An Assessment of Role of Credit Ratings Agencies in the Corporate Governance Process: The Case for Including Internal Contracts in the Formal Rating Assessment
Posted: 21 Oct 2009
Date Written: October 10, 2009
Well-defined and enforced corporate governance provides a structure that, at least in theory, works for the benefit of everyone concerned by ensuring that the enterprise adheres to accepted ethical standards and best practices as well as to formal laws. Now the credit rating agencies play a very important role in the corporate governance. A credit rating for an issuer takes into consideration the issuer's credit worthiness and affects the interest rate applied to the particular security being issued. Some of the important Credit rating Agencies in India are Credit Rating Information Services of India Limited (CRISIL); Investment Information and Credit Rating Agency of India ( ICRA); Credit Analysis and Research Limited ( CARE); Duff and Phelps Credit Rating India Private Limited ( DCR Limited ); ONICRA Credit Rating Agency of India.
Basically the Credit ratings are used by investors, issuers, investment banks, broker dealers, and governments. For investors, credit rating agencies increase the range of investment alternatives and easy to use measurements of relative credit risk, thereby increasing the supply of total risk capital in the market, making it very efficient. The growth rate will increase. For issuers, the credit ratings obtained from agencies; act as an independent verification of their own credit worthiness and the resultant value of the instruments they issue. Investment bankers and broker dealers also use the ratings to calculate their own risk portfolios (risk involved in the total investment). Large banks however, calculate their own risk portfolios, and use the credit rating from the agencies concerned, to check and double check or if need arises a triple check against their own analysis. Regulators use credit ratings as well, or permit ratings to be used for regulatory purposes. Like the banking regulators can allow banks to use credit ratings from certain approved CRAs when calculating their net capital reserve requirements.
Paper analyses that whether the credit rating agencies downgrade companies promptly enough, leading to suggestions that, rather than rely on CRA ratings in financial regulation, financial regulators should instead require banks, broker-dealers and insurance firms (among others) to use credit spread when calculating the risk in their portfolio.
Paper argues that the lowering of Credit ratings by the agencies can create to a vicious circle. The interest rates for the company under consideration would go up, but the other contracts with other financial institutions would be affected adversely causing an increase in expenses and ensuing decrease in credit worthiness. The effect of such ratings triggers, however, can be devastating: under a worst-case scenario, once the company's debt is downgraded by a CRA, the company's loans become due in full; since the troubled company likely is incapable of paying all of these loans in full at once, it is forced into bankruptcy. Credit Rating Agencies have made errors in judgment in rating structured products, particularly in assigning AAA ratings to structured debt, which in a large number of cases has subsequently been downgraded or defaulted.
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