End term Project

An overview of the U.S. Credit Rating

Industry and its lessons for India.

Submitted by-

Parimal Thakker

PGDM-IB (II)

Roll no.62

K.J. Somaiya Institute of management studies and research.

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Table of Contents
Introduction: ................................................................................................................................................ 4

Structure of Credit Rating Industry: ........................................................................................................ 6

Some Characteristics of the Three Major Bond Rating Firms in the U.S. ................................................ 6

Porter’s Five Forces Framework for analyzing the U.S. Credit Rating Industry: ..................................... 7

Factors affecting the Demand in Credit rating Industry: .........................................................................11

Network Effects: ..................................................................................................................................11

Two Rating Norm: ...............................................................................................................................11

Rating Based Regulation .....................................................................................................................12

Factors affecting Supply in the credit rating industry: ............................................................................13

First Movers Advantage: .....................................................................................................................13

Economies of Scale: .............................................................................................................................13

Reputation Building: ............................................................................................................................14

Diversification: .....................................................................................................................................14

Diseconomies of Scale: ........................................................................................................................14

Market Segmentation; ........................................................................................................................15

Strategic Interaction: ...........................................................................................................................16

Behavior: ....................................................................................................................................................19

Pricing. ....................................................................................................................................................19

Who pays? ...........................................................................................................................................19

The structure of fees. ...........................................................................................................................19

Performance: .............................................................................................................................................21

Profitability: ............................................................................................................................................21

Innovation: ..............................................................................................................................................22

Moral hazard behavior ............................................................................................................................22

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Regulation: .................................................................................................................................................23

Safety-and-soundness regulation.............................................................................................................23

NRSRO regulation. .................................................................................................................................24

Indian Credit Rating Industry .................................................................................................................25

CRISIL: ...................................................................................................................................................25

ICRA: ......................................................................................................................................................26

CARE: .....................................................................................................................................................26

Road to Reform in India: .............................................................................................................. 27

Deficient Disclosure Regime ................................................................................................................27

Mandatory Rating Requirements ........................................................................................................28

Lack of Private Enforcement Regime...................................................................................................29

Conclusion:.................................................................................................................................................29

References ..................................................................................................................................................30

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Topic:

An overview of the U.S. Credit Rating industry and its lessons for India.

Introduction:
The role of financial markets in a market economy is that of an efficient intermediate,
mediating between savers and investors, mobilizing capital on hand and efficiently allocating
them between competing uses on the other. Such an allocative role hinges crucially on the
availability of reliable information.

The doctrine of “efficient market allocation” in fact has as its bedrock, what economists
label “ perfect information”. An investor in search of investment avenues has recourse to various
sources of information- offer documents of the issuer(s), research reports of market
intermediaries, media reports etc. In addition to these sources, Credit Rating Agencies have
come to occupy a pivotal role as information providers, particularly for credit related opinions in
respect of debt instruments; a role that has been strengthened by the perception that their
opinions are independent, objective, well researched and credible.

The impetus for the growth of Credit Rating came from the high levels of default in the
US Capital markets after the Great Depression. Further impetus for growth came when
regulatory agencies began to stipulate that institutions such as Government Pension Funds and
Insurance Companies could not buy securities rated below a particular grade.

Ratings, usually expressed in alphabetical or alphanumeric symbols, are a simple and

easily understood tool enabling the investor to differentiate between debt instruments on the
basis of their underlying credit quality. The credit rating is thus a symbolic indicator of the
current opinion of the relative capability of the issuer to service its debt obligation in a timely
fashion, with specific reference to the instrument being rated. It is focused on communicating to
the investors , the relative ranking of the default loss probability for a given fixed income
investment, in comparison with other rated instruments.

A rating is specific to a debt instrument and is intended as a grade, an analysis of the

credit risk associated with the particular instrument. It is based upon the relative capability and
willingness of the issuer of the instrument to service the debt obligations( both principal and
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interest) as per the terms of the contract. Thus a rating is neither a general purpose evaluation of
the issuer, nor an overall assessment of the credit risk likely to be involved in all the debts
contracted or to be contracted by such entity.

The primary objective of rating is to provide guidance to investors/ creditors in

determining a credit risk associated with a debt instrument/credit obligation. It does not amount
to a recommendation to buy, hold or sell an instrument as at does not take into consideration
factors such as market prices, personal risk preferences and other considerations which may
influence an investment decision. The rating process is itself based on certain ‘givens.’ The
agency, for instance, does not perform an audit . Instead It is required to rely on information
provided by the issuer and collected by analysts from different sources, including interactions in-
person with various entities.

