FREE GUIDE

How to

crack IAS in 1 year.

Learn how to use insights from IAS Toppers to crack IAS in one year

Credit rating Agencies- Functioning and Models | UPSC

UPSC Current Affairs for UPSC IAS

Watch the free daily Current affairs video explanation

UPSC Syllabus: Mains – GS Paper III- Indian Economy

Context

Market regulator SEBI came out with a new framework to strengthen policies on provisional rating by credit rating agencies for debt instruments.

Details about Credit Rating Agencies

  • A credit rating agency is an entity which assesses the ability and willingness of the issuer company for timely payment of interest and principal on a debt instrument. The Rating is denoted by a simple alphanumeric symbol, for e.g., AA+, A-, etc.
  • The rating is assigned to a security or an instrument issued by a company.
  • Ratings are based on a comprehensive evaluation of the strengths and weaknesses of the company fundamentals including financials along with an in-depth study of the industry as well as macro-economic, regulatory and political environment.

Different Business Models of Credit Rating Agencies

The different models of Credit rating agencies are based upon “Who Pays to get the Credit rating of an instrument issued by the company?”. Broadly, there are 3 Models of Credit rating agencies:

Issuer Pay Model

  • Under this Model, the Issuer i.e., the company pays the money to the Credit rating agencies (CRAs) in order to get credit rating for the instruments issued by it.
  • To enable the CRAs to give the credit rating, the company provides all the necessary details such as company’s balance sheet and business details. Based upon a thorough and detailed analysis of such details, the CRA issues credit rating to the instrument issued by the company.

Investor Pay Model

  • Under this Model, the investor is required to pay the money to the CRA in order to know the credit rating.
  • Hence, only those investors who are ready to pay for a rating can access the credit rating of the instrument. The credit rating issued by the CRA is not commonly available to all the investors free of cost.

Regulators pay Model

Under this model, the money is paid by the regulator in the country in order to get the credit rating. Either the company or the investor need not pay for the credit rating. The credit ratings would be made available to all the investors.

Issuer Pay Model Investor pays model Regulator pays model
Advantages

●                    Ratings are available to the entire market free of charge and will highly aid the small investors.

●                    It gives the rating agencies access to high-quality information that enhances the quality of analysis.

 

Disadvantages

●                    It can lead to serious conflict of interest since the CRAs are paid by the company to get the rating. The CRAs may inflate the rating to satisfy the company.

●                    It may lead to ‘Rating Shopping’ which refers to the situations where an issuer approaches different rating agencies for the ratings and then choose to publish the most favourable ratings to disclose it to the public via media while concealing the lower ratings.

Advantages

●                    It would avoid the serious conflict of interest of the CRAs.

●                    This would enable the investors to get the credit rating based on the true and actual financial condition of the company.

 

Disadvantages

●                    Ratings would be available only to those investors who can pay for them and takes ratings out of the public domain and thus affects the small investors.

●                    The company may not always share all the necessary information with the CRAs which then can have an adverse impact on the quality of the ratings.

●                    It can pose serious conflict of interest involving the investors themselves. If investors are the payees, they can influence CRAs to give lower-than-warranted ratings to help them negotiate higher interest rates.

 

Advantages

It eliminates the conflict of interest as seen in both Issuer Pay Model and Investor Pay Model.

 

Disadvantages

●                    The problem with this model lies in the choosing the CRA and payment to be fixed.

●                    The CRA chosen by the regulator may not be able to provide the best credit rating. Further, if the regulator pays less amount of money to the CRA, the CRA may find it difficult to continue with its business and could have an adverse impact on the quality of the ratings issued.

 


Conclusion

  • Any CRA business model must facilitate two objectives: 1) ensure ratings are of high quality and 2) ensure all market participants have access to such ratings at a reasonable cost.
  • Additionally, the models must involve minimal or no conflict of interest. ‘Minimal’ is a considered usage here since conflicts cannot be eliminated.
  • Each model has its pros and cons. It’s imperative to pick the model that best meets the primary objectives of credit rating – high quality and open access.
  • In that context, the issuer pays model appears to be the best.
0

Leave a Reply

Your email address will not be published. Required fields are marked *