Dr BK Mukhopadhyay
A noted magement economist and an intertiol commentator on business and economic affairs. He may be reached at [email protected]
Why do we need rating systems?
The search for a perfect rating system is as old as sailboat racing itself. Boat owners, sailors, designers and handicappers are always looking for solutions that work as boat designs change with time.
The rating exercises by the well known intertiol rating agencies are on. For India Moody’s upgraded the outlook on India’s sovereign rating to positive from stable -rating Baa3 – upgraded from ‘Stable to “Positive”, while Fitch retained the stable outlook.
The very process followed on this score must be clearly publicized in as much as there happens variations on this score. If the transparency is there and users become confident about the appropriateness of the exercises, the same process gives rich dividends over time. Let us go in details.
Is the Process Followed Always Unbiased?
The Trading Economics (TE) credit rating is driven by a model created at Trading Economics – taking into account the average grade given by credit rating agencies plus multiple economic indicators, exchange rates, government bond yields, stock indexes, commodity prices and very little discretion. Unlike the ratings provided by the major credit agencies, TE index is numerical because it believes that it is easier to understand and visualize on historical data charts and more insightful when comparing multiple countries. The ratings are also more quantitative and more independent because they are less likely to be manipulated by a single credit rating agency.
The Importance is Never Less
Rating has already gained wide acceptance in the corporate, banks and fincial institutions and the capital market, among others. It is a dependable risk magement tool to identify the individual brisk level of a loan and to ensure that a bank earns a return to the risk the bank in question undertakes. Similarly for the SME Sector [Small and Medium Enterprises] more attention is being paid to risk assessment through rating exercise and the range of price and credit conditions are now definitely wider than before.
Any appropriate assessment helps explain the rating result and accordingly arrive at credit decisions. As such the rating criteria that takes into account the hard facts [fincial situation; fincial position; profitability]and soft facts [magement; fincial reporting; installations, products’ organizations’; market and market forecasts] as well as the warning sigls [profit cuts; cash losses; late handing over of annual accounts] should not lose sight of.
Again, rating agencies are key players in the securitization are. Most asset backed issues worldwide are rated and in India rating is mandatory under Reserve Bank of India guidelines. In fact the rating agencies specifies the level of credit enhancement and other risk mitigation arrangements to be maintained in structure and the rating sought from the rating agency is decided on the basis of investor’s preference. In India, practically an emerging market for securitisation, anything below AAA may not find the investor’s acceptance. Still, it is virtually a matter of time before investors start accepting lower rated papers at higher yields. It remains a fact that the level of credit enhancements and other risk mitigation would vary for different ratings sought for.
The fact is: credit rating [measure of credit risk] agencies put a lot of reasons for the rating such that they do not necessarily get blamed in the event of a result which is a different one that thought of. For example: in a falling market if an investor does not exercise his put option simply blaming the rating agency is not a correct proposition.
An investor, so to say, has to use the rating to his advantage – investing in highly rated bonds only; considering a bond lower than the highest rating [higher risk] I and only if there is a secondary market for bond selling in case of a rating downgrade and thus developing a cut-loss-policy; in case similar rated bonds offer different ROI the bonds offering higher ROI require to be further scanned for evaluating the risk factors; etc. Similarly, a bond having subordited obligation should not normally be graded AAA as in that case the rating would be misleading – so the onuses on both the sides.
Such sort of rating is for ebling the investor to understand the safety of the instrument in which the banks, for example, would be investing. Rating of instruments can vary from highest safety, high safety, reasoble safety, safety, safe, not safe, risky, and too risky. As the rating moves from highest to lowest the risk of default goes up.
That is to say, the need arises as to studying the organisation in question, magement, assets quality as well as the business plans. Standing of the company coupled with the environmental alysis definitely helps the raters to arrive at meaningful conclusions as to whether the money to be invested would be least risky and rewarding. There definitely could exist a degree of variations among theses issues and accordingly the credit rating goes on varying.
In fact rating has a number of benefits thus to reap from. Credibility of the Institution goes up along with confidence building with partners [good rating gives comforts to lenders, customers and suppliers too]. It acts as a self-improvement tool. Any alytical report on the corporate strengths and weaknesses help, in turn, strengthen operations and improves visibility of course.
Rating of an instrument is related to the instrument issued and not meant for the company issuing the same. Rating is the opinion expressed based on logical reasoning aiding the investor to invest. It is also a fact that the companies which use the initial rating with pomp and show for marketing the issues has to announce the downgrading to the investors as well. As such rating itself has some inherent risks if not understood well. Rating is an effective risk assessment method in India. The discipline has merits in many ways if understood well and at the same time put into use appropriately.
Upshot: an ideal rating system should have the following features: be open, transparent and freely available; have rules that are objective, non-biased and open to input; have ratings that are simple, but accurate; have flexible scoring options for use with different course types; be easy to use and understand; be locally maged but available world wide Globally a good score gets a better deal!