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Introduction to Credit Ratings

Course Instructor: Sumbal Waqas

Presentation Content
Meaning and definition
Role and function of credit rating agencies
Global and Pakistan Credit rating agencies

What is Credit Ratings?


A credit rating measures the credit worthiness of

a financial security, a corporation a local


government and even a country

What is Credit Ratings?


Calculated from financial history, current assets

and liabilities
CRA tells a lender or an investor the probability of
the subject being able to meet payment
obligations for the interest and capital repayments

What is Credit Ratings?


Credit rating is an opinion on;
The relative degree of risk associated with timely

payment of interest and principal On a debt


instrument
An opinion on the issuers capacity to meet its

financial obligations in a timely manner

Origin
First CRA was established in New York in 1841 to

rate the ability of merchants to pay their financial


obligations
Later on it was taken by Robert Dun. They
published their first rating guide in 1859
The second agency was established by John
Bradstreet in 1849 which merged with the first to
form Dun & Bradstreet in 1933, which became
the owner of Moodys in 1962

Poor Credit Rating


A poor CR indicates that a company or

government has a high risk to default based on


the agency's analysis

Credit Rating Agency


Company responsible for assessing the financial

strength of a company or government entity


Includes domestic and foreign firms
Responsible for providing investors with
information of a companies credit wrothiness

Credit Ratings
Credit rating issued by CRA is an assessment of

the credit worthiness of individual financial


securities and debt issued by corporations,
government issued securities and a country's
ability to repay debt
CR are ratings assigned to companies and debt
instruments to gauge the likelihood that a
company will default on obligation to creditors. It
gives investors an idea of the risk associated
with loaning money to the entity

Credit Ratings
CR are forward looking opinions about credit risk;
Agencies opinion about the ability of an issuer to

meet its financial obligation in full time

Uses of Credit Ratings


CR critical to activities of securities market to

manage;
Building portfolio
Financial Contracts
Regulatory requirements
Trading
Pricing

Credit Reporting Agencies


Function: provide investors unbiased review and

opinion as credit risk of various securities


Example Activities:
Perform credit and risk analysis to produce ratings
Provide unbiased ratings
Provide quality and dependable information
Provide info to investors at low or no cost
Investors rely on rating to make investment

decisions
Ratings published in form of reports

Functions of a credit rating


agency
Provide easy to understand information;
Gather complex information and interpret and

summarize in simple and readily understood


manner
Provide basis for investment;
An investment rated by a credit rating agency

enjoys higher confidence from investors


Investors can make an estimate of the risk and
return

Functions of a credit rating


agency
Healthy discipline on corporate borrowers;
Higher credit rating make investment more

attractive to investors
Corporations can borrow money more cheaply if
they maintain a high credit rating on their debt

How Credit Ratings are


Established
Adjusted financial data + Other company
specific data + Industry Data
ANALYSIS
Rating Committee Rating and Recommendation

Importance of Credit Ratings


Establish a link between risk and return
Helps in investment decision: Investor uses the

ratings to assess the risk level and compares the


offered return with his expected rate of return
Necessary in view of the growing number of
cases of default

Importance of Credit Ratings


The rating agency regularly reviews the rating

given to a particular instrument. The investor can


decide to keep the instrument or sell it. E.g. If
instrument is downgraded the investor may
decide to sell it and if the rating is maintained the
investor may decide to keep the instrument

Importance of Credit Ratings


Choice of instruments: CR enables an investor

to select a particular instrument from many


alternatives available
Understandability: The CRA gives symbols to
instruments which can easily be understood by
investors

Importance of Credit Ratings


The risk perception of a common investor, in

absence of a credit rating, depends on his


familiarity with the names of company and that
they might know about the company
Saves investors Time and Effort: Not feasible
for corporate issuer to offer every prospective
investor the opportunity to undertake a detailed
risk evaluation

Importance of Credit Ratings


Saves investors Time and Effort: For the typical

investor it would be difficult to assess all of the


financial information available to assign their own
ratings
Helps in investor protection; better information
disclosure, transparency etc
Improves Corporate image: Acts as a marketing
tool

Importance of Credit Ratings


Lowers cost of borrowing: Companies with high

CRs will get funds at lower cost from the market.


High rating will enable the company to offer low
interest rates on fixed deposits and other debt
instruments. Investors will accept low interest rate as
they prefer low risk instruments.

Importance of Credit Ratings


Wider audience for borrowing: a company with

high ratings can get wider audience for


borrowing. It can approach institutions, banks,
investing companies.
Good for non-popular companies: CR can
benefit non-popular companies as if their CR are
good the public will invest in these companies
even if they do not know these companies

Importance of Credit Ratings


Helps in growth and Expansion: CR enables a

company to grow and expansion as a better CR


will enable a company to get finance easily for
growth and expansion
Therefore, the need for credit ratings in todays
world is important!!!

