In this article, I will be discussing everything about Credit Rating Agencies In India Suppose you are a bank and a startup company came to raise capital by borrowing money in the form of a loan.
After going to the financial statements, plan, and past track records, you decided to lend the money to
that company. Guess what happened after a time due to the company’s high competition and lazy execution.
The startup fails to do well, and eventually, it fails to repay your bank loan as well.
So it’s not just the one startup you see; there are a lot of companies and startup companies that take a loan from banks and other institutions in the form of debt instruments, bonds, and many a time, these companies fail to repay the loans.
You may ask why do this institution and Bank lend the substandard loan. You know a bank job is to give a loan, right. It is bound to make mistakes if it has to assess the creditworthiness of the companies.
They have to juggle accounts of various companies’ financial statements of the borrowing company. It would have to understand the business model of that borrowing company. It would have to do that till the borrower return their money.
It is pretty difficult for the Bank to do all this, so now the question is whose job is to take creditworthiness of borrowing companies, so the answer is credit rating agencies.
So generally, whenever any company wants to start its operation or expand, it requires money; it needs capital to do that. Naturally, the company can raise this money from instruments like debenture, bonds or it can take a loan from the Bank.
Or it can raise this money by issuing equity shares to the general public. Generally, whenever the company raises money through debt instruments and bank loans, they get a credit rating from the borrowing company.
And this credit rating agency assesses the financial health of the borrowing company by going through their financial statement or going through their past track record of payments.
They’re telling these lenders that how likely the borrowing companies can’t fault loan payment now; the question is why credit rating agencies are essential?
So if you are not aware, let me tell you about this one company called Infrastructure Leasing and Financial services IL&FS. So this company is in the financial service sector.
It used to fund infrastructure projects, so it took colossal debt to support its project. When its project didn’t get a good return, it took more debt.
And eventually, when the companies revenue got dried up, the company started defaulting in its payment.
Also when this company started the credit rating agencies failed basis the financial picture of this company and gave this company AAA ratings.
And eventually, investors like institutional investors and mutual fund companies invested in this company considering the rating from the rating agencies.
When this company started to default, institutional investors, public investors had to incur losses. The whole NBFC industry faces a liquidity crunch just because of this default.
So in this one incident where the credit rating agencies fail to play their part well, the financial service industry suffers. We know how important credit rating agencies are for the entire financial ecosystem with this incident.
Credit Rating Agencies in India:
The credit rating business is quite crucial and lucrative at the same time for the economy, so let’s deep dive. In India, Seven rating agencies are approved by the Reserve bank of India.
Now you may ask that why is credit rating industry oligopolistic? So one reason for it may be a high entry barrier, so credit rating agencies have a massive responsibility of rating the credit and loans and due to this cause huge responsibility both SEBI and RBI highly regulate these companies.
Because of that, there are substantial regulatory requirements for entering into this industry. Due to this higher regulatory requirement, there are very few players.
Because of this, the existing players enjoy a colossal market share now. Before diving deeper into the credit rating industry, let’s learn the parties involved in the credit rating process so main lead there are three parties number 1 investor’s number 2 issuers and number 3 raters.
Issuers are companies or institutions that lend money by giving interest to the general public or institutional investors. Between issuance and lenders, a vital party is credit rating agencies that assess the creditworthiness of the borrowers.
They rate the securities no credit rating agencies opinion matters a lot in the whole process. Still, these credit rating agencies do not have any skin in the game, as they cannot be held liable if the borrowing companies go bankrupt.
So each issuance of the security or get a rating from the credit rating agencies without the rating of the RBI, that debt instrument cannot be issued.
The objective of this rating is to assess the financial health of the Issuer and to check its loan repayment capabilities, so this was about the major parties involved in the credit rating agencies.
The business model of credit rating agencies globally credit rating agencies works under two models.
The first model is the Issuer pay model. Under this model, the security issue is that the borrower seeks rating from the credit rating agencies, and it pays credit rating agencies to assess the creditworthiness.
Under this model, the research reports are available on all the public domains to follow in most countries. This model has always been the topic of debate for most investors.
Under this model, the credit rating agencies are being paid by the issuers whose creditworthiness they are assessing. One Major drawback of issuers’ payback model is rating shopping.
What is rating shopping, and why does this generally happen when a company wants to raise debt and get a good rating from a credit rating agency? This means the chances of default of this company are significantly less.
Because of this, the investors are interested in investing in these kinds of companies. Since more investors are interested in this company, this company can raise funds even by offering lower interest rates.
This means a higher rating lowers the cost of borrowing. To reduce the cost of borrowing, the companies engage what we called as greeting shopping understand rating shopping with a simple example: Suppose there is one company that got a credit rating from a credit agency and got a junk rating.
This company can refuse this junk rating and contract with another credit rating agency. It can get a better rating just by paying a higher fee, so credit rating agencies sometimes explicitly engage in rating shopping.
They provide the issuer company with a higher rating just for high fees. Now rating shopping does not go well with the investors because investors do not get the correct picture of the borrowing company.
Because of this, investors always argued that credit rating agencies should work on subscription models. Now under the subscription model, investors are investing in the debt instrument.
