REVIEW OF LITERATURE

Transcription

1 CHAPTER - 2 REVIEW OF LITERATURE Credit rating serves as a valuable input in the decision-making process of different participants in the capital market including regulators, issuers and investors. Therefore, it has been attracting the attention of thinkers in the field of finance to study various dynamics of this fast emerging subject. Various studies have been conducted in India as well as in different parts of the world by different bodies and individuals and thus contributing a lot to explore new insights into the concept of credit rating. The area of concern of the studies conducted so far has been mainly to find out the relevance of credit rating in the Indian context as well as at the global level and the extent of awareness among the investors, about the concept of credit rating. The present chapter provides a brief review of the research studies conducted on credit rating at the national and international level. Pogue and Soldofsky (1969) tried to assess the importance of Rater s Judgment in the determination of bond ratings as this judgment was based on much more information than contained in readily available financial statistics by taking data set of industrial, utility and railroad binds rated by Moody s from 1961 through The authors found that the probability of getting higher rating was directly related to firm s size and profitability and it was inversely related to leverage and earning instability of the issuing firm. The authors revealed that although the rater s judgment (which is based on much more information than that contained in available statistics) affected the bond ratings, yet the bond ratings could be better explained by the available financial and operating statistics. Pinches and Mingo (1975) made an attempt to analyze the impact of ratings on debt market and investors in US. The authors evaluated that the bond ratings had a direct impact on the debt market as the cost of the firm and the marketability of the issue were determined by the assigned ratings and the investors regard the 35

2 recent bond ratings as indicators of the firm s overall investment quality including the cost of debt and equity. The study inducted that there were certain difficulties in rating industrial bonds correctly, including qualitative factors called as rater s judgment, which might be properly taken into consideration while rating the bonds to make the ratings more effective. Reilly and Joehnk (1976), in their paper, tried to estimate the market determined risk measures for bonds and the uses of the same. Further, they made a comparative analysis of market related risk measures for bond and bond ratings by taking a sample of 73 bonds rated by Moody s from 1967 to The authors found very limited association between both, because ratings were assigned on the basis of the probability of default, whereas the market risk was based on the relationship of bond yield or price changes and changes in market yield or market prices. Thus, the authors suggested that the limited association between market related risk measures and bond ratings were very important for portfolio managers. Kaplan and Urwitz (1979) tried to highlight the important statistical techniques used by financial analysts in explaining and predicting bond ratings. For the purpose of their study, they selected 120 outstanding or seasoned bonds being rated by Moody s in US during the period as a sample. Further, a second sample of all the new US industrial bonds rated by Moody s between was selected. The various independent variables used in the study included interest coverage ratio, leverage capitalization ratio, profitability ratios, size variables and stability variables. A variety of models using different combinations of independent variables were applied on the two samples of bonds but the results are generally consistent across the two groups. Further, the analysis revealed that a simple linear model (using subordination dummy variable, total assets, long-term to total assets ratio and the common stock 36

3 systematic risk) can better predict the actual risk of a bond than the rating agencies did. Danos et al. (1984) in their study, tried to evaluate whether the bond rater s judgments were more affected by the management s forecast of accounting data as compared to the historical financial statements. Further, they tested if the bond rater s training and experience was helpful for them (or not) in using forecasts while performing rating tasks. They revealed that forecasts often provided an insight into the management s planning process, financing strategies, assumptions and expectations about the future, so the forecasted accounting information influenced bond raters judgments and aided the rating process in a number of ways. Further, the bond raters training and review process coupled with their experience helped in enhancing their judgmental abilities. Duggal (1992) tried to find out the relevance of credit rating in the Indian context and the extent of awareness about the concept of credit rating and the rating agencies in India. She evaluated the working of rating agencies in the light of experience of the rated companies and tried to foresee the future prospects of credit rating in India. The author suggested that the credit rating agencies need to create awareness about their existence and importance. So, they should give publicity to their operations. Further, there is a need for more credit rating agencies in India and a few of them should be from private sector. All the agencies should have a proper co-ordination with one another and they should improve quality of their services. The author also suggested that the high fees charged by the rating agencies should be reduced in order to make their services more efficient. Hand et al. (1992) examined the effects of two types of bond rating agency announcements on bond and stock prices by taking the sample of various US bonds being rated by Moody s and Standard & Poor s from the year 1977 to These announcements include 37

