financial intermediaries also gain
benefits from credit rating as through rated instruments these parties
need to make less efforts in studying the companys credit position to
convince their clients to select a particular investment proposal. The
time, cost and energy of brokers and financial intermediaries is saved.
To Regulators
Credit rating is also helpful to regulators as Rated securities
bring improvement in capital market and reflect upon its efficient
functioning. With the help of the symbols assigned to the rated
company the regulators can differentiate between good and bad
companies without incurring any financial burden. Thus, this helps
them to take timely action against defaulted companies. The credit

18
rating and the related detailed analysis by the Credit Rating Agencies
help in disseminating information to all, and thus, impart
transparency in the system, which is very helpful to small investors,
who otherwise may not have access to such information and who in
turn may rely on regulators for such transparency. Thus, this task of
regulators of providing transparency to investors is done by Credit
Rating Agencies thereby making the regulators task less onerous.
Regulators rely on credit rating for various other purposes also (Arora,
2003).
1.4.2 Disadvantages of Credit Rating
Despite various benefits to different parties including investors,
issues or rated company, etc. credit rating also has many
disadvantages as the system relies heavily on expert judgments and
subjective information. So, there is difficulty in objectively comparing
and re-examining past credit assessments. Some of the drawbacks of
credit rating are stated below:
To Investors
1. Credit rating is given on the basis of past and present performance
of the company and once the rating is assigned to any instrument
it is rarely revised. Thus, this rating exercise is a static process
and not beneficial for investors who rely on rating for their future
investment decision.
2. Credit rating is an indication and no full proof reliability of
assessment as Issuer Company might conceal material
information from the investigating team of the credit rating agency.
In such cases, quality of rating suffers and renders the rating
unreliable.
3. Owing to time and cost constraints, credit rating agencies are not
able to capture all the characteristics of an issuer and issue. This
may lead to biased rating.
4. Rating is done for a particular instrument of the company and not
the company as a whole. Therefore, rating is no guarantee for the

19
 soundness of the company. But many investors do not know this
fact and they take high rating as a certificate of soundness of the
company and other instruments of the company, and therefore,
they lose their money sometimes.
5. The issuer companies have a choice to accept or not to accept
rating; and only favourable ratings are accepted by the companies
and made public. This misleads the investors if the rating given by
one agency is not acceptable by the company, they may go to other
agencies to get their instruments rated. This is called Rating
shopping. In order to compete for clients, agencies will be tempted
to hand out more favourable ratings and to compete for lower fees
for by lowering their research and analysis cost (Jutur, 2005).
6. The issuers are paymasters, thus, independence of ratings
becomes questionable and the issuers may influence the rating
decision according to their own needs.
7. Further, credit rating agencies are not accountable for the ratings
given by them. If they do not work with high integrity and
devotion, their ratings may mislead the investors. Further, the
issuer companys image may also be on stake due to this.
8. There is a possibility of confusion due to existence of many credit
rating agencies, which rate the same instrument differently. This
difference in rating may be due to no common rigid formula for
rating with all agencies. Therefore, subjective bias in the area, viz.
management quality, asset quality, auditors quality, accounting
accuracy, etc. may arise in credit ratings (Azahgaiah, 2004).
9. In western countries, the rating agencies undertake voluntary
rating even if the issuer company does not approach them. This
unsolicited rating is primarily intended towards protection of the
interest of the common investors. However, this aspect is lacking
in India (Azahgaiah, 2004).
10. Time factor affects ratings, so sometimes misleading conclusions
may be drawn as particular company in certain industry may get