Under the subscription model, an investor investing in the debt instrument Arshi would pay the fee to the credit rating agencies. Well, there are drawbacks to this model as well:
- The first drawback in this model, since investors pay for the rating, the issuing company may not disclose all the relevant and vital information about the business model with the credit rating agency.
- The second major drawback is that the sins investor pays for the rating. The investor would always want the rating to be on the lower side as this will help them get higher interest in the company. So here, the conflict of interest would arrive between the investor and the credit rating agency.
- Another major drawback of the subscription model is that revenue continuity for credit rating agencies is less.
So what happened is under the Issuer pay model, the issue comes under long-term contracts with credit rating agencies, and they pay the fees till the time debt is repaid.
But under the subscription model, investors pay credit rating agencies. An investor can sell the debt instrument in 6 months or one year, discontinuing the services.
Because of this, the credit rating agencies prefer the issuer pay model instead of the subscription model. Neither of the models is free from the clause.
In India, we work on the Issuer pay model. Under this model, there are three sources of revenue for credit rating agencies:
- The first source is initial rating fees: This fee is paid by the Issuer company when they initially get themselves rated.
- The primary source of income is surveillance fees: Now, the dynamic of the business and the companies keep on changing every year, and because of this issuer companies need to come into long-term contracts with the credit rating agencies as they have to get the rating updated every year and to give this updated rating these credit rating agencies they charge surveillance fee.
- Now surveillance fee is considered a trump card for the credit rating agencies. This is like annuity-like income for them because once they enter into a contract with the Issuer company, they get surveillance-free every year.
- Another primary source of income for credit rating agencies is subscription fees. Sometimes these companies carry out exclusive researches for institutional investors, mutual fund companies, and the revenue of sale from this complete research is accounted as subscription fees.
This was about the revenue sources of credit rating agencies now; let’s deep dive into the significant revenue series of these companies and look at the instrument these companies give.
The first sentiment that keeps is bank loan ratings; the majority of credit rating agencies’ revenue comes from bank loan ratings.
So in India, we follow a standardized approach under these three norms where most Bank gets loan above 30 crores to 250 crores, rated from external credit rating agencies, as per RBI guideline.
Banks have to assign risk weight to loans in terms of rating received lower the rating higher the risk weight, and in terms of unrated loans, they have to give a risk weight of 100%, and due to the high weight, banks seek a rating from these agencies.
The next is Short Term Debt Instruments. There are different types of instruments for credit rating agencies like commercial papers and treasury bills. Still, most of the revenue comes from short-term debt instruments, i.e., Commercial Papers.
To these credit rating agencies, as of 2017, the reserve bank of India has given a mandate to all the companies who want to issue commercial papers have to provide themselves with rates by these credit rating agencies.
And this decision of the Central Bank gives a significant boost to the revenue of credit rating agencies.
Apart from short-term debt instruments, these agencies also rate long-term instruments like debentures bonds.
These companies widen their basket of offering in India by ordering different sectors, ranking small and medium enterprises, and broadening their overall offerings.
As we discussed, the majority of revenue in the credit rating industry is linked to bank loans and a debt instrument, which implies that these companies’ revenue depends on the credit requirements of the economy.
And generally, when the economy is booming and consumer spending is high, businesses expand to meet their demand.
During that time, companies take a loan and floor credit. Similarly, when there is an economic downturn, credit demand is less in the economy, and the credit rating business is cyclical.
However, the company is cyclical. If you look at long-term growth, it is growing. If you look at the last ten years, this particular industry is growing at a phenomenal rate of 14% cagr.
As per the RBI research report, the Indian corporate bond is 20% of its GDP; if you look at the US, its corporate bond is 120% of its GDP.
If we look at this data, the Indian debt market is still a long way to go. Both RBI and SEBI are striving hard to deepen the bond market in India.
For example, in 2016 Government of India brought the Insolvency And Bankruptcy code, which assures that if a company has gone bankrupt, the resolution process should fast.
Investors face one problem in the debt market: if a company has declared bankruptcy, it will take years for the liquidation to start and for the investors to get their money back.
Still, the resolution process starts 180 days after the company declares bankruptcy with this code. After this bankruptcy law came into the debt market, we have seen a positive reform in other countries.
Now let’s talk about the threat of this credit rating agency. The first is the regulatory threat.
The credit rating agencies are highly regulated by RBI and SEBI; any changes in the regulation can affect the business of these credit rating agencies.
For example, in 2020, RBI changed the threshold bank loan ratings from 10 crores to 30 crores, and this decision by the central Bank affected the working of credit rating agencies.
The second major threat is the cyclical nature of the business majority of the revenue of this business depends upon the credit requirement of the industry.
Credit requirement depends upon the macroeconomic factors of the economy, so this dependence on macroeconomic factors is also a threat to the credit business.
By now, we have discussed all the things about credit rating agencies, and business model revenue growth prospects the threat they face. I hope you learn about the complex industry a lot.
I hope you have liked this article. In case you want to read my other article. Please go through the below article link.
In case you want to open an account in Zerodha please follow the below link