4 warnings of possible rating changes, i.e., additions to credit watch list and actual rating changes by these agencies. The study revealed that the bond returns associated with credit watch list were more reactive to price changes as compared to those associated with actual rating downgrades. Therefore, it was found that bond and stock prices react to both additions to watch list and actual rating changes by Moody s and Standard & Poor s, intensity being different for both. Shankar et al. (1992) tried to evaluate the operations of CRISIL which include the methodology of rating, rating process, rating symbols, etc. The authors found that there were certain shortcomings in the working of CRISIL. First of all, ratings were not frequently revised by the agency as done in other countries. The companies not scoring well did not reveal their ratings because neither it was mandatory on them to reveal their ratings nor CRISIL had any arrangements to let know the public the credit status of the companies rated by it. It was also found that the agency was not engaged in rating of equity instruments, which form the major share in public borrowing of the companies. Further, the agency had almost similar parameters to evaluate the business of the clients in different lines of economic activities, whereas in foreign countries different parameters were used for the purpose. Thus, the authors suggested that all these flaws in the working of CRISIL should be overpowered to make credit rating more powerful tool which would have greater effect on the capital market in India. Goh and Ederington (1993) examined the reaction of stock return to bond rating changes. They had tried to explore whether equity shareholders consider all downgrades as bad news or they react on it as otherwise. They took a data set of 1078 rating changes announced by Moody s during the period 1984 to 1986 and described that there were two types of rating downgrades firstly, due to a deterioration in the firm s financial prospects; and secondly, those due to an increase in leverage. The first one had the negative implication 38

5 on the stockholders because these downgrades reflected the rating agencies expectations of the firm s future earnings or sales. The second one had the positive implications because these downgrades were generally in response to the past known leverage increases. Thus, the study inferred that the market reactions to different rating changes should not be treated as similar but their causes must be considered first. Khan and Akbar (1993) studied the conceptual and methodological aspects of CRISIL rating as well as the progress of its operations in India. They reviewed the shortcomings in the working of CRISIL and suggested some measures to make the credit rating a successful scheme in India. They explained that methodology of CRISIL considers various factors including business analysis, financial analysis, fundamental analysis, management evaluation, geographical analysis, regulatory and competitive analysis. But there were certain shortcomings in the working of CRISIL as it was the only rating agency at that time, so it needed to revise its ratings frequently; the fees charged by it should also be revised; it should use different parameters to evaluate different lines of business; and it should extend its scope by rating equity instruments. CRISIL should also periodically publish its revised ratings so that it could be of more help to the investors. Moon and Stotsky (1993), in their study, examined the differences between the determinants of ratings of the two major US rating agencies Moody s and Standard & Poor s. For this purpose, the determinants of municipal bond ratings of the said agencies were studied. They analyzed that there was a statistically significant difference between the determinants of ratings of the two rating agencies. Further, they revealed that both the agencies not only attach different weights to the specific determinants of ratings but they also had different ways of classification of bonds. Thus, the differences in the ratings could be attributed to both non-identical weighting and 39

6 non-identical classification schemes being employed by the two rating agencies. Patnaik and Narayan (1993) explained the mechanism of credit rating in India and the procedure adopted by credit rating agencies, viz. CRISIL and ICRA to rate the instruments. The authors compared the rating procedure adopted by international rating agency Standard & Poor s with that of CRISIL and ICRA, and explained that the approach adopted by ICRA and S&P was the same as both gave more importance to historical rates and past performance whereas CRISIL attached more importance to the market position, operating efficiency, professional management and future projections of the organization. So, the authors suggested that each company should get itself rated by both CRISIL and ICRA to make their rating really meaningful. Further, these agencies should work independently, and should give professional and impartial assessment of instruments without any fear or favour. Raghunathan and Varma (1993), in their study, made an attempt to assess the quality of credit rating in India. Ratings assigned by the leading Indian Credit Rating Agency- CRISIL had been compared with those of US Rating Agency-Standard & Poor s by using financial ratios. The comparison showed that the standards of all sampled Indian AAA rated debentures fall short of S&P s AAA standards. They found that S&P s ratings show very high discriminatory power, i.e., higher rated companies had significantly better ratios than lower rated ones, but CRISIL ratings did not show this. They highlighted that CRISIL s ratings were liberal by international standards and internally inconsistent also. Thus, they suggested that to improve the quality of credit rating in India there must be more competition; credit rating must be opened up to the private sector; and raters must provide unsolicited ratings. Nayar and Rozeff (1994) examined the relationship between stock prices and credit ratings announcements of new commercial 40