Demerits of CRs
Possibility of bias exist: Rating teams try their

best to provide unbiased opinion of the credit


quality of the company but the information
collected by the rating team may be subject to
personal bias.
Improper disclosure may happen: the company
being rated may not disclose certain material
facts to the investigating team. This can effect the
quality of the CR

Demerits of CRs
A credit rating is not a guarantee for financial

soundness of the company. Many changes can


take place in the future due to changes in
economic, political, social technological
environments.
Problems for new companies: for new
companies it might be hard to collect funds from
the market because it may not be able to prove
its financial soundness. So, it might receive a
lower CR

Demerits of CRs
Downgrading by Rating Agency: if the

performance of a company is not as expected


then the CRA will downgrade the instrument. This
will affect the image of the company.
Difference in rating: there are cases where
different CRs are assigned by different CRAs for
the same instrument. This can cause confusion in
the minds of the investor

Disclosure of Ratings
Rating agency should make public the definitions

of the concerned rating along with the symbol


E.g: Pakistan government rating by S&P is B-

Registration
Credit rating agencies are regulated by both SBP

and SECP
License is mandatory for carrying out the rating
business

Eligibility Criteria
Is set up and registered as a company
Has specific rating activity as one of its core

objects in its Memorandum of Association


Has a minimum Net worth of PKR 100million
(Pakistan)
Has adequate infrastructure
A joint venture/technical collaboration with a
reputed CRA for not less than five years
(Pakistan)

Eligibility Criteria
Promoters have professional competence,

financial soundness and a general reputation of


fair integrity in business transactions
Has employed persons with adequate profession
and other relevant experience

What makes A CRA fall from SECP


favor?
Any non-compliance with SECP
Any conduct deemed detrimental in the public

interest would result in;


Suspension
Cancellation of a CRA license

The CRA would be given the right to defense

before such a decision

Grant of Certificate of
Registration
SECP will grant to eligible applicants a Certificate

of Registration on the payment of fee


Certificate of registration valid for one year, it is
renewed on payment of fee

Agreement with the client


CRA enters into a written agreement with

respective client
Fee charged
Clients agreement to cooperate and provide true
and adequate and timely information
Disclosure by CRA to client regarding the rating
assigned
Clients agreement to disclose the rating assigned

Monitoring of Ratings
CRA should continuously monitor the rating of

securities/corporations rated by it during its tenor


CRA should disseminate information regarding
newly assigned rating and its changes in the
earlier rating through press release and websites

Global Credit Rating Agencies


Three best known CRAs:
Moodys Investors services
Standard &Poors
Fitch

Credit Rating Scale


Moodys

S&P

Fitch

Meaning

Aaa

AAA

AAA

Highest Quality

Aa1

AA+

AA+

Aa2

AA

AA

Aa3

AA-

AA-

A1

A+

A+

A2

A3

A-

A-

High quality: VERY


Strong
Capacity to meet
financial obligations. It
Differs from the top line
rating only in a small
degree
High Quality: STRONG
but is somewhat more
susceptible to adverse
effects
Of changes in
circumstances and

Moody
s

S&P

Fitch

Baa1

BBB+

BBB+

Baa2

BBB

BBB

Baa3

BBB-

BBB-

Meaning
Medium Grade: ADEQUATE capacity to
meet financial obligations
But adverse conditions or changing
circumstances are more
Likely to lead to a weakened capacity to
meet financial commitments

BBB-/Baa3 is the lowest investment grade rating


Ba1

BB+

BB+

Ba2

BB

BB

Ba3

BB-

BB-

Lower medium grade: LESS VUNERABLE


but faces major
Ongoing uncertainties and exposure to
adverse conditions which
Could lead to inadequate capacity to meet
financial commitments

Moodys

S&P

Fitch

Meaning

B1

B+

B+

B2

B3

B-

B-

Caa

CCC

CCC

Poor Quality: CURRENTLY


VULNERABLE and dependant on
favorable conditions to meet
commitments

Ca

CC

CC

Poor Quality: CURRENTLY


HIGHLY VULNERABLE

CURRENTLY HGHY
VULNERABLE to non-payment

Failed to pay anyone or more of


its financial obligations

Low grade: MORE VULNERABLE


and adverse business
Financial or economic
conditions will likely impair its
capacity
Or willingness to meet financial
commitments

PAKISTAN

Mandatory Ratings in Pakistan


SECP and Central Bank made it mandatory for

financial sector entities to obtain credit ratings on


regular basis
Commercial Banks (regulated by SBP)
Insurance companies (regulated by SECP)
Micro finance Banks (regulated by SBP)
Asset management (regulated by SECP)
Leasing companies (regulated by SECP)

Why Ratings Made Mandatory?


Commercial banks
Can raise deposit; rating agencies provide

independent opinion on the likelihood that


commercial banks would not default on their deposit
repaying obligations
Insurance Companies
Provide insurance coverage; rating agencies

provide independent opinion that insurance


companies will honor claims

Why Ratings Made Mandatory?


Microfinance Banks
Can raise deposit; rating agencies provide

independent opinion on the likelihood that


microfinance banks would not default on their
deposit repaying obligations
Asset Managers
Managing investor money; provide an opinion on

the relative capacity of asset managers to manage


funds

Why Ratings Made Mandatory?


Leasing Companies
Provide leasing services and also raise deposits;

credit rating agencies provide an independent


opinion on the likelihood that leasing companies
would not default on their deposit repaying
obligations

Rating Agencies in Pakistan


PACRA: Pakistan Credit Rating Agency
JCR-VIS: Japanese Credit Rating Agency-Vital

Information System