Figure 1: Information Intermediation by credit rating Agencies.

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Structure of Credit Rating Industry:

There are currently three major bond rating firms in the U.S.: Moody's; Standard & Poors
(S&P); and Fitch.Moody's is currently a freestanding company that is highly specialized on
rating activities. S&P's credit rating activities are only part of the larger financial information
services that are provided by S&P, which in turn is owned by McGraw-Hill. Fitch is owned by a
French company, FIMALAC. Of the three rating firms, Moody's and S&P are by far the largest.

Some Characteristics of the Three Major Bond Rating Firms in the U.S.

Moody's:
• Annual revenues: $602 million (2000); about 70% arises in the U.S.; about 90% is
derived from bond rating
• Annual (after tax) net income: $158 million (2000)
• Assets: $300 million (2000)
• Employees: 1,500, including 700 analysts
• Coverage:
o over $30 trillion in debt issuances (ratings and analysis)
o 143,000 corporate, government, public finance issuances
o 4,200 corporate relationships
o 100 countries (offices in 14 countries)

S&P:
• Coverage:
o well in excess of $11 trillion in debt issuances
o more than 38,000 corporate, sovereign, municipal, and financial institution
o more than 98,000 issuances
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 o more than 86 countries (offices in 16 countries)

Fitch:
• Annual revenues: $260 million (2000)
• Employees: 1,100
• Coverage:
o 75 countries (offices in 16 countries)

Porter’s Five Forces Framework for analyzing the U.S. Credit Rating Industry:

1. Bargaining power of Suppliers:

• The main suppliers here are the highly skilled workforce and the analysts.

• Switching costs of suppliers is low.

• Differentiation of Inputs is very high. The workforce required (suppliers), should

have high analytical skills as well as high ethical standards required in this industry.

• Impact of inputs on cost or differentiation : High

• Threat of forward integration: Low.

Bargaining power of suppliers can be considered High for this industry.

2. Bargaining power of Buyers:

• Buyers concentration : The number of buyers in this industry is very high, with all the
issuers wanting to lower their issuing cost by receiving credit ratings for their issues.

• Switching Cost: High

• Brand Identity (Reputational impact of CRAs) : high

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 • Ability to backward integrate: Low.

• Substitute Products: None.

Bargaining power of Buyers is Low.

3. Threat of New Entrants:

• Entry Barriers:

o Economies of Scale and scope: Higher economies of scale and scope leads to
more reputation. Reputation is vital for a bond rating firm.

o Brand Identity (Reputational impact of CRAs) : High

o Capital Requirement: High.

o Regulation of credit rating agencies and awarding of the NRSRO status only
to the incumbent players greatly increases the entry barriers.

Thus the Entry barriers for this industry are very high.

• Switching costs: High.

• Proprietary learning curve: Very High.

• Government policy: Unfavorable to new entrants.

• Expected Retaliation: High.

Thus the threat of New entrants is low.

4. Threat of Substitute : Low.

5. Industry Competitors:

• Factors affecting rivalry:

o Industry growth : Medium.

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 o Fixed Costs: Medium

o Brand Identity: High.

o Switching costs: High.

o Informational Complexity: High

Many bond issuers in US opt for the dual credit rating approach. E.g. A bond issuer will
pay for receiving credit rating from both, say S&P and Moody’s, this further reduces the cost of
issuance and increases the credibility of the issuer. This practice significantly reduces the direct
competition among the credit rating agencies.

Thus the Industry competition is medium and the U.S. credit rating industry is considered
attractive and is quite profitable. Some of the points considered in this analysis are discussed
below.

In order to understand the U.S. Credit rating industry, lets look at other countries and their credit
rating industries.

Numbers of Prominent Credit Rating Firms outside the United States (as of October 2000)
(excludes branch offices of Moody's, S&P, and Fitch)

Argentina: 1 Italy: 1
Bangladesh: 1 Israel: 1
Brazil: 1 Japan: 3
Canada: 1 Korea: 3
Chile: 2 Malaysia: 1
China: 2 Pakistan: 2
Columbia: 1 Peru: 1
Cyprus: 1 Russia: 1
Egypt: 1 South Africa: 1
France: 1 Sweden: 2
Germany: 2 Taiwan: 1
India: 3 Tunisia: 1
Indonesia: 1 Venezuela: 1

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Sources: BIS (2000); rating firms' websites

The U.S. currently has only three general-purpose bond rating firms and has never had
more than five in operation at any given time. India, Japan, and Korea have only three; Chile,
China, Germany, Pakistan, and Sweden each have only two; the remaining countries have only
one each. It is also striking that the U.K., despite its prominence as an international finance
center, has no bond rating agency headquartered in the country.