7 papers (CP) programmes by taking the data on Commercial Paper rating changes during the years 1977 to It was found that the equity prices of industrial firms respond favourably if commercial papers carried higher ratings and did not respond if the ratings were of lower grades. Further, it was found that the firms having high commercial paper ratings and having letter of credit had a more positive stock price response than those without letter of credit. Thus, the authors suggested that bank s letters of credit were associated with positive effects on stock prices. The authors also revealed that commercial paper rating downgrades had negative information content while upgrades had no equity price effects. Thus, the stock price effects of changes in commercial paper ratings demonstrated the relevance of ratings to the financing of firms. Sarkar (1994) studied different guidelines regarding credit rating in India and gave certain suggestions for improvement of credit services in India. He suggested that more credit rating agencies should be formed in addition to CRISIL and ICRA to insure healthy competition among these agencies and to provide better, efficient and effective services to the users. The ratings assigned by the agencies must be revised frequently and these agencies should continuously watch the performance of companies rated by them. The fees charged by the agencies should also be revised from time to time to meet their expenditure and thus, offering unbiased and effective services to the users. For the rating purpose, the agencies should rely on statistical methods too in order to make their rating services more efficient. Gopal (1995) examined the practices and procedures followed by two Indian credit rating agencies CRISIL and ICRA. He also analyzed the effect of bond rating changes on the security prices. He observed that the basic approach to rate certain instruments was similar for all the rating agencies though they all used different terminology. He also pointed out that the investors did not take into consideration the rating of debt instruments while investing in the 41

8 equity shares; and the credit rating agencies were not information specialists as the investors might have taken information from other sources also. He suggested that the rating agencies would have to take unsolicited ratings and should publish their opinions in order to make their operations more transparent and useful. Kumar (1995) studied history of credit rating on international as well as on Indian level. The author explained that the rating is based on the status of the industry, its past performance, its future prospects, performance commitments, management strategies and on SWOT (Strength, Weakness, Opportunities and Threat) analysis. The author revealed that credit rating is an efficiency chip to banks because credit rating of borrowing companies or individuals would help banks to restore and maintain their financial soundness. Singh (1996), in his paper, described that as the number of companies borrowing from capital market increased, the investors felt a need for an independent and credible agency which could impartially judge the credit quality of debt obligations of different companies. So, in order to fulfill this requirement credit rating agencies were set up in India. The author explained the conceptual framework of credit rating and its various types including bond rating, equity rating, commercial paper rating, the borrowers ratings and sovereign rating. The author assessed the role of credit rating agencies and pointed out that credit rating agencies could meet the needs of corporate borrowers in particular and the common investor in general. Cantor et al. (1997), in their paper, pointed out the meaning of split rating (i.e. the difference of opinion of different rating agencies regarding a particular bond). The authors explained this by taking evidence from ratings assigned by both Moody s and Standards & Poor s. They also examined the benefits of using both the ratings assigned by Moody s and Standard & Poor s and compared the number of different methods for accounting for split ratings in estimating bond pricing models. The authors found that when bonds 42

9 were split rated by Moody s and Standard & Poor s, both these ratings affect their yields. The pricing models that rely on both the ratings produced unbiased and highly inefficient estimates. Therefore, they stressed that the average rating was the best guide in predicting the yields of the rated products. Blume et al. (1998) made an attempt to find out if the declining credit quality of US corporate was a myth or a reality. Thus, the authors tried to analyze whether the company that maintains the same values for its accounting and equity risk measures overtime received the lower rating during the period under study as compared to the past. For the purpose of the study, the authors examined eighteen years of ratings from 1978 to 1995 of different firms and the variables examined for the same were a subset of those accounting variables that Standard & Poor s utilized. It was revealed in the study that decline in the level of actual bond ratings was due to the use of more stringent rating standards by the rating agencies. The authors also found out in the study that the firm variables used in the study had changed overtime. The authors further predicted that though there might be many reasons for the increasing number of downgrades than the upgrades but the main reason for this was that the rating agencies were using more strict standards in assigning ratings. Ederington and Goh (1998) in their paper, tried to sort out the relative information provided to the equity market by bond rating agencies as well as by stock analysts. The authors indicated that both parties bring certain new information to the market since stock prices react to both rating changes and changes in earning forecasts by the analysts. The rating agencies claimed to have received the internal information, which is further reflected in their ratings but all such information is not as such available to the stock analysts. The stock analysts only take into consideration the outlook of firms equity. As far as timeliness of information is concerned most of the bond rating 43

