(Online Course) Contemporary Issues for IAS Mains 2012: Yojana Magazine - Credit Rating

Yojana Magazine

Credit Rating

What is Credit Rating?

Answer: A credit rating evaluates the creditworthiness of an issuer of specific types of debt, specifically, debt issued by a business enterprise such as a corporation or a government. It is an evaluation made by a credit rating agency of the debt issuers likelihood of default. Credit ratings are determined by credit ratings agencies. The credit rating represents the credit rating agency’s evaluation of qualitative and quantitative information for
a company or government; including non-public information obtained by the credit rating agencies analysts. Credit ratings are not based on mathematical formulas. Instead, credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government. The credit rating is used by individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations.

Are Credit Ratings and Credit Scores the same? If not, what is the difference between the two?

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Credit ratings are often confused with credit scores. Credit scores are the output of mathematical algorithms that assign numerical values to information in an individual’s credit report. The credit report contains information regarding the financial history and current assets and liabilities of an individual. A bank or credit card company will use the credit score to estimate the probability that the individual will pay back loan or will pay back charges on a credit card. However, in recent years, credit scores have also been used to adjust insurance premiums, determine employment eligibility, as a factor considered in obtaining security clearances and establish the amount of a utility or leasing deposit. A poor credit rating indicates a credit rating agency’s opinion that the company or government has a high risk of defaulting, based on the agency’s analysis of the entity’s history and analysis of long term economic prospects. A poor credit score indicates that in the past, other individuals with similar credit reports defaulted on loans at a high rate. The credit score does not take into account future prospects or changed circumstances. For example, if an individual received a credit score of 400 on Monday because he had a history of defaults, and then won the lottery on Tuesday, his credit score would remain 400 on Tuesday because his credit report does not take into account his improved future prospects. An individual’s credit score, along with his credit report, affects his or her ability to borrow money through financial institutions such as banks.

The factors that may influence a person’s credit score are:

  • ability to pay a loan

  • interest

  • amount of credit used

  • saving patterns

  • spending patterns

  • debt

What are different types of credit ratings?

1. Corporate credit rating

The credit rating of a corporation is a financial indicator to potential investors of debt securities such as bonds. Credit rating is usually of a financial instrument such as a bond, rather than the whole corporation. These are assigned by credit rating agencies and have letter designations such asA, B, C.

2. Sovereign credit rating

A sovereign credit rating is the credit rating of a sovereign entity, i.e., a national government. The sovereign credit rating indicates the risk level of the investing environment of a country and is used by investors
looking to invest abroad. It takes political risk into account.

Short-term rating

A short-term rating is a probability factor of an individual going into default within a year. This is in contrast to long-term rating which is evaluated over a long timeframe. In the past institutional investors preferred to consider long-term ratings. Nowadays, short-term ratings are commonly used. First, the Basel II agreement requires banks to report their one-year probability if they applied internal-ratings-based approach for capital requirements. Second, many institutional investors can easily manage their credit/ bond portfolios with derivatives on monthly or quarterly basis. Therefore, some rating agencies simply report short-term ratings.

What is the difference between Credit Bureaus&Credit Rating Agencies?

Credit bureaus and credit rating agencies Credit scores for individuals are assigned by credit bureaus (US; UK: credit reference agencies). Credit ratings for corporations and sovereign debt are assigned by credit rating agencies. In India, commercial credit rating agencies include CRISIL,CARE, ICRA and Brickwork Ratings. The credit bureaus for individuals in Indiaare Credit Information Bureau (India) Limited (CIBIL) and Credit Registration Office (CRO).

In the United States, the main credit bureaus are Experian, Equifax, and Trans Union. A relatively new credit bureau in theUS is Innovis. In the United Kingdom, the main credit reference agencies for individuals are Experian, Equifax, and Callcredit. There is no universal credit score as such, rather each individual lender credit scores based on its own wish-list of a perfect customer.

In Canada, the main credit bureaus for individuals are Equifax and Trans Union

The largest credit rating agencies (which tend to operate worldwide) are Dun & Bradstreet, Moody’s, Standard & Poor’s and Fitch Ratings

A Credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations aswell as the debt instruments themselves. In some cases, the servicers of the underlying debt
are also given ratings.

Inmost cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be  traded on a secondary market. A credit rating for an issuer takes into consideration the issuer’s credit worthiness and affects the interest rate applied to the particular security being issued.

What are the uses of ratings ?

Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use
measurements of relative credit risk; this generally increases the efficiency of the market, lowering costs for both borrowers and lenders.

This in turn increases the total supply of risk capital in the economy, leading to stronger growth. It also opens the capital markets to categories of borrower who might otherwise be shut out altogether: small governments, startup companies, hospitals, and universities.

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