JAIIB IE and IFS Paper-1 Module-D Unit 12 : Credit Rating and Credit Scoring

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Aug 4

JAIIB Paper 1 (IE and IFS) Module D Unit 12 : Credit Rating and Credit Scoring (New Syllabus)

IIBF has released the New Syllabus Exam Pattern for JAIIB Exam 2023. Following the format of the current exam, JAIIB 2023 will have now four papers. The JAIIB Paper 1 (Indian Economy & Indian Financial System) includes an important topic called "Credit Rating and Credit Scoring ". Every candidate who are appearing for the JAIIB Certification Examination 2023 must understand each unit included in the syllabus. In this article, we are going to cover all the necessary details of JAIIB Paper 1 (IE and IFS) Module D (FINANCIAL PRODUCTS AND SERVICES ) Unit 12 : Credit Rating and Credit Scoring Aspirants must go through this article to better understand the topic, Credit Rating and Credit Scoring and practice using our Online Mock Test Series to strengthen their knowledge of Credit Rating and Credit Scoring . Unit 12 : Credit Rating and Credit Scoring

What Is Credit Rating

Credit rating is an analysis of the credit risks associated with a financial instrument or a business entity.
It is a risk grade given to a particular entity, based on its credentials and the extent to which, the financial statements of the entity are sound, in terms of borrowing and lending that has been done in the past.

Usually, a credit rating is in the form of

An alpha/numeric grade,
Accompanied by a detailed report, based on the financial history of borrowing or lending and
Credit worthiness of the entity or the person obtained from the statements of its assets and liabilities,

With a view to determining their ability to meet the debt obligations
It helps in assessment of the solvency of the particular entity.
In other words, a credit rating may be defined as an opinion of a Credit Rating Agency (CRA) as to the issuer's (i.e., borrower of money) capacity to meet its financial obligations to the depositor or bondholder (i.e., lender of money), on a particular issue or type of instrument (e.g., a domestic or foreign currency - short-term or medium or long-term, etc.), in a timely manner.
HIGH credit rating indicates a high possibility of paying back the loan in its entirety, without any issues;
POOR credit rating suggests that the borrower has had trouble paying back loans in the past and might follow the same pattern, in the future.

Credit Rating Agencies (CRAs)

A private company
Looks at the credit worthiness of a large-scale borrower, such as a company or country.
Effectively ranks the borrower on their ability, to pay off their loan.
It assigns credit ratings, which assess a debtor's ability to pay back debt, by making timely payments of interest and repayments of principal and the likelihood of default.
An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, and in some cases, of the servicers of the underlying debt, but not of individual consumers.
The debt instruments rated by CRAs may include, corporate bonds, Certificate of Deposits (CDs), Commercial Paper, Municipal Bonds, Preferred Stock, Debentures, and collateralised securities, such as mortgage-backed securities, collateralised debt obligations, etc.

History Of Credit Rating

1909: John Moody started rating US railroad bonds.
- Currently, three rating agencies dominate the international scene.
- Moody's Investors Service,
- Standard & Poor's Global Ratings
- Fitch.
While normally CRAs assign a rating on the request of an issuer, there are occasions, when unsolicited ratings are assigned.
While the rating of corporate bonds started in early 20th century, sovereign ratings represent a relatively new line of business for the agencies.
1959: 1^st industrial country to be rated was France, by S&P
The Credit Rating Information Services of India Limited (CRISIL) initiated the concept of credit rating in India.
1987: CRISIL was established
Jan 1988: Started its operations
Currently, 7 rating agencies are in operation in India, for rating bonds, time deposits, CPs and structured obligations.

Some of these Indian rating agencies have tie-ups/alliances with international rating agencies, such as

- CRISIL with S&P,
- ICRA with Moody's
- CARE with Fitch.