20
 low rating due to temporary adverse condition of that particular
industry, which may adversely affect the companys interest and
goodwill.
11. Sometimes rating agencies in order to attract business lure a
corporate with a prospective high rating. Subsequently, after 2-3
months, the rating is downgraded and the issuer does not have
any choice but to accept it (Goel, 1998).
12. Validity of rating ends with the maturity of a debt instrument and
it no longer subsequently benefits the issuer company, because a
rating is valid for the life time of the debt instrument being rated.
Therefore, for a short period its validity amuses the investors but
over a long period it cannot escape uncertainty and doubts
(Verma, 2000).
13. Another major controversy surrounding corporate ratings is rating
agencies providing consultancy services to the firms whom they
rated (Jutur, 2005).
1.5 HISTORICAL PARALLELS OF CREDIT RATING
The World Scene
US has been the birth place of rating agencies as in the
background of great financial crisis of 1837 in USA the need was felt
to predict the ability of merchants and traders to pay their financial
obligations. In this context, one of the pioneer professional thinker,
Louis Tappan established the first mercantile bank credit rating
agency in New York in 1841, which rated the debt paying ability of the
merchants. This mercantile rating agency was further acquired by
Robert Dun, and its first rating guide was published in 1859. Another
similar agency was set up by John Bradstreet, a financial analyst, in
1849, who published the analytical work done by it in its rating book
in 1857. The mercantile rating agency acquired by Robert Dun and
agency set up by John Bradstreet were merged together to form Dun
& Bradstreet in 1933. Corporate bond ratings were developed prior to
World War-I in response to a commercially viable need for

21
independent and reliable judgment about the quality of corporate
bonds (Pogue and Soldofsky, 1969).
As such in 1900 John Moody founded Moodys Investors Service
in US and in 1909 published his Manual of Railroad Securities with
comments on 200 major railroad companies by John Moody. Further,
utility and industrial bonds were rated by the Moodys in 1914
followed by bonds issued by US cities and other municipalities in the
early 1920s. Moodys also assigned sovereign ratings to debt of various
nations including Britain, Italy, Japan, China, etc. Further, the
Moodys started rating the debt of international issues in 1950 by
rating the Yankee bond issue of Canada and the World Bank. The
purpose of Moodys ratings is to provide the American investor with a
simple system of gradation by which the relative investment qualities
of bonds may be noted. Gradations of investment qualities are
indicated by rating symbols representing a group in which the quality
of characteristics are broadly the same (Pogue and Soldofsky, 1969).
Thus, Moodys was the first to use the alphabetical symbols like Ass,
As and so on in the credit rating system which became the base of
modern credit rating. Then in 1962, the Dun and Bradstreet which
was formed in 1933, acquired the Moodys Investor Services. Evidence
of the application of credit rating to corporate instruments for the first
time is also traceable to the time when Henry Vernum Poor (a
journalist) and his son started a firm to publish Poors Manual of
Railroad of the United States in 1860s in USA. The manual reported
financial and operating statistics covering several years for most of the
major American rail roads.
After John Moody began his ratings of railroad bond in 1909,
the Poors company also entered the bond rating business, by
publishing its first ratings in 1916. A new entrant in information and
rating business by the name of Standard Statistics Company also
started its operations in 1922 followed by Fitch Publishing Company
in 1924. The Poors Publishing Company and Standard Statistics

22
Company merged together in 1941 to form Standard and Poors (S&P).
S&P was further taken over by McGraw-Hill, the publishing giant in
1966. The credit rating agencies expanded from the 1970s through
the 1990s, much as they did from 1909, when John Moody introduced
the concept, to the 1930s (Jutur, 2005).
In the 1970s a number of rating agencies started rating
activities all over the world. In 1972, Canadian Bonds Rating Service
was established followed by the incorporation of Thomson Bank
Watch in 1974, which was based in Toronto, Canada and which was
exclusively following financial institutions including banks, securities
firms and finance companies. In 1975, Japanese Bond Rating
Institute was incorporated by Japan Economic Journal. The other
rating agencies in Japan such as Japan Bond Research Institute,
Japan Credit Rating Agency, and Nippon Investors Services came to
be established soon thereafter. In 1975, McCarthy Crisanti and Maffei
was established in USA which was acquired by Duff and Phelps in
1991. Dominion Bond Rating Service was established in 1977 in
Canada, and IBCA Limited in 1978. IBCA Ltd. was an independent
and privately owned international credit rating agency based in
London (UK) and was established with the objective of offering credit
analysis of bonds in different countries. In 1980, Duff and Phelps
Credit Rating Company was formed which is a major source of credit
information internationally. It rates all major types of fixed income
securities, long and short-term debts of corporations, sovereign
nations and financial institutions. This company operates in Latin
American countries and also in Asian countries, viz. Pakistan and
India.
US is the originator of concept of credit rating but now with the
development of capital markets the world over, it is becoming a
universal phenomenon (Sarkar, 1994). Now there are credit rating
agencies operating in many other countries of the world also including
Malaysia, Bahrain, Bangladesh, China, Philippines, Mexico,

