With the increasing market orientation of the Indian economy, investors value a systematic assessment of two types of risks, namely "business risk" arising out of the "open economy"and linkages between money, capital and foreign exchange markets and "payments risk". With a view to protect small investors, who are the main target for unlisted corporate d [1] ebt in the form of fixed deposits with companies, credit rating has been made mandatory.
India was perhaps the first amongst developing countries to set up a credit rating agency in 1988. The function of credit rating was institutionalized when RBI made it mandatory for the issue of Commercial Paper (CP) and subsequently by SEBI. When it made credit rating compulsory for certain categories of debentures and debt instruments. In June 1994, RBI made it mandatory for Non-Banking Financial Companies (NBFCs) to be rated. Creditrating is optional for Public Sector Undertakings (PSUs) bonds and privately placed non-convertible deben [2] tures upto Rs. 50 million. Fixed deposits of manufacturing companies also come under the purview of optional credit rating.
Credit Rating
A credit rating evaluates the credit worthiness of a debtor, especially a business (company) or a government. It is an evaluation made by a credit rating agency of the debtor's ability to pay back the debt and the 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. Individuals and entities that purchase the bonds issued by companies and governments to determine the likelihood that the government will pay its bond obligations use the credit rating.
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 prospect
Sovereign credit ratings
Short-term rating
Corporate credit ratings
Credit Rating Agency
A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings.
In most 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 (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued.
The value of such security ratings has been widely questioned after the 2007-09 financial crisis. In 2003, the U.S. Securities and Exchange Commission submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest. More recently, ratings downgrades during the European sovereign debt crisis of 2010-11 have drawn criticism from the EU and individual countries.
A company that issues credit scores for individual credit-worthiness is generally called a credit bureau (US) or consumer credit reporting agency (UK) [3] .
Current Role And Legal Status
http://liberte.typepad.com/.a/6a00e54ef28dc188340133f4cfd215970b-800wi [4]
Despite the controversy surrounding them, credit rating agencies have an important function: they provide markets with information. They issue ratings of both financial products (assessing the risk associated to them) and issuers of financial products (evaluating their solvency and the likeliness of default).
Their ratings influence the price of financial products. This is especially true for the most complex products for which no liquid market exists (which was the case for many complex derivatives such as CDOs until the creation of the ABX.HE). They also influence investors' trust in issuers of financial products and thus the cost of borrowing of governments and companies alike. The recent downgrading of Greece and Spain's ratings, which triggered a sharp rise in both the interest rate of their treasury bonds and corresponding CDS is truth of that.
The ratings issued by CRA also contribute to shaping the structure of investors' portfolio. Many mutual and pension funds are barred from holding anything below AA or in some cases AAA. The European Central Bank itself cannot hold Treasury bonds rated below BB.
According to the Basel II agreements, capital requirements for banks depend on the risk-weighted composition of their portfolio. The complex formulas used to calculate the appropriate amount of capital banks are to hold used ratings from CRA to assess assets' risk. The amount of capital banks must hold thus depends on the letter apposed on the assets they own, which makes CRA all the more powerful and influential [5] .
Controversy And Role In The Financial Crisis
Much had been said and written lately about CRA's chronic failure to properly accomplish the mission they were trusted with. A look at their recent history indeed shows a worrying incapacity to foresee major financial earthquakes and a troubling tendency to react a posteriori. For instance, Enron's notation remained at investment grade until 4 days before what remains one of the greatest bankruptcies in history. CRA's also failed to foresee the 97 Asian crisis and the 2001 Argentinean debt crisis. Furthermore, it today appears that CRA were out like bandits stamping AAA CDOs that turned out to be worth nothing.
The incompetence was apparent in the way they attributed notations to CDOs. The following graphic shows how this kind complex mortgage based commodity is built and at which stage CRAs come into play.