Characteristics Of Credit Rating

Assessment of issuer's capacity to repay: It assesses issuer's capacity to meet its financial obligations, i.e., its capacity to pay interest and repay the principal amount borrowed, as per the decided repayment schedule.
Based on data: A credit rating agency assesses financial strength of the borrower, on the basis of its financial data.
Expressed in symbols: Ratings are expressed in symbols, e.g., AAA, BBB, etc., which can be understood by non-experts, as well.
Carried out by experts: Credit rating is done by experts of reputed, accredited institutions.
Guidance about investment not recommendation: Credit rating is only a guidance to investors. It is not a recommendation to invest in any particular instrument.

Benefits Of Credit Rating

There are 2 main stakeholders in the credit rating by CRAs, viz.,

Investor
The issuer.

Benefits to the Investors

Assessment of risk
Information at low cost
Advantage of continuous monitoring
Provides the investors a choice of Investment

Benefits to the Issuer

Ease in borrowing
Borrowing at cheaper rates
Facilitates growth
Recognition of lesser-known companies
Imposes financial discipline on borrowers
Greater information disclosure

Factors Considered While Rating Companies/Instruments

Issuer's ability to service its debt:

For this, credit rating agencies take into consideration:

The issuer Company's past and future cash flows.
Assess how much money the company will have to pay as interest on borrowed funds and how much will be its earnings.
The current outstanding debts of the Company.
The company's short-term liquidity position
Value of assets pledged as collateral security by the company.
Availability and quality of raw material to be used, advantages of its location, its cost advantage in operations.
Track record of the promoters and directors.

Market position of the company

What is the market share of various products of the company, whether the Company's market shares will be stable, does the company possess any competitive advantage due its distribution network, customer base research and development facilities, etc.

Quality of management

The CRA will also take into consideration the Company's track record, strategies, competency and philosophy of senior management.

Industry risks

Industry risks are studied in relation to position of demand and supply relating to the products of that industry, how much is the international competition, what are the future prospects of that industry, etc.

Regulatory environment

Whether that industry is being regulated by government (like liquor industry), whether there is a price control on it, Whether there is government support for it, can it take advantage of any tax concessions, etc.

Other factors

In addition to the above, certain other factors to be noted for credit rating of a company are its cost structure, accounting quality, market reputation, quality of working capital management, human resource quality, funding policy.

Process Of Credit Rating

Credit Rating Symbols

Presently, in India, there are seven CRAs which have been approved by SEBI. These are:

CRISIL Ratings Limited
India Ratings and Research Pvt. Ltd. (Ind-Ra, formerly Fitch Ratings India Pvt. Ltd.)
ICRA Limited
CARE Ratings Ltd.
Brickwork Ratings India Pvt. Ltd.
Infomerics Valuation and Rating Pvt. Ltd.
Acuite Ratings & Research Limited

Presently, in India, there are 7 CRAs which have been approved by SEBI.

These are:

All these 7 CRAs also have been accredited by RBI, for the purpose of risk weighting banks' claims for capital adequacy purposes.

The investment-grade is considered by CRAs to be a significantly safer grade than the rest.
Rating agencies use symbols such as AAA, AA, BBB, B, C, D, to convey the credit rating to the investors for long tenor instruments of the issuers.
In all, risk is classified into 14 or 15 categories.
Signs '+' or '-', are used to further fine tune the rating.
The suffix + or - is also used to indicate the comparative position of the instrument within the group covered by the symbol.
Thus, BBB- : lies one notch above (better) BB+.

High Investment Grades AAA

Triple A denotes highest safety in terms of timely payment of interest and principal. The issuer is fundamentally strong and any adverse changes are not going to affect it.

AA: Double A denotes high safety in terms of timely payment of interest and principal. A: denotes adequate safety in terms of timely payment of interest and principal. Changes in circumstances can adversely affect such issues.

BBB: Triple B denotes moderate safety in terms of timely payment of interest and principal speculative grades.

