Credit Rating is an assessment of the borrower’s ability to repay the loan/debt sanctioned by a bank or financial institution. These ratings are assigned by credit rating agencies (CRA), which are few in number and spread across globally. Credit ratings are assigned to companies, businesses, countries and other entities seeking funds/loans for various business and administrative, investment purposes. These agencies are paid by the companies who seek ratings to their existing or proposed credit facilities.
CRAs assign ratings for entire range of debt instruments like bank loans, certificates of deposit, commercial paper, non-convertible debentures, asset backed and mortgage backed securities, perpetual bonds and guarantees etc. Coming to Indian context, Credit ratings are assigned by established and accredited agencies like CRISIL, CARE, ICRA, India Ratings (earlier Fitch Ratings) and Brickwork Ratings India Pvt Ltd .
Impact of Basel Norms on Bank Lending
A bank loan rating indicates the degree of risk regarding timely payment of the bank facility being rated; the facility includes principal and interest, if any, on the principal. Reserve Bank of India’s guidelines on capital adequacy for banks, in 2007 made all banks with loan book of more than Rs. 5.0 crore has to be externally rated.
The Basel II guidelines require banks to provide capital on the credit exposure as per credit ratings assigned by approved external credit assessment institutions like CRISIL, CARE, ICRA and India Ratings. Basel II is a set of international banking regulations put forth by the Basel Committee on Banking Supervision in June 2004. The objective of Basel II is to bring about common standards globally in terms of capital measurement and other key standards in the banking system. The revised framework has been applicable to all other commercial banks (except local area banks and regional rural banks) from March 31, 2009.
In line with the above, CRAs rate bank facilities of all types: term loans, project loans, corporate loans, general purpose loans, working capital demand loans, cash credit facilities, and non-fund-based facilities, such as letters of credit and bank guarantees.
The Problem with Credit Rating Agencies
When 2008 sub-prime crisis happened, globally, credit rating agencies were also blamed in addition to lenders and investment bankers. The key contention against CRAs was that top investment grades were assigned to different types of instruments though underlying risk was higher. As a result, Investment banks and other financial institutions were able to securitise thousands of sub-prime (low quality and risky) loans and sell them globally across different investors.
From Indian context, CRAs were partially blamed for assigning more than investment grade ratings to Infrastructure and other companies when underlying projects were not cash positive and unviable. As a result, in many instances, CRAs downgraded rating of companies from ‘A’ category to default category ‘D’ overnight. This tantamount to downgrading by more than 5 notches which was never heard of.
In defense of CRAs, it had to be noticed that each company works in an industry with different levels of hidden and unknown risks and it would be difficult for any single agency to measure and capture it in a single rating. Over period, as data gets collected, even the CRA systems and processes are expected to improve in gauging the intensity better.