23
Indonesia, Israel, Pakistan, Cyprus, Korea, Thailand, Kazakhstan,
Uzbekistan and Australia.
Origin and Growth in India
In India, the rating activities started with the incorporation of
the Credit Rating Information Services of India Ltd. (CRISIL) in 1987
which commenced its operations of rating of companies in 1987-88
and was promoted by Industrial Credit and Investment Corporation of
India Ltd. (ICICI) and Unit Trust of India (UTI). Thus, India became the
first among the developing world to set up a credit rating agency.
CRISIL has its association with internationally recognized rating
agency Standard and Poors (S&P) since 1996. The second rating
agency Investment Information and Credit Rating Agency of India Ltd.
(ICRA) was incorporated in 1991 and was jointly sponsored by
Industrial Finance Corporation of India (IFCI) and other Financial
Institutions and banks. ICRA is an associate of the International
Rating Agency Moodys Investors Services. The other rating agency,
Credit Analysis and Research Ltd. (CARE), incorporated in April 1993,
is a credit rating information and advisory services company promoted
by Industrial Development Bank of India (IDBI) jointly with Canara
Bank, Unit Trust of India (UTI), private sector banks and financial
services companies. Another rating agency Onicra Credit Rating
Agency of India Ltd., which was incorporated in 1993, is recognized as
the pioneer of the concept of individual credit rating in India. Further,
Duff and Phelps Credit Rating (India) Private Ltd. (DCR) was
established in 1996, presently known as Fitch Ratings India Private
Limited.
One more rating agency, SME Rating Agency of India Limited
(SMERA) which was a joint venture of SIDBI, Dun & Bradstreet
Information Services (D&B), Credit Information Bureau of India
Limited (CIBIL), and 11 other leading banks in the country, was
established on September 5, 2005. It is the countrys first rating
agency that focuses primarily on Indian SME sector. A new rating

24
agency, Brickwork Ratings (BWR) which is based in Bangalore was
incorporated in 2007. Besides CRISIL (Standard & Poor), ICRA
(Moodys), CARE and Fitch, Brickwork Ratings is the fifth Credit
Rating Agency to be recognized by SEBI. The growth of credit rating
agencies across the world is shown in Table 1.1.
Table 1.1
Growth of Credit Rating Agencies
Country Credit Rating Agency
USA Mercantile Credit Agency(1841)
USA Moodys Investors Service(1900)
USA Poor Publishing Company(1916)
USA Standard Statistics Company(1922)
USA Fitch Publishing Company(1924)
USA Dun & Bradstreet(1933)
USA Standard & Poor(1941)
USA McGraw-Hill(1966)
Canada Canadian Bond Rating Service(1972)
Canada Thomson Bankwatch(1974)
Japan Japanese Bond Rating Institute(1975)
USA McCarthy Crisanti & Maffei(1975)
Canada Dominican Bond Rating Service(1977)
UK IBCA Limited(1978)
USA Duff & Phelps Credit Rating Company(1980)
India CRISIL(1987)
India ICRA(1991)
India CARE(1994)
India Duff & Phelps Credit Rating India (P) Limited (Now Fitch Ratings
India Private Ltd.)(1996)
India SME Rating Agency of India Limited (SMERA)(2005)
India Brickwork Ratings India Pvt. Ltd (BWR)(2007)

1.6 GLOBAL REGULATORY OVERSIGHT

Credit rating agencies conduct business in numerous countries,
and have a great impact on the financial system across the globe.
Thus in view of the critical role played by credit rating agencies and