Speculative Grades

BB: Double B denotes inadequate safety in terms of timely payment of interest and principal. Uncertain changes can lead to inadequate financial capacity to make timely payments in the immediate future.

B: Denotes high risk. Adverse changes could lead to inability or unwillingness to make timely payment.

C: Denotes substantial risk. Issue rated is vulnerable to default.

D: Denotes default in terms of timely payment of interest and principal. These symbols are just a current opinion of an agency and they are not recommendations to invest or not to invest. The rating assigned applies to a particular instrument of the company and is not a general evaluation of the company.

CRAs are required to give uniform credit rating codes, so that there is no confusion amongst the stake holders, with regard to interpretation of a credit rating. Example of the ratings given by CRISIL are as tabulated in table, AAA being the highest and D being the lowest credit

Ratings Outlook

Credit Ratings are forward-looking opinions on the relative credit risk associated with the rated debt instrument, as represented by an appropriate symbol, on the relevant rating scale.
A rating outlook gives additional information to lenders, investors or other users, about the expected direction of rating movement in the near to medium term (typically six months to two years).

The rating outlooks assigned by CRAs generally fall into four categories:

Stable,
Positive,
Negative,
No Outlook.

Regulations For CRAs In India

In India, CRAs are regulated by the Securities and Exchange Board of India (SEBI).
SEBI was one of the first regulators globally, to put forth a comprehensive framework, for the regulation of CRAs, through the SEBI (Credit Rating Agencies) Regulations, 1999 ('CRA Regulations').
Some of the CRA Regulations cover the following areas:

Registration:

Broadly, the CRA Regulations require that the CRAs should be companies promoted by persons who have experience in the field of credit rating, i.e., by financial institutions or
by persons who have a net worth of more than Rs. 100 crores.
CRAs need to have a minimum net worth of Rs. 5 crores, and adequate infrastructure, professionals and employees to carry on the activity of issuing credit ratings.
Additionally, registration would only be granted, if it is registering the applicant in the interest of investors and the securities market.

Obligations:

The CRA Regulations envisage that the CRAs need to carry out their activities, in accordance with the terms of their engagement with the issuer, and the baseline principles in the Regulations.
Comply with the Code of Conduct prescribed by SEBI : Duties with integrity, professional competence, independence and confidentiality.
CRAs are required to monitor their rating throughout the lifetime of the securities rated and carry out periodic reviews of their rating as well.

Fees For Credit Rating

In the credit rating business, the users of rating services, i.e., investors, financial intermediaries and other end-users, do not pay the rating fees.
The issuer of the financial instrument pays fees to the credit rating agency and this is the major source of revenue of the CRA.
The issuer's fees constitute 95% of the total revenues of rating agencies.
In addition to rating fees, CRAs also charge an annual surveillance fee to monitor the rated instrument/company.

What Is Credit Scoring

Credit scoring is a statistical analysis performed by lenders and financial institutions to determine the creditworthiness of an individual.
A credit score can impact many financial transactions, including home loans, auto loans, credit cards, and personal loans.
Lenders also use credit scoring in risk-based pricing, in which, the terms of a loan, including the interest rate, offered to borrowers are based on the probability of default.
While credit ratings apply to corporations and governments, credit scoring applies to individuals.
In India, credit scores are evaluated and monitored by Credit Information Companies (CICs).
Originated in USA, where consumer credit, in the form of personal and home loans and credit cards, has been established for a long time.

The three major credit bureaus, globally, are

Experian,
Equifax and
TransUnion.

Credit Information Companies (CICs) In India

A Credit Information Company (CIC) collects and maintains records of an individual's payments and dues pertaining to loans and credit cards.
These records are submitted by the respective banks and other credit institutions to the CIC.
This information is then used to create credit information reports, which is provided to credit institutions, in order to access the credit worthiness and capacity of a borrower to repay his loan and advances and discharge his other obligations in respect of credit facility availed or to be availed by him.
This requirement has been fulfilled by The Credit Information Companies (Regulations) Act, 2005, under which, CICs in India are licensed by the RBI and governed by the various other rules and regulations prescribed for them.