Gentle-2
CDOs are structured financial products based on financial assets. In their most common form, they are made of mortgages packaged and are then divided into tranches according to the level of risk. It should be noted that no mortgage is actually owned by one investor. Holding the safest tranches does not mean owning the soundest mortgages, it simply means that you will be the last one to be hit if things go awry.
Use of Ratings
Investors, issuers, investment banks, broker-dealers, and governments use credit ratings. 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 [6] .
Ratings use by bond issuers
Ratings use by government regulators
Ratings use in structured finance
Functions Of Credit Rating Agencies In India
The credit rating agencies in India offer varied services like mutual consulting services, which comprises of operation up gradation, risk management.
They have special sections to carry on research and development work of the industries.
They provide training to the employees and executives of the companies' for better management.
They examine the risk involved in a new project, chalk out plans to fight with the problem successfully and thus ameliorate the [7] percentage of risk to a great extent. For this they carry on thorough research into the respective industry.
The major industries currently graded by the credit rating agencies include agriculture, health care industry, infrastructure, and maritime industry.
Gudelines For Credit Rating Agencies in India
The Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 offers various guidelines with regard to the registration and functioning of the creditrating agencies in India:
The registration procedure includes application for the establishment of a creditrating agency, matching the eligibility criteria and providing all the details required.
They have to undergo the strict examination procedure with regard to the details furnished by them.
They are required to prepare internal procedures, abidance with circulars.
They are offered guidelines regarding the credit rating procedure, by the Act.
The credit rating agencies are provided with compliance officers.
They are required to show their accounting records [8] .
Credit Rating Agencies In India
In India, at present, there are four credit Rating Agencies:
Credit Rating and Information Services of India Limited (CRISIL).
Investment Information and Credit Rating Agency of IndiaLimited (ICRA).
Credit Analysis and Research Limited (CARE).
Fitch ratings.
CHAPTER 2
LITERATURE REVIEW
LITERATURE REVIEW
Importance Of Review Of Related Literature
The study, which I am taking, is descriptive in nature, most of the studies done focus on the potential impact on investor investment decisions, capital flows to countries, the accountability of the decisions made by them, the study will help in understanding investors. It will also give fair knowledge of rating agencies and existing methodology agencies are adopting to credit rate bonds, companies & countries.
Before going forward with it is very essential to know and understand the investors and the points that they consider while making investment decisions and review of literature will give fairly good idea on it.
How review has been done
Literature review includes research papers from SSRN, journals and online material available, review starts with understanding the abstract of the study available and if the paper is relevant to my area of study, relevant topic of the paper is studied and analyzed.
Studies Conducted
Roman Kraussl (2003) conducted a research called "Do Credit Rating Agencies Add to the Dynamics of Emerging Market Crises? [9] " It states that during the 1990s, global securities markets have become an increasingly important source of external funding for many emerging market countries. As a result, the portfolio preferences of institutional investors have been vital determinants of the scale and composition of capital flows to emerging markets, and of the terms and conditions under which those markets can be accessed. In this regard, credit rating agencies such as Standard & Poor's (S&P) and Moody's Investors Service (Moody's) have been perceived by both market participants and policymakers as having a strong impact on both the cost of funding and the willingness of institutional investors to hold certain types of financial instruments.
E.W. van Leeuwen conducted a research called "Do announcements by credit rating agencies affect the sentiment of individual investors?" This paper is primarily motivated by the question to what extent the sentiment of AEX investors is influenced by (negative) adjustments of credit rating agencies (hereafter CRAs) on the solvency of countries. In addressing this question, we present a study of investor sentiment. The study is based on investor predictions of the Amsterdam Stock Exchange (AEX index). In our research we investigate whether the predictions by the investors on the AEX index were affected by credit worthiness of sovereign credit rating news facts coming to the market by three major CRAs, namely Moodys, Standard&Poors and Fitch. Hence, this paper examines the importance and significance of CRAs as source of information for investors forecasting [10] .