10 downgrades were preceded by decline in actual and forecasted earnings. However, there was little change in actual earnings following upgrades but the analysts tend to forecast the increase in earnings after the rating upgrades. Goel (1998) discussed the need for regulating credit rating agencies as the investors look upon ratings as a measure of safety associated with the investment decision. The author suggested that the companies should get the fresh ratings done after the expiry of one year and the time limit of sixty days might be imposed on surveillance when an entity was put under the rating watch. The regulator should have the right to carry out inspections on rating agencies to check whether due diligence had been complied with by the agencies and the agencies should be held responsible for not taking action against the issuer for furnishing wrong or inadequate information. The author also suggested that a harmonized fee structure and rating symbols should be adopted by all rating agencies to make the rating consistent across all the agencies. Rao (1999) described that credit rating agencies were gaining importance as information providers to investors, issuers, intermediaries and regulators. He explained the genesis, features and functions of credit rating agencies and revealed that the ratings were opinions of the rating agencies on a specific issue of a corporate entity. Thus, credit ratings encourage investors to inflow their savings into the capital market activities, which resulted in the productive use of funds and thus enhancing production. So, the author suggested that keeping in view the significance of credit rating for both Joint Stock Company and investing public, the government should instil a law to mandate and popularize credit rating in Indian public and private corporate sector. Kliger and Sarig (2000) made an attempt to examine whether the rating information was price relevant and useful. To study this, the reactions of bond and stock prices to rating changes 44

11 announcements by US rating agency - Moody s, after its 1982 rating refinements, were noted. The authors found that the rating information did not affect the overall value of firm but the debt value increased and equity value fell when Moody s announced better than expected ratings and vice versa. Further the authors worked out that the rating information was valuable because the issuers disclosed the inside information to raters, who assign ratings after considering that information and that too without fully disclosing the specific underlying details to the public. Reddy (2000) tried to investigate the changing perspectives and issues of credit rating in India. He gave an overview of credit rating and agencies involved in such ratings both at Indian and International level, the benefits expected by the issuers, investors and regulators from credit rating and the criticisms leveled on such rating agencies. He also focused on the issues relating to sovereign rating and use of credit rating by regulators especially in banking sector. The author advocated that the appropriate disclosure of information and accounting standards across the board and freedom of expression and independence of credit rating agencies would help in improving the rating system. Further, the credit awareness of the investors on the operations of the rating systems should be encouraged to make the credit ratings more viable. Baker and Mansi (2001) examined the views of two types of respondents, i.e., issuers of investment and non-investment grade bonds, about the four major US Nationally Recognized Statistical Rating Organizations (NSROs). These US rating agencies include Standard & Poor s, Moody s, Duff & Phelps and Fitch. The results of the study reveal that the issuers of investment and non-investment grade bonds differ significantly from each other as the number of bond ratings maintained by the former was higher than those maintained by the latter. But as far as their satisfaction level is concerned, both types of issuers were generally satisfied with these credit rating agencies but 45

12 their level of satisfaction was higher for S&P. This was because of S&P s more frequent company visits, its speed in issuing upgrades, its understanding of the firm and industry, and its willingness to listen. Mansi and Baker (2001), in their study, tried to assess the perceptions of bond issuers and institutional investors regarding four major US credit rating agencies, viz. Moody s, S&P, DCR and FITCH by taking sample of 474 US industrial issuers and 387 institutional investors. The objectives of the study include finding out whether the number of rating agencies hired by issuers and investors differ and if they perceive any difference in accuracy of ratings assigned by different agencies. Further, the authors studied whether both the issuers and investors believed if the agencies maintain corporate bond ratings on a timely basis and if published ratings were the true indicators of issuers creditworthiness. Thus, the study evaluated that the issuers use multiple ratings whereas investors require one rating only. Both issuers and institutional investors perceived that Moody s and S&P provide accurate ratings than the other agencies. Most of the issuers believed that agencies maintain timely ratings but most of the investors did not think so. Further, majority of the issuers and investors perceive that the published ratings accurately reflect the firm s creditworthiness. Dichev and Piotroski (2001) examined the long run stock returns following bond rating changes by using a sample that comprised all Moody s bond rating changes during the period They found no reliable abnormal returns following upgrades but negative abnormal returns were found following the downgrades. They revealed that the poor returns of downgraded firms were more pronounced for small firms. They also tried to find out whether the abnormal returns following downgrades were compensation for risk or due to some other explanation. The evidences from the study suggested that the poor returns resulted from the under reaction to 46