The fewness of the number of bond rating firms outside of the U.S. (and the U.K.) is
probably best explained by the less well developed corporate bond markets in these countries (as
compared with the U.S.) and hence a lesser need for specialized institutions to help pierce the
asymmetric information fog in bond markets. But what about the U.S.? The fewness of the bond
rating firms contrasts sharply with the thousands of stock analysts, employed by hundreds of
securities firms, who regularly offer opinions about companies' equity share price prospects.
Why are there so many of the latter (none of whom command the sweeping authority of Moody's
and S&P) and so few of the former?

There are a few possibilities. First, in 1975 the U.S. Securities and Exchange
Commission (SEC) initiated the designation of bond rating firms as "nationally recognized
statistical rating organizations" (NRSROs). At the time of the initial designation, the SEC
"grandfathered" Moody's, S&P, and Fitch. It subsequently designated Duff & Phelps (1982) and
McCarthy, Crisanti & Maffei (MCM) (1983) as NRSROs (MCM was absorbed by Duff &
Phelps in 1991), and designated IBCA (1991) and Thomson BankWatch (1992) as NRSROs for
banks and financial institutions. The SEC has not granted the NRSRO designation to any new
entities since then, despite applications by non-U.S. firms. Indeed, IBCA's frustration with its
inability to expand its NRSRO designation beyond bank ratings was a major factor underlying
IBCA's purchase of Fitch in 1997.

Regulation, then, is currently limiting entry. But this cannot explain the fewness before
1975. Instead, the explanation may be partly based on economies of scale and scope and of
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standardization: Reputation is vital for a bond rating firm. Reputation gets built by having
extensive experience with a wide range of bond issues. And lenders (bondholders) may well
prefer having only a few standardized ratings and raters, so that the lenders can more readily
make comparisons of the ratings of issues and issuers based on a relatively straightforward
"probability of default" judgment on the part of the rater. By contrast, the process of predicting
outcomes for equity instruments may well be considerably more complex (since the extent of
gain and loss are important considerations) and more judgmental; investors may well be more
open to varied opinions from many sources, none of which command sweeping authority.

Some more characteristics of the U.S. Credit rating industry are –

Factors affecting the Demand in Credit rating Industry:

Network Effects:

The demand for ratings is also influenced by direct network effects or, in general terms,
demand side economies of scale. It demonstrates users' desires for consistency of rating
categories across issuers.

Two Rating Norm:

In the market for big international debt securities a ‘two-rating norm’ has developed over
time, i.e. a majority of big bond issues is simultaneously rated by Moody’s and S&P. The two-
rating norm is a major factor determining demand and can be attributed to several factors. Two
questions must be asked: Why do issuers buy two ratings, and why are these invariably the
ratings of Moody’s and S&P? The simplest reason for investors to want more than one rating is
additional information. If two ratings convey more information than one, investors prefer debt

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securities featuring two ratings, just as they use many research opinions in equity investment
decisions. Empirically, studies have indeed documented an additional information value of a
second rating. While the additional value is not necessarily very high, investors still prefer it
because they do not directly carry the rating costs. As their perceived risk is lower when
investing in a bond with two ratings, they are willing to accept a lower interest rate.

Ratings by Moody’s and S&P are regarded as equivalent and therefore compatible in the
sense of network effects. Investors have a low preference for ‘incompatible’ ratings, which might
be based on different standards. It is natural for issuers to pick the two leading and comparable
agencies. Moody’s and S&P also feature the highest absolute reputation in the market. Since
investors prefer ratings of the most reputable agencies, issuers stick to the top players in the
market.