25
their increased importance in the modern financial architecture the
International Organization of Securities Commission (IOSCO), the
United States Securities and Exchange Commission (SEC), the
European Commission Committee of European Securities Regulations
(CESR), and the United States Congress and Senate have collectively
tried to remove certain shortcomings inherent in credit ratings
including barriers to entry and lack of competition, conflicts of
interest, lack of transparency and accountability. IOSCO has, thus,
formulated a Code of Conduct Fundamentals for the working of credit
rating agencies, which were recently updated in May 2008. The Code
Fundamentals are designed to apply to any credit rating agency and
any person employed by a credit rating agency in either full time or
part time capacity. The Code of Conduct focuses on transparency and
disclosure in relation to credit rating agency methodologies, conflicts
of interest, use of information, performance and duties to the issuers
and public, the role of credit rating agency in structured finance
transactions, etc (Government of India, 2009).
The US Securities and Exchange Commission (SEC) in 1975
began an informal process of recognizing rating agenciesby giving
them the designation Nationally Recognized Statistical Rating
Organizations (NRSROs)which permitted regulated entities such as
brokerage companies and mutual funds to rely on their ratings to
satisfy specific regulatory requirements. This designation involved
minimal informal oversight, since it relied on market acceptance
rather than regulatory standards.
In 2006, following a series of corporate scandals and especially
the one involving Enron, the US Congress passed the Credit Rating
Agency Reform Act. It provided the SEC with explicit legal authority to
require rating agencies electing to be treated as NRSROs to register
with it (thereby opening a clear path of entry for new competitors) and
to comply with certain requirements (Katz et al., 2009). Thus, in the
US, credit rating agencies are subject to the Credit Rating Agency

26
Reform Act of 2006, which sets standards which are similar to those
established under the IOSCO Code of Conduct. In 2009, the US
Securities and Exchange Commission (SEC) amended its regulations
for rating agencies to require enhanced disclosure of performance
statistics and rating methodologies, disclosure on their website of a
sample of rating actions for each class of credit ratings, enhanced
record keeping and annual reporting, and additional restrictions on
activities that could generate conflicts of interest (for example,
prohibiting rating agencies from advising issuers on ratings and
prohibiting ratings personnel from participating in any fee discussions
or negotiations). Regulators in Europe, Japan, and Australia are
actively reviewing formal oversight of rating agencies. A regulation on
credit rating agencies was approved in April 2009 by the European
Parliament and was followed by a communication on financial
supervision by the EU Commission in May 2009. All rating agencies
that would like their credit ratings to be used in the European Union
will need to apply for registration to the Committee of European
Securities Regulators (CESR) and be supervised by it and the relevant
home member state (Katz et al., 2009).
The Securities and Exchange Board of India (Credit Rating
Agencies) Regulations, 1999 empower SEBI to regulate credit rating
agencies operating in India. In fact, SEBI was one of the first few
regulators, globally, to put in place an effective and comprehensive
regulation for credit rating agencies. It is observed that all SEBI
regulated credit rating agencies in India have framed their internal
code of conduct, which have provisions, inter alia, of conflict of
interest management, avoidance and disclosures of conflict of interest
situations, etc. and such provisions prescribed are by and large in
accordance with the IOSCO Code of Conduct Fundamentals for credit
rating agencies. The internal code of conduct formulated by the credit
rating agencies is in addition to the Code of Conduct prescribed under

27
the SEBI (Credit Rating Agency) Regulations 1999 (Government of
India, 2009).
Further, few of the Indian credit rating agencies are members of
Association of Credit Rating Agencies in Asia (ACRAA). These include
Brickwork Ratings India Pvt. Ltd., Credit Analysis and Research Ltd.
(CARE), CRISIL Ltd., and ICRA Limited. Association of Credit Rating
Agencies in Asia (ACRAA) was formed on September 14, 2001 by 15
Asian Credit Rating Agencies from 13 countries and it is assisted by
Asian Development Bank (ADB). It was a pioneering event to bring
domestic credit rating agencies in a regional co-operative effort. As of
June 2010, membership has increased to 27 members from 14
countries as shown in Table 1.2.
Table 1.2
Asian Credit Rating Agencies which are Members of ACRAA
Country Credit Rating Agency
Bahrain Islamic International Rating Agency (IIRA)
Bangladesh Credit Rating Agency of Bangladesh Limited (CRAB)
Credit Rating Information & Services Limited (CRISL)
China China Chengxin International Credit Rating Co., Ltd. (CCXI)
Dagong Global Credit Rating Co. Ltd. (Dagong)
Shanghai Far East Credit Rating Co. Ltd. (SFECR)
Taiwan Ratings Corp. (TRC), Taipei
Shanghai Brilliance Credit Rating & Investors Service Co. Ltd
India Brickwork Ratings India Pvt. Ltd.(BWR)
Credit Analysis and Research Ltd.(CARE)
CRISIL Ltd.
ICRA Ltd.
Indonesia PEFINDO Credit Rating Indonesia (PEFINDO)
Japan Japan Credit Rating Agency Limited (JCR)
Korea Korea Investors Service, Inc. (KIS)
Korea Ratings Corporation (Korea Ratings)
NICE Investors Service Co. Ltd. (NICE)
Seoul Credit Rating & Information, Inc. (SCRI)
Kazakhstan JSC "Rating Agency of Regional Financial Center of Almaty
City"
Malaysia Malaysian Rating Corporation, Berhad (MARC)
Rating Agency Malaysia, Berhad (RAM)
Pakistan JCR-VIS Credit Rating Co. Limited (JCR-VIS)
Pakistan Credit Rating Agency Limited (PACREDIT RATING
AGENCY)
Philippines Philippine Rating Services Corporation (PhilRatings)
Sri Lanka RAM Ratings (Lanka) Ltd.
Thailand TRIS Rating Co. Limited (TRIS)
Uzbekistan Ahbor Rating (Ahbor)