13 the announcement of downgrades, rather than from lower systematic risk. Kuhner (2001) tried to analyze whether credit rating agencies have some benefits in misrepresenting their clients credit quality during the systematic crisis. The author tested the given hypothesis through various models. He revealed that in maximum situations the agencies did not report the true credit quality of their clients. Thus, there might be certain incentives available to the rating agencies. Further the author also highlighted that the creditors did not act contingent on rating assignments instead the creditors anticipate that the agency s report has no informational value. Thus, the study inferred that there was no relationship between agency s announcements and the creditors withdrawal decisions. Ferri and Liu (2002) tried to evaluate whether three major world players of rating industry Moody s, S&P, and Fitch IBCA, convey market high quality information on borrowers in both developed and emerging markets by taking database covering three years 1997, 1998 and The authors observed that in the developing countries there was a close relationship between firm and sovereign ratings but this was not the case with developed countries. They highlighted that the rating criteria used for firms in developing countries did not differ with respect to those reserved to firms in developed countries, thus, the global rating agencies did not think globally. Thus, the authors suggested that the firms in least developed countries (LDCs) should be penalized because of their domicile as low sovereign ratings would cause low private ratings, thus, bringing about high cost of capital in LDCs. Arora (2003) made an attempt to evaluate the credit rating system in India. The main objectives concentrated in the study were to study the factors and their relevant weightage in bond rating and to develop a model for testing bond rating by various agencies. The results of the study indicated that both qualitative and quantitative 47

14 factors were important for bond rating but the findings revealed that credit assessment done by credit rating agencies was relatively weak. The post-rating performance of companies did not justify initial ratings assigned to them. Further, the external inconsistency and variability in rating of bonds was observed due to changing corporate business environment and poor forecasting abilities of the analysts. Convitz and Harrison (2003) in their paper, described that the bond rating agencies had a dual objective of getting the financial incentives on the one hand and the stated goal of supplying independent and objective credit risk analysis to the investors on the other hand. So, they had a conflict of interest between profitability and reputation. Thus, the authors tried to evaluate whether the actions of rating agencies were influenced by this conflict of interest or not. For this purpose, a data set of about 2000 corporate bond rating changes by Moody s and Standard & Poor s from 1997 to 2002 was observed. They found that rating changes were not as such influenced by rating agencies financial incentives but rather the rating agencies were more concerned towards their reputation related incentives. It means that the rating agencies appeared to be relatively responsive to their reputation concerns and thus ultimately protected the interest of investors. Du and Suo (2003) in their study, examined the duration effect, momentum effect and rating policy effect on credit rating upgrades and downgrades. Duration is defined as the length of time that the firm has been in current rating, whereas momentum means one rating upgrade or downgrade followed by next rating change in the same direction. The data set of study includes 1508 firms in total which were assigned ratings by S&P from 1988 to The authors found that the duration effect on credit rating changes was not fixed but it varies with time. They also found that the downgrading rating momentum exists but there was no evidence for upgrade rating momentum. Further, they highlighted that rating agencies had been 48

15 adopting strict and restrictive rating policies over time because although there were more downgrades than upgrades in the studied years, yet they did not observe much defaults related to that. So, downgrades did not necessarily mean larger probabilities of defaults. Kraussl (2003) in his working paper, assessed the role of credit rating agencies in the international financial market particularly in the emerging market economies in the second-half of 1990s. Credit rating agencies played an important role in financial decision-making by providing information about credit risks associated with different financial investments and they provided standardized evaluation of the likely risks and returns associated with alternative investments. The role of sovereign credit ratings had also been examined by the author in financial markets of the emerging economies because sovereign credit ratings might convey certain new information about any country s credit worthiness and thus might encourage financial market downturns. Therefore, the study inferred that the credit rating agencies affect the size and volatility of emerging market lending. These results were stronger in the case of government bond downgrades. Further, the study also revealed that the speculative grade rated emerging market economies were more vulnerable to interest rate changes in the financial markets. Azahagaiah (2004) in his study, made an attempt to highlight the practices and problems of credit ratings in India. He studied the perceptions of Indian investors and revealed that out of various investment options, maximum respondents (37%) preferred company deposits. The analysis on the basis of investment showed that 35 per cent of respondents depend on credit rating for their investment decision. The analysis also revealed that majority of respondents (50%) depended on CRISIL ratings followed by those of ICRA (30.43%). The study concluded that even though with many problems, the issue with a credit rating had more chances of getting subscribed than that without a credit rating. 49