Rating Based Regulation

The demand for ratings has been modeled so that it will be driven by the issuers’ desire to
convey information about their creditworthiness to investors. A second major driver of demand
is rating-based regulation. This is most obvious in the case of disclosure requirements where an
appropriate credit rating may lower legislative requirements. Issuers have an incentive to buy a
rating simply to reduce reporting costs, completely independent of the information value for
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investors. Rules concerning investment restrictions and capital requirements have a similar
effect. They help to lower financing costs and increase financial flexibility, as issuers can reach a
larger pool of potential investors with an appropriate rating. In a nutshell, ratings receive an
additional value other than informational: they provide a ‘license’ for accessing certain areas of
the financial markets, or to avoid regulatory burdens

Above the market environment for credit rating agencies has been analyzed with a focus
on the reputation mechanism and the drivers of demand. To acquire the complete picture one
needs to look more closely at the economics on the supply side.

Factors affecting Supply in the credit rating industry:

First Movers Advantage:

Being first to market is an advantage in the credit rating industry; and all the more so in
the early days of the industry when the agencies and their rating quality were not generally
known. Today it still plays a role in innovative new market segments.

Economies of Scale:

The analysis of demand has shown that issuers favor big, high quality rating agencies.
The opposite approach is to ask if big rating agencies are more efficient than small ones.
Economies of scale may arise from production factors such as access to databases, for instance.
Usually, it is on average cheaper if more people within an institution use the same database.
However, given the importance of human capital the overall impact on production costs from
these factors should be limited,. One can conclude that the production function of credit rating
agencies does not exhibit major economies of scale. On the contrary, it seems quite easy for
small companies to compete with bigger ones on costs.
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Reputation Building:

One needs to look at the value derived from ratings, i.e. the reputation value. An
unproven newcomer must generate trust among the issuers. There needs to be an initial
investment with later returns on reputation. In principal, a growing reputation requires new
investments for every unit of output. While the actual production of ratings does not feature scale
economies, the development of reputation certainly does.

Diversification:

Reputation is the rating agencies’ main asset, which must be carefully protected.
Company size helps the rating agencies to dissipate risks to the reputation base. In principal,
reputation can be negatively impacted in two ways. On the one hand, correct ratings might be
wrongly perceived. Accidental events can lead to unexpected defaults distorting short-term and
even long-term correlation statistics. On the other hand, an agency might indeed provide some
low quality ratings because of internal quality problems. This could most notably be employees
trying to benefit privately from bringing in low effort While the business strategy aims to de liver
high quality, the implementation is imperfect in some cases. This is harmful for the agency’s
good reputation. The risk diversification effect in the credit rating industry is more pronounced
than in other markets because of the special nature of ratings and their quality measurement.

Diseconomies of Scale:

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 Whereas it is obvious to point to economies of scale in the credit rating market, there are
also diseconomies of scale. At the heart of this argumentation lies the possibility of serious
criminal negligence or fraud. The best illustration is the failure of the auditor Arthur Andersen in
2001 over an accounting scandal at the energy company Enron As Enron’s accountant, Arthur
Andersen was shown to have published a dodgy analysis of the company’s financials, in many
cases not disclosing the illegal behavior but helping to cover it over. The Enron case was such a
major challenge to Andersen’s integrity that all major clients and the public abruptly lost faith in
the company.

This risk applies to any reputation-based business model, not least to credit rating
agencies. A major scandal can prove fatal Very importantly, clients may in many cases not
differentiate between the reputation in different market segments once an agency is firmly settled
in a new field. If a rating agency delivers low quality in one segment, not only clients in this
sector but also clients across the board will become wary. The potential loss of reputation
through an individual transaction is far greater than the value of the transaction itself. The
advantage of large companies using existing reputation to move into new market segments can
easily backfire if reputation suffers.

Market Segmentation;

In the credit rating market, three areas of segmentation are theoretically relevant: quality,
geography and product class. Furthermore, the market can be split from the supply side into
officially recognized and non-recognized agencies.

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 Theoretical scope of credit Rating Market Segmentation

Without the possibility of differentiating in terms of quality, rating agencies lack a key
competitive variable available in other industries. For newcomers it is hard to establish
themselves in such a situation because it is difficult to differentiate from the incumbents. The
same is true for the incumbents themselves, who have little leeway to differentiate from each
other.

Strategic Interaction:

Incumbent agencies have first mover advantages, while new players face entry barriers.
Big agencies have an advantage over small ones in reputation building and risk costs, and
investors generally prefer the market leaders. These underlying economic factors apply
everywhere, be it in national markets or specialized branches. Therefore, it is not surprising that
virtually all segments of the credit rating market have a high concentration with only a few
sizable players. Moody’s, S&P and to a certain extent Fitch dominate the market for big
international debt securities.

