While having a discussion with few of my friends who have initially started their own ventures, one of them asked me “How do banks or financial institutions calculate Credit Rating?”
Just thought sharing it with all of you…
Credit Rating means an assessment made from credit-risk evaluation, translated into a current opinion as on a specific date on the quality of a specific debt security issued or on obligation undertaken by an enterprise in terms of the ability and willingness of the obligator to meet principal and interest payments on the rated debt instrument in a timely manner.
1) Request from issuer and analysis – A company approaches a rating agency for rating a specific security. A team of analysts interact with the company’s management and gathers necessary information. Areas covered are: historical performance, competitive position, business risk profile, business strategies, financial policies and short/long term outlook of performance. The team of analysts makes an assessment of the issuer’s prospects in the light of information available from management. Also factors such as industry in which the issuer operates, its competitors and markets are taken into consideration.
2) Rating Committee – On the basis of information obtained and assessment made the team of analysts present a report to the Rating Committee. The issuer is not allowed to participate in this process as it is an internal evaluation of the rating agency. The nature of credit evaluation depends on the type of information provided by the issuer.
3) Communication to management and appeal – The Rating decision is communicated to the issuer and then supporting the rating is shared with the issuer. If the issuer disagrees, an opportunity of being heard is given to him. Issuers appealing against a rating decision are asked to submit relevant material information. The Rating Committee reviews the decision although such a review may not alter the rating. The issuer may reject a rating and the rating score need not be disclosed to the public.
4) Pronouncement of the rating – If the rating decision is accepted by the issuer, the rating agency makes a public announcement of it.
5) Monitoring of the assigned rating – The rating agencies monitor the on-going performance of the issuer and the economic environment in which it operates. All ratings are placed under constant watch. In cases where no change in rating is required, the rating agencies carry out an annual review with the issuer for updating of the information provided.
6) Rating Watch – Based on the constant scrutiny carried out by the agency it may place a rated instrument on Rating Watch. The rating may change for the better or for the worse. Rating Watch is followed by a full scale review for confirming or changing the original rating. If a corporate which has issued a 5 year 8% debenture merges with another corporate or acquires another corporate, it may lead to the listing of the specified debenture rating under this policy.
7) Confidentiality of information – As the information provided by the issuers is very sensitive in nature; the rating agencies are required to keep them strictly confidential and cannot use such information for any other purpose.
8) Rating Credibility – The rating agencies follow a thorough and transparent evaluation so as to lend credibility to their findings. The policies followed are:
i. Clear and Specific ideas for a rating score.
ii. Rationale and Sensitiveness behind the ratings being made public.
iii. Publication of the limitations of rating, adequacy of information and validity of the rating score.
iv. Limiting dependence on information from third parties viz auditors, trustees, consultants, experts.
v. Not carrying out a rating exercise on an unsolicited basis.
vi. Withdrawing the ratings after expiration of the tenure and following a strict policy of not disclosing the rejected ratings except when required.
9) Rating Coverage – Ratings are not limited to specific instruments. They also include public utilities; financial institutions; transport; infrastructure and energy projects; Special Purpose Vehicles; domestic subsidiaries of foreign entities. Structured ratings are given to MNCs based on guarantees or Letters of Comfort and Standby Letters of Credit issued by the banks. The rating agencies have also launched Corporate Governance Ratings with emphasis on quality of disclosure standards and the extent to which regulatory obligations have been complied with.
10) Rating Scores – A score is given on the basis of the set parameters.
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