Uses of Credit Rating :
Credit rating is useful to investors, issuers, intermediaries and regulators.
For Investors : The main purpose of credit rating is to communicate to the investors the relative ranking of the default loss probability for a given fixed income investment, in comparison with other rated instruments. In a way it is essentially an information service. In the absence of professional credit rating, the investor has to largely depend on his familiarity with the names of promoters or collaborators of a company issuing debt instruments. This is not a reliable method. Credit rating by skilled, competent and credible professionals eliminates or at least minimizes the role of name recognition and replaces it with a well researched and properly analysed opinions. This method provides a low cost supplement to investors. Large investors use information provided by rating agencies such as upgrades and downgrades and alter their portfolio mix by operating in the secondary market. Investors also use the industry reports, corporate reports, seminars and open access provided by the credit rating agencies.
For Issuers : The market places immense faith in opinion of credit rating agencies, hence the issuers also depend on their critical analysis. This enables the issuers of highly rated instruments to access the market even during adverse market conditions. Credit rating provides a basis for determining the additional return (over and above a risk free return) which investors must get in order to be compensated for the additional risk that they bear. The difference in price leads to significant cost savings in the case of highly rated instruments.
For Intermediaries : Rating is useful to Intermediaries such as merchant bankers for planning, pricing, underwriting and placement of the issues. Intermediaries like brokers and dealers in securities use rating as an input for monitoring risk exposures. Merchant bankers also use credit rating for pre-packaging issues by way of asset securitization / structured obligations. For Regulators: Regulatory authorities in different countries such as US, Australia and Japan have specified rules that restrict entry to the market of new issues rated below a particular grade, that stipulate different margin requirements for mortgage of rated and unrated instruments, that prohibit institutional investors for purchasing or holding instruments rated below a particular level and so on.
Factors for Success of a Rating System :
(a) Credible and independent structure and procedures;
(b) Objectivity and impartiality of opinions;
(c) Analytical research, integrity and consistency;
(d) Professionalism and industry related expertise;
(f) Timeliness of rating review and announcement of changes;
(g) Ability to reach wide range of investors by means of Press reports, print or electronic media and investor oriented research services.
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