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 Major elements influencing credit rating agency competition

Overall it is extremely difficult for incumbents to acquire business through price

reduction. Even if Moody’s or S&P could lower the price enough to lure away issuers from their
rival in a not fully penetrated segment, they would face direct sanctions: the other agency would
also lower its price to prevent an exodus of its customers. The result would generally be lower
prices with unchanged market shares. Profits would be lower for both agencies; especially the
‘aggressive’ agency that lowered prices first would suffer. From a strategic perspective it is
virtually impossible for the leading incumbents to profit from reducing prices. On the contrary,
increasing prices is a promising option. In the same way that switching costs prevent issuers
from changing their agency when prices fall, issuers will not switch when prices rise moderately.
If the second agency follows all price increases, profits for both will rise.

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 Realistically, entrants can only follow a niche strategy, initially concentrating on a special
country, product class, or both. The Japan Credit Rating Agency, for instance, successfully
entered the rating business by concentrating on the Japanese market and Thomson Financial
Bankwatch built up a high reputation for its bank ratings. Such a strategy needs less capital than
rating thousands of different issues from the outset. The entrant can concentrate his resources on
building up reputation in a narrow filed. If he is catering to a limited and closely defined group
of investors and issuers, it is much easier to generate attention than trying to cater to a worldwide
clientele. A promising strategy is to focus on evolving innovative segments of the rating market.
Smaller rating agencies are likely to move more quickly into new rating niches because of their
leaner organizational structures. This is one of the few competitive advantages of small, young
rating agencies. Fitch, e.g., early concentrated on structured finance products which might
explain why the agency still has a comparably high market share in this segment. If a small
agency is successful in establishing a good reputation in a specialized niche, it can use its
position as a basis for expansion. One can conclude that there is some scope for newcomers
despite the high entry barriers.

This necessarily poses the strategic question for incumbents of how to react to entrants.
From an overall strategic perspective it is questionable if incumbents in the credit rating business
actively try to discourage entry by price policy. The structural entry barriers provide substantial
advantages for the first movers. As a result, only very few newcomers will be able and willing to
enter in the first place. It is not worth investing into a reputation for aggressive post entry
behavior if the number of successful entrants is limited anyway. A superior strategy is to wait
and see while keeping prices high. If a newcomer is indeed able to successfully build up a good
reputation and client base, it seems most profitable for incumbents to simply buy the newcomer
or to merge with it rather than to engage in a price war.

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Behavior:
Pricing.

Who pays?

Until the early 1970s the major credit rating firms earned their incomes by selling
publications (containing their ratings) and related materials. In essence, they were charging the
bondholders for the information provided. In 1970 Moody's and Fitch began to charge the issuers
for the ratings; S&P followed suit a few years later.

The bulk of their ratings-related incomes now come from issuer fees. This change in the
early 1970s coincides with the spread of low-cost photocopying; the issuers were going to have
difficulties in preventing free-riding on the publication of their information. Also, in 1970 the
default by the Penn Central on $82 million in commercial paper, followed by liquidity crises by
other short-term issuers and their defaults, was a defining moment that focused both issuers and
investors on the risks of such issuances. Issuers were more desirous of reassuring nervous
investors of the quality of their issuances and actively sought ratings. Charging the issuers for the
ratings naturally followed.

The structure of fees.

Both Moody's and S&P follow similar patterns with respect to pricing and coverage of
corporate issuances: They state that they will rate and make public all (or virtually all) SEC
registered corporate bonds, whether requested or not by the issuer. If the issuer does not request
the rating, then the rating firm will simply do the rating on the basis of publicly available
information.

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 If the issuer requests the rating, then it gets the privilege of sharing its information with
the rating firm, but it must pay a one-time fee. Both Moody's and S&P have the following "list
prices" for the requested ratings: 3.25 basis points28 on issues up to $500 million, with a
minimum fee of $25,000 and a maximum of $125,000 (S&P) or $130,000 (Moody's); both
charge an additional 2 basis points on amounts above $500 million (S&P caps the amount at
$200,000; it also has a one-time fee of $25,000 for first-time issuers). Both offer negotiated rates
for frequent issuers and offer quarterly charges on amounts outstanding for issuers of
commercial paper.