Credit Information Companies (Regulations) Act, 2005

Objective - An Act to provide for regulation of credit information companies and to facilitate efficient distribution of credit and for matters connected therewith or incidental thereto.
Other features - The CIC Act, 2005 further provides for the functioning of CIC, its registration procedure, settlement of dispute, privacy principles and furnishing of credit information. The RBI has further issued Credit Information Companies Regulations, 2006 to facilitate the smooth working of CIC.

At present, there are 4 CICs operating in India.

TransUnion CIBIL

CIBIL is the first entrant in the country.
Incorporated: August 2000
Recommendations by: Siddiqui Committee.
Commenced commercial bureau operations: in May 2004.
Prepares credit information reports for: Individuals & corporate entities.
Apart from compiling a credit history, a credit score is also compiled and is made available to lenders as well as proponents.
Members: 500 members including more than 200 cooperative banks.
Credit score varies from 300 to 900.
A credit score gives an indication about the borrower's propensity to pay, so that a lender can decide quickly on the request received for a loan/credit card.

Experian

2006: Established as a joint venture with several banks and financial institutions in India.
Prepares credit reports of individuals, based on the information provided by banks and other financial institutions about the financial history of the individual.

Equifax

1899: Founded in Atlanta.
One of the oldest CIC as of now
2010: Started operations in India.

CRIF High Mark Credit Information Services

An RBI approved credit bureau in India.
It serves retail, agriculture and rural, MSME, commercial and microfinance.

Membership To CICs

Available to the following institutions-

Credit Institutions (banks, RRBs, Cooperative banks, NBFCs, Public Financial Institutions, Housing Finance Institutions, etc., companies engaged in the business of credit cards and other similar cards and companies dealing with distribution of credit in any other manner or any other institution, which the Reserve Bank may specify, from time to time, for this purpose).
Insurance Companies,
Companies providing cellular or telephone services,
Credit Rating Agencies and Asset Reconstruction Companies

Regulatory Guidelines Governing CICs

Following enactment of the Credit Information Companies (Regulation) Act (CICRA) in 2005, three other Credit Information Companies (CICs) were also set up.
Section 15 of the CICRA, every Credit Institution is required become member of at least one CIC.
Section 17 of CICRA stipulates that a CIC may seek and obtain credit information from its members only (that is, member banks and other credit institutions).
As a result, whenever there was any enquiry, the enquiring bank was able to obtain credit information on a particular borrower/client as maintained by that CIC.
Accordingly, the information was incomplete as it did not include credit history related to those non-member Credit Institutions with which the borrower had a current or a past exposures.
To overcome such issues, RBI appointed a committee, under the Chairmanship of Mr. Aditya Puri, which submitted its Report in January 2014.
Recommendations: RBI issued guidelines to the effect that all Credit Institutions should become members of all CICs and the CICs should, therefore, moderate their membership and annual fees suitably. Consequently, now:

All banks and concerned financial institutions are members of all CICs, and,
No CIC should charge membership fee and annual renewal fees exceeding 10,000 and Rs 5,000, respectively.

Credit Scores

A credit score is a statistical number that evaluates a consumer's creditworthiness and is based on credit history.
Lenders use credit scores to evaluate the probability that an individual will repay his/her debts.
A credit score is a three-digit summary of the credit history of an individual.
All CICs use a uniform system of scoring so that interpretation is uniform across the entire spectrum of CICs.
Credit scores range from 300 to 900 – with 900 being the best score and 300 being the worst.
Consequently, applications with higher credit scores have better chances of success in sanctions and those with lower scores have lesser chances of sanctions.
Nearly 90% of all loans sanctioned are those with credit scores of 700 and above

A typical credit report has six sections, which sum up the applicant's demographic and credit profile and provide details of his/her credit history.