Gautam Setty & Randall Dodd (2003) conducted a research called "Credit Rating Agencies: Their Impact on Capital Flows to Developing Countries" [11] This paper tells the impact of credit rating agencies on financial markets has become one of the most important policy concerns facing the international financial architecture. They have found that ratings indicate a relative credit risk and serve as an important metric by which many investors and regulations measure credit risk. They also concluded that the additional improvement can come through investor education about the method and meaning of credit ratings, and greater transparency by the agencies to level the playing field for all investors. The poor performance of these agencies, especially as indicators of the East Asian financial crises and the sudden collapse of Enron, has brought renewed criticism of their methods, their regulatory status and their role in financial markets.
Ranadev Goswami & S. Venkatesh (1999) conducted a research called "Understanding and Use of Credit Rating in India: A Survey of Individual and Institutional Investors [12] " This papers casual and anecdotal evidence suggests that there are concerns among investors and regulators about the performance of rating agencies in India. It discovered a high diffusion of rating usage among all class of investors, though there is a perceptible disenchantment with reliability of ratings, propensity of subsequent downgrading and timeliness of rating surveillance. The survey also reveals that the institutional investors possess superior knowledge and understanding about ratings than individual investors. Thus, the survey underlines the need for rating agencies to work on educating the common investors to propagate proper understanding and usage of credit rating.
Professor Stéphane Rousseau conducted a research called "Enhancing The Accountability Of Credit Rating Agencies: The Case For A Disclosure-Based Approach" [13] Credit rating agencies (CRAs) play a vital role in enabling financial markets to operate efficiently by acting as informational intermediaries specializing in the appraisal of the creditworthiness of corporations that issue debt. Gradually, they have become central to the financial markets' infrastructure through their role in rectifying information asymmetries that exist between issuers and investors. Concurrently, CRAs have gained considerable clout over market participants, as their assessments of creditworthiness have come to be viewed as authoritative. Despite their importance, however, rating agencies remain unregulated private institutions.
Whereas rating agencies have always been subject to periodic complaints and criticism, the recent wave of corporate scandals has led many to call their contribution to market efficiency into question. In light of such criticism, studies conducted by lawmakers and regulators sought to further examine the role and effectiveness of CRAs. Although the studies revealed no particular wrongdoing on the part of CRAs, they warned of potential problems that could disrupt the smooth operation of capital markets. These problems relate to the reliability and integrity of ratings, as well as to possible anti-competitive practices on the part of CRAs.
These potential problems are worrisome given that CRAs wield considerable power over issuers and investors through the information disseminated in their ratings. As widely accepted standards of creditworthiness, ratings have a coercive impact on issuers through their relevance to various regulatory schemes. Irrespective of regulation, ratings also affect issuers on a more direct level, as they can determine the conditions under which they may access debt markets, those affecting their relationships with lenders, as well as the general structure of their transactions. For investors, ratings constitute a screening tool those influences.
Frank Partnoy conducted a research called "How and Why Credit Rating Agencies Are Not Like Other Gatekeepers [14] " ans said that credit ratings continue to present an unusual paradox: rating changes are important, yet they possess little informational value. Credit ratings do not help parties manage risk, yet parties increasingly rely on ratings. Credit rating agencies are not widely respected among sophisticated market participants, yet their franchise is increasingly valuable. The agencies argue that they are merely financial journalists publishing opinions, yet ratings are far more valuable than the opinions of even the most prominent and respected financial publishers.
John Patrick Hunt conducted a research called "Credit Rating Agencies & The Worldwide Credit Crisis: The Limits Of Reputation, The Insufficiency Of Reform & A Proposal For Improvement" and stated that the worldwide credit crisis. of 2007-08 has focused attention on credit rating agencies, as many observers have argued that undeserved high credit ratings on novel financial products contributed materially to the turmoil. Welters of regulatory reports on the crisis assert that high credit ratings on novel financial instruments helped induce investors to purchase these instruments. When the instruments started to appear much riskier than traditional investments carrying similar ratings, investors lost confidence in the ratings and the novel instruments themselves, leading markets for the products to seize up and thus to severe adverse consequences for the global financial system.