16 Achalapathi and Rajani (2004) tried to evaluate the corporate governance rating methodology being used by the two leading Indian credit rating agencies including ICRA and CRISIL. The authors made an attempt to apply the transparency and disclosure requirements and rating technology to analyze the corporate governance reports of various companies and tried to find out whether most of the companies comply to statutory requirements or not. It was found that financially better performing companies disclosed much as compared to financially weak companies. Similarly, the companies having relatively higher proportion of Foreign Institutional Investors in the shareholding pattern disclosed more about their corporate governance as compared to the companies which have less proportion of Foreign Institutional Investors. Though corporate disclosures were always at a cost being borne by the shareholders yet the disclosures were required by the shareholders. So, most of the companies comply with the statutory requirements as corporate disclosures increase the corporate image of the company. Robbe and Mahieu (2004) studied both timeliness and predictability of rating changes by S&P. For the purpose of this study all 583 rated companies that were included in S&P 500 index between July 1998 and June 2003 were taken as a sample. The study analyzed the rating changes by S&P in relation to another credit risk measure which was developed by another company named KMV Corporation, a new entrant in credit rating industry. The rating methodology adopted by S&P and KMV was substantially different. S&P determined the rating on qualitative-oriented accounting based approach. KMV calculated the rating probabilities called Expected Default Frequencies which was quantitative-oriented market based approach. The study highlighted that timeliness and predictability of S&P rating changes is low as 75 per cent of the S&P rating changes were significantly anticipated by KMV more than a year in advance. Further, Expected Default Frequencies of KMV possessed considerable predictive powers 50

17 to forecast future rating changes by S&P. So, they suggested that both qualitative and quantitative approaches should be used by the agencies to predict the rating changes properly. Gill (2005) in her research paper, made an attempt to examine the performance of ICRA on the basis of average default rate. The study relates to the long-term debt instruments over a period of seven years from The author brought out that ICRA s performance about the companies rated by it had not been up to the mark and default on ICRA rated long-term debt instrument are the highest in manufacturing sector followed by financial sector. Further the study found that many of the debt issues that defaulted during the period were placed in ICRA s investment grade until just before being dropped into default grade. So, the author suggested that excessive reliance on credit ratings should be reduced and proper steps should be taken to make the working of credit rating agencies more accountable. Martell (2005) analyzed the sovereign credit rating changes issued by Standard & Poor s and Moody s on 29 emerging countries from 1986 to 2003 and the effect of the same on the stock prices of the locally traded stocks of each country. The author found that the local stock markets reacted only to news of sovereign credit rating downgrades and that too which were issued by Standard & Poor s. Thus, he established that the rating changes from S&P were more informative than those by Moody s. He also found that larger firms were more sensitive to sovereign credit downgrades and the firms that had access to international capital markets experienced larger abnormal returns than the firms that did not have access to international financial markets. Poon and Firth (2005), in their research paper tested whether there were any differences in the distribution of solicited and unsolicited ratings. For this purpose, the bank ratings issued by Fitch in 82 countries were studied. They also examined if the financial 51

18 profiles of banks with solicited ratings differ from those with unsolicited ratings. The researchers found that the solicited ratings were generally higher than the unsolicited ratings because unsolicited ratings were based only on public information. Further, the firms with unsolicited ratings had poorer financial profiles than those with the solicited ratings. So, according to the researchers this might be the reason why certain banks could solicit the ratings while others could not. Upadhye (2005), in her study, concentrated on an overview of credit rating system in India. The paper explained the various factors being taken into consideration by rating agencies which include past performance, profit turnover, cash flow and fund flow, nature of competition, etc. and various types of ratings being done by ICRA. The paper also gave details of various Credit Rating Agencies in India like CRISIL, ICRA, CARE, and ONICRA. The author criticized the working of these agencies and suggested that a standardized fee structure and standardized rating grades should be adopted by all rating agencies in order to simplify the procedures. Guttler and Wahrenburg (2006), in their working paper, made an attempt to examine the adjustment of credit ratings in advance of defaults by taking evidence from issuers with multiple ratings by US rating agencies including Moody s and Standard & Poor s from 1997 to The authors found that the Moody s adjusted its ratings to increasing default risk in a timelier manner than S&P. Moreover, there was no home biasness on the part of these US based rating agencies to US or non-us issuers. Further, the authors predicted that when any agency downgrades or upgrades certain issues, the second agency did the same action and that too with the greater magnitude in the short- term and the rating changes by the second rating agency were significantly more likely after downgrades than after the upgrades by the first rating agency. 52

