The history and objectives of credit rating?

A credit rating is an opinion of a particular credit agency regarding the ability and willingness of an entity (government, business, or individual) to fulfill its financial obligations in completeness and within the established due dates. A credit rating also signifies the likelihood a debtor will default. Credit ratings date back to the early 20th century. They became particularly influential after 1936 when US federal banking regulators issued new rules prohibiting banks from investing in speculative bonds—bonds with low credit ratings. Credit rating agencies in India began in the second half of the 1980s. In India, CRAs are regulated by SEBI (Credit Rating Agencies) Regulations, 1999 of the Securities and Exchange Board of India Act, 1992.

A credit rating is a comprehensive tool for the assessment of the financial strength of corporates and Government entities. A credit rating agency is a company that provides an independent evaluation of the creditworthiness of debt securities issued by governments and corporations especially their ability to meet principal and interest payments on their debts. These ratings provided by rating agencies on an entity allow it to borrow money from financial institutions or public debt markets easily. Credit ratings are also important at the country level. Foreign Institutional Investors rely on credit ratings from credit rating agencies for investment in a particular country.

In India, CARE, CRISIL (Crisil Rating Ltd), FITCH India, ICRA, and Brickwork Ratings (certificate was canceled for some time, however, The Reserve Bank of India has permitted banks to use the rating s of Brickwork Ratings for risk weighting their claims for capital adequacy purposes according to RBI statement dated July 10,2024), SMERA, and INFOMERICS are the seven domestic rating agencies approved by RBI for risk weighting their claims for capital adequacy purposes. Banks have the option to select credit rating agencies of their choice for both risk weighting and risk management purposes.

Credit rating agencies employ unique terminologies within their credit rating scales to delineate the risk inherent to corporate entities. These credit rating systems are designed for this purpose.

Please see the following image of different credit rating agencies indicating their credit rating uniquely. Reserve Bank of India has permitted banks in India to use ratings of international rating agencies like Fitch; Moody’s; and Standard & Poor’s for risk weight mapping for long-term and short-term ratings. Short-term debt is rated on a different scale than long-tenor debt because the ability of the issuer to meet obligations in the short term is related to different parameters than the ability to repay in the long term. This is because of the ability to repay short-tenor obligations based more on financial liquidity than the issuer’s growth or risk potential. The rating scale is divided into “Investment Grade” and “Speculative Grade,” with both categories divided into three sub-levels. For example, an “A” rating is divided by Standard & Poor’s and FITCH into A-, A, A+, and A3, A2, and A1 by Moody’s. Besides rating decisions, the rating agencies comment on the credit outlook. The ‘Outlooks’ are also divided into three types viz. negative, stable, and positive based on financial and accounting parameters and data analysis. The ‘outlooks’ provided by the credit rating agencies on an entity or country project the probability of nonpayment of debt which may cause deterrent effects on the investment decisions of the investors in such entity/country.

While assessing the credit rating of a sovereign the rating agencies utilize a large number of economic and other ratios. The most important variables examined include economic characteristics, Monetary Environment, Foreign Trade, Security instability, etc.

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