28
 ACRAA was formed to promote:
Exchange of skills and ideas amongst Asian rating agencies,
Promotion of best practices and norms of conduct among Asian
rating agencies, and
Development of financial markets in Asia.
ACRAA has been active in bringing together rating agencies from
across Asia for regular interchange of experiences. It has been
instrumental in arranging world-class training for persons involved in
the rating process in member agencies. A significant initiative
undertaken by the Best Practices Committee of ACRAA was to create
the ACRAA Best Practices Checklist. All Member Agencies are
expected to declare their positions on each of the items in the
checklist.
Moreover in India as SEBI administers the activities of credit
rating agencies with respect to their role in securities market only
there are different regulatory authorities connected to different
instruments which require mandatory rating for issuance of certain
instruments. The list of various products, and the relevant regulators
are shown in Table 1.3.
Table 1.3
Products / Instruments Requiring Mandatory Rating Before Issuance
S. No. Instrument Regulator
1. Public/Rights/Listed issue of bonds SEBI
2. IPO Grading SEBI
3. Capital protection-oriented funds SEBI
4. Collective Investment Schemes of SEBI
plantation companies
5. Commercial Paper RBI
6. Bank loans RBI (Basel-II capital computation for
banks)
7. Security Receipts RBI (For NAV declaration)
8. Securitised instruments (Pass RBI (Basel-II capital computation for
Through Certificates) banks)
9. Fixed Deposits by NBFCs & HFCs RBI
10. LPG/SKO Rating Ministry of Petroleum and Natural Gas
11. Maritime Grading Directorate General of Shipping

29
 As clear from the table, the regulators such as Reserve Bank of
India (RBI), Ministry of Petroleum (MoP), IRDA and Directorate
General of Shipping have incorporated ratings into the investment
guidelines for the entities they regulate.
It may be stated ay the end that in the environment of
uncertainty, bond ratings serve as an important source of information
for comparing and evaluating the credit worthiness of debt (Moon and
Stotsky, 1993). Thus, credit rating is index assigned by rating
agencies as a measure of creditworthiness and default probability of a
company regarding its debt obligations. It is a professional opinion
given after studying all available information at a particular point of
time. Further, there is no privity of contract between an investor and a
rating agency and the investor is free to accept or reject the opinion of
the agency. An informed decision-making is the hallmark of Corporate
Governance and this is what Credit Rating Agencies are for: to inform
the investor upon the viability of the securities and the pros and cons
associated with investing in them. Credit Rating Agencies influence
investor behaviour and regulate issuers access to financial markets
as thus, they act as markets gatekeepers (Jain and Sharma, 2008).
Nevertheless, rating is essentially an investor service and a rating
agency is expected to maintain the highest possible level of analytical
competence and integrity. So, in the long run, credit rating agencies
have to build their credibility on the quality of its services. The impact
of credit rating in the modern financial system can be highlighted in
the words of Thomas Friedman, a journalist, who had once said,
There are two superpowers in the world today. Theres the United
States and theres Moodys Bond Rating Service. The United States
can destroy you by dropping bombs, and Moodys can destroy you by
downgrading your bonds. And believe me, its not clear sometimes
whos more powerful.

30
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