19 Kanagaraj and Murugesan (2006), in their paper, tried to evaluate the relationship between credit rating and financial variables. The sample of the study includes the group of manufacturing firms whose debentures were rated by CRISIL and the study covers a period of six years from to The author had grouped the important variables, which form the basis for rating classification, into nine financial dimensions including profitability, liquidity, activity, debt service coverage, liabilities structure, size, firm s age, leverage and sales turnover. The authors revealed that there is a very good relation between the financial performance of a firm and credit rating. The authors further worked out that the variables such as debt coverag, profitability and leverage hold a dominant position in credit rating classification while size of the firm, working capital management and liabilities structure are given a moderate consideration in rating assignments. Tang (2006) studied the impact of more refined rating information on firm s credit market access, financing decisions and investment policies, by using Moody s 1982 credit rating format refinement. The author pointed out that the firms which were upgraded as a result of finer rating gradation experienced a significant drop in their cost of borrowing as compared to those with rating refinement downgrades. Further, firms with rating refinement upgrades had less equity issuance as compared to those with rating refinement downgrades, which confirmed that improved capital market access allows upgraded firms to substitute away from equity to debt financing. Thus, this showed that the firms with higher rating refinements were associated with more capital investments, less cash accumulation and faster asset growth than those with lower ones. Thus, the study highlighted the role of credit ratings in determining firm s capital structure both in terms of cost of borrowing and amount of debt issued. 53

20 Vepa (2006), in her study, made an attempt to trace trends in the corporate debenture issues of the private sector in India and the rating trends of the same with special reference to the pioneer rating agency of India CRISIL. The time period of the study was from to The author observed that the number of public and rights issues had decreased during the period under study, whereas the percentage of private placement out of total issues had increased consistently. Many of the debt instruments including debentures were downgraded during the period but the presence of multiple credit rating agencies gave scope to issuers to approach more than one credit rating agency with a hope to secure better ratings. The author highlighted that when credit rating became mandatory in in India, private placements of debentures gained importance as a preferred route of financing as credit rating was not mandatory for private placements but in spite of that, the debentures or issues which were rated were more safe and reliable than the unrated ones by the investors. Cantor et al. (2007) analyzed the behaviour of various plan sponsors and investment managers regarding the use of rating guidelines in the conduct of their investment activities. For the purpose of study, 200 plan sponsors and investment managers of US and Europe were taken as sample. They also investigated a number of important issues regarding the linkage between market dynamics and use of credit rating. The authors revealed that the rating based guidelines were widespread but their forms and motivations vary considerably but the usage of ratings appeared remarkably similar in US and Europe. Further, they found that the adoption of rating based guidelines by investment managers was dominated by client requirements rather than the regulatory needs. They also highlighted that the market participants expressed a preference on more accuracy of ratings over more stability of ratings. 54

21 Czarnitzki and Kraft (2007), in their study, tested whether the credit ratings give more specific information about creditworthiness of the firms as compared to the publicly available information (which is available to the potential investors without any substantial cost). They selected a sample of about 8000 firms of German manufacturing sector for the purpose of study and the time period of study was They compared the ratings given by leading German credit rating agency Credit Reform with the publicly available information. The study revealed that the young firms were more likely to default than the established ones. Further, the lower the productivity the more would be the probability of default. They further inferred that credit rating has some additional informational value for lenders but the rating agencies overemphasized the factor firm size in construction of rating index. Jain and Sharma (2008), in their paper, attempted to examine the working of credit rating agencies in the light of role played by them in the capital market as information disseminators. The authors identified conflicts of interest affecting the rating decisions and the manner in which the regulations have attempted to address them. Further, they also studied the regulatory framework for credit rating agencies in India. The authors revealed that credit rating agencies play a central role in the capital markets through their informed and independent analysis. The various conflicts of interest highlighted in the study were relating to the fee charged, ancillary services of credit rating agencies, ownership interest of credit rating agencies in client securities and the problem of notching. The study highlighted that despite the significant role played by credit rating agencies in capital markets, they are not properly regulated as not much responsibility is put on them in respect of their rating actions. Further, in the Indian context too, the authors revealed certain loopholes in the regulatory system of credit rating agencies. These included deficient disclosure regime, lack of private enforcement regime, management conflict of 55

