- A credit rating is an assessment of a borrower’s creditworthiness, indicating their ability to repay debt. This evaluation can apply to various entities, including individuals, businesses, local or state governments, and sovereign nations.
What are Credit Rating Agencies (CRA)?
- CRAs provide independent, research-based opinions on borrowers’ financial strength and reliability, effectively assigning a probability of default to specific financial instruments.
- In India, credit rating agencies emerged in the late 1980s and are regulated by the SEBI under the SEBI (Credit Rating Agencies) Regulations, 1999.
- There are six credit rating agencies registered under SEBI, namely, CRISIL, ICRA, CARE, SMERA, Fitch India, and Brickwork Ratings.
Importance of Credit Rating
- For Money Lenders
- Investment Decision: This provides lenders with insights into an individual or company’s creditworthiness, helping them evaluate the associated risk. This enables lenders to make more informed and effective investment decisions.
- Safety: A high credit rating offers assurance to lenders about the safety of their investment, indicating a high probability that the money will be repaid with interest on time.
- For Borrowers
- Loan: Borrowers with high credit ratings are more likely to have their loan applications approved easily by banks and financial institutions.
- Capital Allocation and Financial Innovation: Credit ratings establish independent benchmarks for pricing debt, promote a culture of financial discipline, ensure efficient capital allocation by appropriately pricing risk, and support financial innovation.
Sovereign Rating Agency (SRA)
- It evaluates a country’s creditworthiness, assessing its ability to meet debt obligations. These ratings provide insight into the risk level of investing in a country’s bonds or other financial instruments.
- By analyzing economic, political, and financial factors, sovereign rating agencies help investors make informed decisions and assist countries in understanding their financial health and potential risks.
Examples of SRA:
- Three globally recognized credit rating agencies are Moody’s, Standard & Poor’s (S&P), and Fitch. Moody’s, established in 1900, is the oldest and issued its first sovereign ratings before World War I.
Criticism of SRA
- Opaque Methodology and Bias Against Developing Economies
- The GOI criticizes the lack of transparency in rating methodologies, particularly noting biases against developing nations.
- It highlights that Fitch’s preference for significant foreign ownership in the banking sector disadvantages countries with a predominant public sector banking industry.
- This approach is viewed as discriminatory, ignoring the developmental role of public sector banks in fostering financial inclusion.
- Transparency in Selection of Experts
- The government raises issues regarding the non-transparent selection of experts consulted during rating assessments.
- Unclear Assignment of Weights for Parameters
- The GOI contends that rating agencies fail to clearly communicate the weights assigned to various parameters.
- While Fitch provides numerical weights for some parameters, it states these are merely for illustrative purposes, leading to further ambiguity.
- Questionable Use of Composite Governance Indicator
- The government questions the reliance on the composite governance indicator, which is heavily weighted at 21.4 and derived solely from the World Bank’s Worldwide Governance Indicators (WGI).
- The WGI relies on subjective assessments of factors such as freedom of expression, rule of law, and corruption based on perception-based surveys.
- The government argues that such heavy reliance on subjective appraisals, along with the Qualitative Overlay, raises concerns about the objectivity of the rating process.
- Subjectivity and Arbitrary Indicators
- Developing economies are often required to show progress on arbitrary indicators, which are constructed from one-size-fits-all perception-based surveys, making them inappropriate for accurately reflecting the unique economic contexts of these nations.
