Credit rating, in general sense, is the evaluation of the credit worthiness of an individual or of a business concern or of an instrument of a business based on relevant factors indicating ability and willingness to pay obligations as well as net worth.
‘Encyclopedia of Banking & Finance’ by Charles J. Woelfel states that a credit rating is a letter or number used by a mercantile or other agency in reports and credit rating books to denote the ability and disposition of various businesses (individual, proprietorship, partnership or corporation) to meet their financial obligations. It also states that ratings are used as a guide to the investment quality of bonds and stocks. based on security of principal and interest (or dividends), earning power, mortgage position, market history and marketability.
Credit ratings establish a link between risk and return. An investor or any other interested person uses the rating to assess the risk-level and compares the offered rate of return with his expected rate of return.
Credit rating is extremely important as it not only plays a role in investor protection but also benefits industry as a whole in terms of direct mobilisation of savings from individuals. Rating also provide a marketing tool to the company and its investment bankers in placing company’s debt obligations with a investor base that is aware of, and comfortable with, the level of risk. Ratings also encourage discipline amongst corporate borrowers to improve their financial structure and operating risks to obtain a better rating for their debt obligations and thereby lower the cost of borrowing. Companies those get a lower rating are forewarned, as it were and have the freedom, if they desire, to take steps on their financial or business risks and thereby improve their standing in the market.
The need for reliable information in channelisation of the resources to the most productive uses can hardly be overemphasized. Relevant and reliable information helps the investors to arrive at their investment decisions. These include offer documents of the issuers, research reports of market intermediaries and media reports. In the developed markets, credit rating agencies have also come to occupy a leading position as information providers along with rating of financial instruments. Particularly for the credit related opinions in respect of debt related instruments, such agencies offer independent opinions which are objective, well researched and credible.
During the great American depression years, high levels of default triggered the growth of credit rating as an essential input for the investors. The recognition for credit rating received a new impetus when Government Pension Funds, Insurance Companies etc were directed not to invest in securities rated below a particular grade by credit rating agencies. This led to the growth in the awareness of credit rating as a primary tool of risk assessment.
The first Mercantile Credit Agency was established inNew Yorkin 1841. Its first rating guide was published in 1859 by Robert Dun. Another similar agency was set up by John Bradstreet which published its rating guide in 1857. These two agencies were merged to form Dun and Bradstreet in 1933 which acquired Moody’s Investor Service in 1962. Moody’s was founded by Moody in 1900. The other world renowned rating agency namely Standard and Poor was created in 1941 by merging the Standard Statistics Company and Poor’s Publishing Company which had their origin earlier.
In India CRISIL (Credit Rating and Information Services (India) Limited) was set up as the first credit rating agency in 1987. This was followed by ICRA Limited (Investment Information and Credit Rating Agency of India Limited) in 1991 and CARE (Credit Analyses and Research Limited) in 1994 and Fitch Rating India Pvt. Ltd. Both these four credit rating agencies are registered with the Securities and Exchange Board of India.