22 interest and lack of rules for structured finance ratings, which need to be corrected in a proper and timely manner. Reddy and Gowda (2008), in their paper, explained the importance and problems of credit rating in India. They also highlighted the basis of credit rating and credit rating practices prevalent in India. For this purpose, the opinions of sample of investors from Hyderabad were taken. The results of the study inferred that majority of the respondents were aware of the existence of various credit rating agencies including CRISIL, CARE, ICRA, etc. About 40 per cent (80 out of 200) of the respondents depend on credit rating for their investment in debt instrument but more than 50 per cent from them (94 out of 180) rely on CRISIL for their investment than the other credit rating agencies. The study worked out that though there is confusion among various investors due to existence of more than one credit rating agency but majority of them are satisfied with the guidance of credit rating agencies. Bhattacharyya (2009), in her paper, evaluated the issuer rating system in India with special reference to ICRA s issuer rating model, since ICRA introduced the issuer rating services in India in The author identified various quantitative variables having major impact on the issuer rating along with their relative importance with the help of discriminant analysis. The time period of the study is from the date when the issuer rating started in 2005 to March 2008 and the sample consists of 17 companies which have been rated by ICRA during this period. The study highlighted that out of the ten variables being used by ICRA for issuer rating the PBIT & Debt plus net worth ratio, current ratio and net sales growth rate play an important role but the qualitative factors can also affect the ratings at any time. Bheemanagauda and Madegowda (2010) made an attempt to evaluate the performance of credit rating agencies in India including CRISIL, ICRA, CARE and FITCH. Secondary data relating to long-term 56

23 debt instruments from time period has been used for the purpose of the study. The analysis of the study brings out that during the given period there is a substantial increase in the rating business in India. During the study period, the maximum percentage of instruments rated is assigned the investment grade rating. As far as rating revisions are concerned, the study depicts that the downgrades were more than double the upgrades both in terms of number of instruments and the volume of debt. This depicts that the ratings were issuer biased. So, the authors suggested that stringent methods should be adopted to avoid frequent downgrades. The study further highlights that among the agencies which maintain the stability of ratings, Fitch India Ratings holds the top most position followed by CRISIL, ICRA and CARE in line. Thus, it can be said at the end that many studies relating to credit rating have been conducted in India as well as abroad but a glimpse of existing literature reflects that despite of the increasing importance of credit rating agencies as the information providers for credit related opinions, the comprehensive research pertaining to credit rating in Indian context is still limited. Most of the studies conducted so far in India focused mainly upon the theoretical and conceptual framework of credit rating in India. 57

24 REFERENCES Achalapathi, K.V.; and Rajani, D. (2004), ICRA and CRISIL Rating Methodologies: An Evaluation, Indian Journal of Accounting, Vol. 34 (2), June, pp Arora, M. (2003), Credit Rating in India Institutions, Methods and Evaluation, New Century Publications, Delhi. Azahagaiah, R. (2004), Credit Rating Practices and Problems, The Indian Journal of Commerce, Vol. 57, No. 4, October-December, pp Baker, H. K.; and Mansi, S. (2001), Assessing Credit Rating Agencies by Corporate Bond Issuers: The Case of Investment Vs. Non- Investment Grade Bonds, ssrn abstract id , April 17. [available at Bhattacharyya, M. (2009), A Study of Issuer Rating Service with an Appraisal of ICRA s Rating Model, Indian Journal of Accounting, Vol. XXXIX(2), June, pp Bheemanagauda; and Madegowda, J. (2010), Performance of Credit Rating Agencies in India, The Indian Journal of Commerce, Vol. 63, No. 3, June-September, pp Blume, M. E.; Lim, F.; and Mackinlay, A.C. (1998), The Declining Credit Quality of U.S. Corporate Debt: Myth or Reality, The Journal of Finance, Vol. 53, No. 4, August, pp Cantor, R.; Packer, F.; and Cole, K. (1997), Split Ratings and the Pricing of Credit Risk, Federal Reserve Bank of New York, Research Paper No. 9711, March [available at Cantor, R.; Gwilym, O.; and Thomas, S. (2007), The Use of Credit Rating in Investment Management in US and Europe, 16 February, ssrn abstract id [available at Convitz, D. M.; and Harrison, P. (2003), Testing Conflict of Interest at Bond Rating Agencies with Market Anticipation: Evidence that Reputation Incentive Dominate, FEDS Working Paper No

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