S&P states that it does only solicited ratings for structured securities and non-U.S.
company bonds. Moody's, however, does unsolicited as well as solicited ratings of such
securities. By contrast, both Fitch and Duff & Phelps (before its merger with Fitch) have only
done solicited ratings of any type of security. With respect to corporate securities, either or both
have been asked to provide a rating most often when the two "major" rating firms have split in
their ratings. Apparently, in such instances issuers hope that the additional rating will be on the
more favorable side. Also, Duff & Phelps did not make its ratings public unless the issuer
requested that it do so. The structure of both issuers' fee schedules have been similar to that of
Moody's and S&P; but, as would be expected from firms that are perceived to be more
peripheral, their fee levels have been lower (2.5 basis points for Fitch; 2.75 basis points for Duff
& Phelps).

Virtually all corporate issuers request a listing, believing that the opportunity to present
their financial "story" directly to the rating firms offers a sufficiently high probability of
improving their ratings (and thus lowering their issuing costs) so as to justify the fees.

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Performance:
Profitability:

The typical industrial organization assessment of performance begins with a report of profits.
Supra-normal profits may be an indicator of the exercise of market power The only credit rating firm for
which stand-alone profit data are available is Moody's, For 2004 to 2008, we have obtained the
revenues and net income for Moody’s and found out the Net Margin, which ranges from 26% to 37%,
which is quite breathtaking. It certainly raises the suspicion that Moody's is able to exercise market
power.
Figures in Million.
Year 2004 2005 2006 2007 2008
Revenue 1483.6 1731 2037.1 2259 1755.4
Net Income 425.1 560.8 753.9 701.5 457.6
Net Margin 28.65% 32.40% 37.01% 31.05% 26.07%

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Innovation:

A second measure of performance is the extent and sources of innovation in an industry.

There is no absolute standard against which an industry can be judged, and judgments with
respect to innovation in the credit rating industry do seem particularly difficult.

It does seem to be the case, however, that innovations -- such as expanding the ratings to
non-traditional instruments, and adding finer gradations to ratings -- have often (though not
always) been initiated by the smaller rating firms, with the larger two then following. This
finding, plus the lower fees that the smaller firms charge, indicates that competition brings the
same beneficial effects to this industry that it does in others.

Moral hazard behavior

For bond rating firms, the temptations for moral hazard or opportunistic behavior are
constantly present. A rating firm might offer to improve an issuer's rating in return for a higher
fee. Or it might threaten that an unsolicited rating would be substantially lower than a requested
(fee based) rating.

There have not been widespread instances of such moral hazard behavior on the part of
the rating firms. Apparently, their institutional concerns about their long-run reputations have
been sufficiently strong so as to keep the moral hazard tendencies in check.

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Regulation:

SEC since 1975 has designated rating firms as "nationally rated statistical rating
organizations" (NRSROs) and has used this regulation to limit entry into the U.S. industry. We
now consider these regulatory impacts in greater depth. We will begin with the safety-and-
soundness regulation.

Safety-and-soundness regulation.

The safety-and-soundness regulation of financial institutions -- notably banks and other

depositories, insurance companies, and defined-benefit pension funds -- in the U.S. has a long
history. The general goal is to protect the liability holders of such institutions from the losses that
would arise from the insolvencies of the institutions, as well as specifically to preserve the
systemic stability of the banking system. As part of those schemes, regulators have attempted to
limit the riskiness of the assets that such institutions hold. And, beginning in 1931 regulators
have grafted bond ratings into these limitations, either by banning the holding of securities that
fall below a specified grade or by specifying capital requirements for holding the securities that
are geared to their ratings. In addition, the SEC has employed the same tools for safety regulation
of broker- dealers and of money market mutual funds.

The net effect of these requirements is to create a specific demand for ratings that might
not be present in the absence of this specific manifestation of safety-and-soundness regulation.
But whose ratings can be used for these regulatory purposes? Until 1975 this question remained
unaddressed. In that year, the SEC apparently realized that by specifying ratings it thereby had to
address the "whose ratings" question, and it created the NRSRO category. Since then, other
regulatory agencies and the Congress have adopted the NRSRO terminology and accepted the
SEC designees within that category.

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NRSRO regulation.

The SEC last approved a new general-purpose NRSRO in 1983; it last approved a new
specialist (banks and financial institutions) NRSRO in 1992. Applicants, including rating
agencies that are headquartered in other countries, have applied; the SEC has not acted. In
essence, the SEC's behavior has raised an absolute barrier to entry, thereby limiting supply.