Lawrence J White conducted a research called "Credit Rating Agencies & The Financial Crisis: Less Regulation of CRA Is a Better Response [15] " where he concludes that there is a better route for public policy. That route involves less regulation of the credit rating agencies but also a major revision in the prudential regulation of institutions' bond portfolios. Instead of delegating safety judgments to the rating agencies (as has been done for over 70 years), prudential regulators would place the burden for safe bond portfolios directly on the regulated financial institutions and allow them to seek advice about the creditworthiness of bonds as they see fit (but subject to prudential oversight). Since the participants in the bond markets are primarily institutional investors, these sophisticated investors should be able (again, subject to prudential regulatory oversight) to make sensible choices with respect to the sources of their information, so that extensive regulation of those sources - the incumbent rating agencies plus smaller firms and entrants - would not be necessary.
Bheemanagouda & Madegowda J conducted a research called "Working Of Credit Rating Agencies in India: An Analysis Of Investors Perception [16] " where he concluded that there was a mixed response from the investing class as to the rating surveillance by the rating agencies & there is also criticism against the working of rating agencies.
This criticism centers on the rating agencies of not showing much interest in the surveillance as compared to the interest they show at the time of the initial rating. This may be due to lower fees for surveillance when compared to initial rating fees. The rating agencies have to take up the rating surveillance with all seriousness to gain the confidence of investors as otherwise the very purpose of the entire exercise is defeated.
Aysun Alp conducted a research called Essays On Forces Underlying 2008 Financial Crisis: Credit Rating Agencies And Investor Sentiment [17] where in which he conducted a research on the investor sentiment because of the financial crisis and he found that there is some movement in sentiment through much of the crisis period but it is relatively moderate. However, tests detect a sharp structural break around the Lehman bankruptcy, after which there are breaks in both pricing across multiple asset classes and co-movement, especially in hard-to-arbitrage fund classes. Fund discounts also exhibit significantly increased co-movement with non-financial Gallup sentiment measures after the Lehman bankruptcy, and closed-end fund discount betas with respect to the market increase significantly during this period. While fund discounts may reflect liquidity issues in normal conditions, they seem to better reflect sentiment in stressed environments, so funds have undesirable conditional betas. The results are consistent with the view that the Lehman bankruptcy induced a negative shock to the supply of arbitrage capital, and as predicted by behavioral finance models of costly arbitrage, sentiment then matters more and is closely tied to returns. The results are also consistent with theories of financial crisis in which sentiment or confidence is an extra force that amplifies and transmits economic shocks that add to the usual credit and collateral mechanisms studied in the literature.
Suzana Baresa, Sinisa Bogdan & Sasa Ivanovic conducted a research called "Role, Interests & Critics Of Credit Rating Agencies [18] " where they concluded that the purpose of credit rating agencies is to measure objectively the creditworthiness of government, business subjects and securities. The attitudes of credit rating agencies are used as instruments of regulation and supervision of financial markets for which the publisher of the financial instrument pays them, in most cases. Due to the conflicts of interests, credit rating agencies are not able to perform their job credibly and objectively. Profit, as the main goal to the credit agencies, was often opposite to interests of market regulation, so the agencies (challenged by profit) awarded ratings to the detriment of objective grades, although they were aware of real situation of a business entity or financial instrument. Credit rating agencies have enormous power in the world of finance by demonstrating their opinions and paying legal responsibility to obtain better information and behavior that is more responsible. However, the way of theirs operating protect them very well, and that is fact way which they use. We can imagine situation in which investor orders a rating of a financial instrument, which they rate wrong and gets earnings on it. What would be the reaction of investor, which, in this case, has bought a fake product (wrong categorized security) and realized losses on it, there wouldn't be no opportunity to try seeking compensation from the same credit agency. However, if we imagine different situation, the publisher orders and then pays the credit rating, and earns AA grade, but objectively it's in BBB grade. This situation fits to both, the publisher and the credit agency, but investor loses. If an investor reacts with the complaints, credit rating agencies will defend; justifying that the opinion that it gives can be but don't have to be accepted and it does not sale guarantees. Secrecy of methodology of calculating the credit rating of governments, business entities or securities allows freedom in the creation of grades.
