The Process of Credit Rating - Essay Example

CREDIT RATING Credit Rating I. Introduction The process of credit rating and its implications have achieved considerable relevance in the recent years. In this context, this report discusses the process of credit rating, its methods and implications. This report is organized as follows. Section 2 discuses the definition of credit rating, section 3 discusses the methods of credit rating, section 4 examines the implications of credit rating and section 5 concludes the report. 2. Credit Rating Process The creditworthiness of a company or individual is formally evaluated by credit rating (Irish Banking Federation, 2008). It is defined as the indication of the likelihood of default of an issuer on a debt instrument relative to the likelihood of default of other issuers in the market (Katz etal, 2009). In other words, it measures the degree of risk associated with the relative payments of interest and principal on a debt instrument (Govt of India, 2009).Other aspects of investment decisions like market liquidity or price volatility are not measured by credit rating. Hence, different market prices can be there for bonds with the same ratings (Katz et al, 2009). A third party assesses the creditworthiness of the assesse based on different sources of information in the credit rating process. The three major international credit rating agencies are Fitch, Standard and Poor and Moody’s Investor Services. In addition to these, there are local credit rating agencies in each country. 3. The method of Credit Rating There are many methods to assess credit rating. The assessment for larger corporate is done based on the financial accounts assessment, operation of customer accounts and non financial factors like experience and track record of management. The length of loan requested and the amount of available security are also considered for credit rating in the case of loan applications in banks. Two different credit scorings namely application scoring and behaviour scoring are done by banks (Irish Banking Federation, 2008).In the case of application scoring the information on applicant and the business conducted by him as well as information supplied by the applicant or information obtained from other organizations like credit reference agencies or fraud prevention agencies are taken into account for credit rating. In the case of behaviour scoring, the customers are rated based on the way they operate their financial affairs, using the activity pattern observed by banks on existing customer accounts. This is usually used for credit rating customers who have been with a bank for a long period. The assumption here is that previous trends reflect future patterns in loans especially small business loans. Both the application and behaviour scoring are used together sometimes to assess the creditworthiness of an existing customer. The credit rating agencies rely on many qualitative and quantitative methods for assessing creditworthiness. The forward looking probability of occurrence of default is captured by the Standard and Poor’s Ratings while Expected loss which is a function of probability of default and the recovery rate is the focus of Moody’s Ratings. At the same time, Fitch’s ratings focus on forward looking probability and also possible discontinuities between past and present records. They focus both on probability of default and expected recovery rate (Elkhoury, 2008). In the risk assessment process, the credit rating agencies consider the economic, political, fiscal, monetary risk factors and the debt burden. Three types of performance variables are considered for a country by the credit rating agencies namely measure of a country’s domestic economic performance, measure of a country’s external position and its ability to service external obligations as well as the influence of external developments (Elkhoury, 2008). 4. Implications of Credit Rating The credit rating is supposed to help the investors by providing information about the credit risk faced by them at the time of lending to a borrower or purchasing an issuer’s debt like securities (Govt of India, 2009). Thus it is aimed at reducing information asymmetries by providing information on the rated security (Katz etal, 2009). It also helps in solving the principal agent problem through assessing the amount of risk the principal can take on the behalf of agent. Credit ratings also help to monitor performance and thus help in collective action problems of dispersed debt investors. The downgrading is usually taken as a signal of action. Thus credit ratings reduce the burden on investors to find out the creditworthiness of an issuer. The credit ratings are thus used as main tools in investment decisions by portfolio managers and lenders (Katz et al, 2009). With the emergence of financial globalization the role of credit rating has increased since Basel II incorporates the decisions of credit rating agencies into the rules for setting weights for credit risk(Elkhoury,2008).Thus credit rating is supposed to be a good thing. . In spite of all these, the experience of recent global financial crisis shows that one of the main contributors of the crisis was the faulty credit ratings and the flawed rating processes in the USA and the Europe (Katz etal, 2009). The credit rating agencies failed to assess the real creditworthiness of many financial institutions as shown by the recent experience. Thus the reliability of the credit ratings came under doubt. Since most institutional investors and banks relied on the credit rating agencies, the most complex, innovative instrument could be sold since it received good rating from the agency. This was one of the main contributors to the recent financial crisis. In consequence to this, call for widespread reforms emerged all over the world regarding the credit rating process. In this context, the debate has been whether to strengthen the reliability of the ratings or to depend on alternative arrangements for assessing credit worthiness (Katz et al, 2009). 5. Conclusion In this essay the process of credit rating is defined. Moreover how credit rating is done and its implications are also discussed. On the one hand, credit rating is supposed to be a good thing through reducing the information asymmetry and thus reducing the burden of investors. However, the recent financial crisis brings the reliability of the credit ratings by many important agencies under doubt. Thus it can be concluded that the credit rating process needs to be reliable based on correct and appropriate methods to ensure its effectiveness. References Elkhoury M (2008): “Credit Rating Agencies and Their Potential Impact on Developing Countries”, Geneva: UNCTAD Discussion Papers No.16, January. Govt of India (2009): “Report of the Committee on Comprehensive Regulation for Credit Rating Agencies”, Ministry of Finance, Capital Markets Division. Irish Banking Federation (2008): “The Credit Rating Process for Business Customers Explained”, Katz J,E Salinas and C Stephano(2008): “Credit Rating Agencies”, Crisis Response: Public Policy for the Private Sector, Financial and Private Sector Development and Presidency, October 2009,NoteNo,8,World Bank. Read More