In 1994 and again in 1997 the SEC proposed regulations that would formalize its criteria
for designating and monitoring NRSROs. The attributes of a rating firm that the SEC proposes to
use as its criteria for designating NRSROs are as follows (the following language is taken
directly from the proposed regulation):

1) National recognition, which means that the rating organization is recognized as an issuer of
credible and reliable ratings by the predominant users of securities ratings in the United States;

2) Adequate staffing, financial resources, and organizational structure to ensure that it can issue
credible and reliable ratings of the debt of issuers, including the ability to operate independently
of economic pressures or control by companies it rates and a sufficient number of staff members
qualified in terms of education and expertise to thoroughly and competently evaluate an issuer's
credit;

3) Use of systematic rating procedures that are designed to ensure credible and accurate ratings;

4) Extent of contacts with the management of issuers, including access to senior level
management of the issuers; and

5) Internal procedures to prevent misuse of non-public information and compliance with these
procedures.

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 The SEC has taken no action on these proposals, and seems in no hurry to do so. In the
interim, however, the supply-limiting effect of the de facto ban on new NRSRO designations
remains intertwined with the demand-enhancing effect of the expanding safety-and-soundness
regulation discussed above. It is not surprising that Moody's can earn such handsome profits in
this environment.

In essence, the "national recognition" criterion creates a "Catch 22" barrier to entry. The
remaining four criteria (adequate resources; systematic procedures; adequate contacts; internal
procedures) are measures of inputs, not output. Smaller firms or firms with innovative rating
technologies will be at a disadvantage if judged by these criteria. In sum, if the SEC cannot or is
unwilling to exit from the NRSRO designation field, then it must become serious about
certifying qualified firms, and it must re-focus its criteria toward output oriented measures.

Indian Credit Rating Industry

The rating coverage in India is not too old, beginning 1987 when the first rating agency,
CRISIL was established. At present there are three main rating agencies –CRISIL(Credit Rating
and Information Services of India Ltd.),ICRA Ltd. (Investment Information and Credit Rating
Agency of India Limited) and CARE(Credit Analysis and Research). The fourth rating agency is
a JV between Duff & Phelps, US and Alliance Capital Limited , Calcutta.

CRISIL:
It was promoted by ICICI, nationalized and foreign banks and insurance companies in 1987. it
went public in 1992 and is the only listed credit rating agency in India. In 1996 it entered into a
strategic alliance with Standard & Poor’s to extend its credit rating services to borrowers from
the overseas market. The services offered are broadly classified as Rating, Information services ,
Infrastructure services and consulting.

Rating services cover rating of Debt instruments-long, medium and short term, securitised assets
and builders. Information services offer corporate research reports and the CRISIL 500 index.
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The Infrastructure and consultancy division provide assistance on specific sectors such as power,
telecom and infrastructure financing.

ICRA:
It was promoted by IFCI and 21 other shareholders comprising nationalized and foreign banks
and insurance companies. Established in 1991 , it is the second rating agency in India. The
services offered can be broadly classified as Rating services , Advisory services and Investment
Information services. The rating services comprise rating of debt instruments and credit
assessment. The Advisory services include strategic counseling, general assessment such as
restructuring exercise and sector specific services such as for power, telecom, ports, municipal
ratings , etc. The information or the research desk provides research reports on specific
industries, sectors and corporates. The Information services also include equity related services,
viz, Equity Grading and Equity Assessment. In 1996, ICRA entered into a strategic alliance with
Financial Proforma Inc. , a Moody’s subsidiary to offer services on Risk

Management Training and software: Moody’s and ICRA has entered into a memorandum, of
understanding to support these efforts.

CARE:

It was set up in 1992, promoted by IDBI jointly with other financial institutions, nationalized and
private sector finance companies. The services offered cover rating of Debt instruments and
sector specific industry reports from the research desk and equity research.

Market share

Marketshare of the different Credit Rating

Agencies in India

11% 2%
CRISIL
48% ICRA
CARE
39%
Duff& Phelps

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Road to Reform in India:
Before making a foray into the proposals for reform, it would be worthwhile to note four
India-specific features which necessitate better oversight of CRAs. Firstly, unlike the US, UK,
France or Australia where rating is obtained on a voluntary basis by the issuers, the SEBI
(Disclosure and Investor Protection) Guidelines, 2000, make it obligatory for debt issuers to
obtain a credit rating from at least one CRA as a condition precedent to such issue. Secondly,
SEBI has put in place a mandatory system of grading Initial Public Offerings extending the
scope of credit rating from debt to equity markets. This step has no parallel on the international
plane and increases the comparative significance of CRAs for the Indian capital markets.
Thirdly, the Indian banks are in the process of shifting to the Basel II capital adequacy norms
under which the Standardized Approach for measurement of credit risk requires them to rely
upon ratings provided by CRAs for assigning risk weights to their financial
assets/obligations.Lastly, the use of structured finance products is at a nascent stage in India and
the Indian CRAs have made their foray into rating these products.