CHAPTER 3
RESEARCH & METHODOLOGY
RESEARCH & METHODOLOGY
In this section I describe my methodology. In the next section I would present my findings. The concluding section I would discuss the findings and suggests some possible extensions of this study. The final questionnaire used in the study is presented in the Appendix.
Statement Of The Problem
The problem in the study is to find out the effect of credit ratings given by the CRA's, to know whether the investors are taking into account the credit ratings while making investment decisions. It has been seen that after the financial crisis of 2008, the enron scam there have been questions raised about the creditworthiness of the ratings given by the CRA's. There are also various other allegations raised i.e. the relaibility, timeliness and adequacy of the credit ratings.
This would enable the researchers to find opportunities for further contribution in this area. The title of the study is "Significance Of Credit Ratings Given By Credit Rating Agencies On Investors Investment Decisions"
Scope of the Study
The study will tell the perception of the investors, what are the factors that they consider while making investment decisions and what is the significance of the credit rating among those factors.
The study also will help us to know whether the investors really do understand the credit ratings, and if they do whether they think that they are creditworthy, reliable, adequate and timely. The study would also let us know the investors perception on the various financial crisis whether they think that the CRA's are the major cause for them, and also whether the CRA's should be regulated or not.
Operational Definition
Credit Rating: An assessment of the credit worthiness of individuals and corporations. It is based upon the history of borrowing and repayment, as well as the availability of assets and extent of liabilities.
Credit is important since individuals and corporations with poor credit will have difficulty finding financing, and will most likely have to pay more due to the risk of default.
Credit Rating Agencies: A credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings.
In most 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 (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued.
Objectives Of The Study
To know whether the ratings assigned by the rating agencies in India are understood and found useful by the individual investors.
To know whether the credit ratings influence the decision of the investors.
To know whether the credit rating agencies are/were the major reason for the various financial crisis.
To find out how investors obtain information on ratings.
Hypothesis
H0: Investor decisions are not influenced by credit ratings.
H1: Investor decisions are influenced by credit ratings.
Design Of The Study
Sample Universe
Sample population is individual investors.
Sample Unit
Sample unit is individual investors across Bangalore.
Sampling Type
100 in questionnaire form from the individual investors in Bangalore.
Sampling Type
Random Sampling
Variables Tested
Realiability.
Timeliness.
Creditworthiness.
Tools Used In The Study
The research study conducted includes primary research and hence data is collected in a questionnaire format that would capture the various parameters.
A set of questions have been framed as part of (MCQs) Multiple Choice Questions using Likert Scale, Bi-polar Scale method and was asked from the investors to fill the questionnaire accordingly.
Factor analysis and corelation analysis are the tools that are to be used to check the corelation between the variables tested and the decision of the investors while making investment decisions. It is conceivable that even an investor, who is aware of ratings and rating symbols, may ignore them out of a belief that rating agencies are not credible. Given casual evidence of investment behavior, it is also conceivable that investors rely on advice of brokers and other intermediaries in making investment decisions and do not consider ratings at all. Some may even go by the long-standing reputation of the issuing firm and see no use for referring to ratings. The issue of use of ratings is important because under the current regulations in India, ratings are mandatory. It would be important to understand, even if not in precise numbers, whether the costs imposed by such regulations are matched by benefits.
Limitations Of The Study
The investors can give biased details and not the correct details asked in the questionnaire.
Sample size is very small in such a big population and the impact is very difficult to judge using a size of 100 respondents.
The study is limited to Bangalore region only, which can also give dubious results.