Keeping in view the aforesaid discussion, the following lacunae are evident in the Indian
approach:

Deficient Disclosure Regime

Judged by international standards, the Indian disclosure standards require improvement

on two counts. Firstly, Indian CRAs have to disclose the definitions of rating, the rationale of
ratings and the rating methodology. However, unlike US, the information to be covered under
rating methodology is not specified. According to the IOSCO Code, there should be both
‘qualitative disclosure’ including definition of default, time horizons used by the CRA and
‘quantitative disclosure’ including actual default rates in each assessment category or transition
rates from one assessment category to another over time. Such improved disclosure will enable
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the users of credit ratings to compare the rating quality of different CRAs. The absence of
comprehensive rating statistics makes it difficult to assess the accuracy or veracity of ratings
offered by Indian CRAs over a medium or long term. Thus, disclosure standards have to be
aligned with the IOSCO standards.

Secondly, the Code of Conduct requires the Indian CRAs to frame their own internal
code. However, no public disclosure of the Code is mandated. To fill this accountability gap, it is
suggested that, in line with the approach in Australia and European Union, the SEBI should
adopt a ‘comply and explain’ approach wherein a CRA should publicly disclose its internal Code
and describe how the provisions of its Code fully implement the provisions of the ‘IOSCO
Principles Regarding the Activities of Credit Rating Agencies’ and the ‘IOSCO Code of Conduct
Fundamentals for Credit Rating Agencies’. They should be required to reasonably explain the
deviations and disclose the proposed method of enforcement of Code. Further, timely disclosures
about changes in the Code and about its implementation should be mandated.

Mandatory Rating Requirements

It is a worrying aspect that both RBI and SEBI are creating regulatory demand for credit
ratings turning ratings into ‘regulatory licenses’. While the SEBI has made rating of debt and
equity mandatory for issuers, the RBI is using it for controlling investments of regulated entities
like NBFCs, banks and other financial institutions. Indisputably, the purchase of a good when
made mandatory by law will force its purchase primarily to comply with the law and not by
reason of its intrinsic utility. Similarly, the requirement of mandatory grading creates artificial
demand for ratings. Further, an investment grade rating should not be made the key for accessing
the debt or equity markets for the simple reason that it restricts access to small issuers while
increasing the de facto power of CRAs. It is suggested that such mandatory requirements which
increase market’s overall dependence on CRAs and furnish scope for abuse need to be discarded.

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Lack of Private Enforcement Regime

The US Senate Committee which investigated the Enron case cited the practical
immunity of CRAs to lawsuits as a major problem. In the US, the main rationale for not having a
private enforcement regime against CRAs is the fear of frivolous litigation which may force the
raters to rate only high quality issuers and increase bias against smaller ones. This will decrease
the quantity and quality of information flow into the market. However, it makes little sense to
impose standards of ‘due diligence’ on CRAs and restrict their accountability only to the market
regulator. Though it is plausible that the Indian regime does not exclude the possibility of a law
suit against an Indian CRA on the grounds of fraud or negligence, the silence of law creates a
practical immunity. Further, the SEBI Regulations define rating as merely an ‘opinion’ and
authorize CRAs to insert disclaimers to the effect that investors should not rely on them for
making investment choices. Hence, it is suggested that CRAs should be explicitly made liable
towards the investors for their wrongful acts amounting to fraud, deceit or negligence. Such an
explicit provision will ensure responsible action by creating deterrence. In short, it is unwise to
increase the reliance of investor on credit ratings but deny them a right to proceed against CRAs
in cases of wrongful conduct.

Conclusion:

In this project, the structure – behavior – performance paradigm of the U.S. credit Rating
industry has been studied , and the various characteristics of the U.S. credit rating industry has
been examined. The regulatory environment in U.S. and its impact on the level of competition
and industry attractiveness for the credit raring industry have also been examined. Finally the
lessons of the U.S. CR industry for India have been examined and a road to reform for the Indian
CR industry has been laid out.

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