Advantages And Disadvantages Of Credit Rating


Credit rating serves as a straightforward tool to assess the creditworthiness of an individual, company, or country. It provides alphanumeric symbols that describe the financial assets and liabilities of the rated entity, enabling lenders and investors to evaluate the associated risk of providing a loan or entering into a financial obligation.

It’s important to note that a credit rating represents an opinion on the creditworthiness and reliability of the instrument but does not guarantee repayment. It reflects the financial history, current financial position, and other relevant factors of the rated instruments. A credit rating should not be considered as a recommendation to buy, hold, or sell any debt instrument.

Credit ratings assist lenders and investors in making informed investment decisions. A high credit rating indicates a low risk of default, making it a desirable investment. Conversely, instruments with poor credit ratings indicate higher levels of risk. Investors often weigh the risk-reward trade-off and may choose to invest in lower-rated instruments to potentially earn higher returns compensating for the increased risk.

It’s important to understand that credit ratings are not fixed and may change periodically based on new information. They are subject to continuous review and revision. For example, if a company communicates its inability to pay interest within a specified timeframe, its reliance on the credit rating for its bonds may decrease. Credit ratings are assigned to various debt instruments such as bonds, debentures, fixed deposits, bank loans, commercial papers, and others.

The Securities and Exchange Board of India (SEBI) defines credit rating as “an opinion about securities, expressed as a standard symbol or any other standardized way, assigned by a credit rating agency.” SEBI regulations require issuers of such securities to comply with specific requirements and provide credit ratings to bond investors.

Origin & Development Of Credit Rating

The origin and development of credit rating can be traced back to the 1840s in the United States. The first credit rating agency was established by Louis Tappan in 1841 as a response to the financial crisis of 1837. This agency, known as the mercantile bank credit agency, provided ratings on traders’ and merchants’ ability to meet their financial obligations. In 1859, it published its first rating guide.

In 1849, John Bradstreet founded another credit rating agency called Dun & Bradstreet, which published its rating guide in 1857. These two agencies eventually merged in 1933 to form Dun & Bradstreet, which later became Moody’s Investors Service in 1962. Moody’s has a history spanning over 100 years, with its founder John Moody establishing it in 1900. Moody’s initially focused on publishing manuals and guides related to railroad securities.

In 1916, another credit rating agency was created by Poor’s Publishing Company, which issued its first ratings in the same year. In 1941, the Standard Statistics Company and Poor’s Publishing Company merged to form Standard & Poor’s, which was later acquired by McGraw Hill.

During the 1970s, many credit rating agencies were established globally. In 1987, India became the first developing country to establish a credit rating agency with the founding of CRISIL in 1988. This was followed by the establishment of ICRA in 1991 and CARE in 1993. Other agencies, such as ONICRA and Brickwork Ratings India Private Limited, also emerged in subsequent years.

In 2000, Credit Information Bureau (INDIA) Ltd. (CIBIL) was established in India to provide credit information on consumers and commercial borrowers to credit granting agencies. Currently, there are five SEBI-registered credit rating agencies in India.

Overall, the credit rating industry has evolved over time, with multiple agencies being established worldwide to provide ratings on the creditworthiness of individuals, corporations, and countries, aiding lenders and investors in making informed decisions.

The objectives of credit rating can be summarized as follows:

Objective Rating: The primary goal of credit rating is to rate debt instruments objectively, providing an unbiased assessment of the creditworthiness of the issuer. This helps increase market confidence and provides investors with reliable information for making investment decisions.

Market Growth: Credit rating aims to encourage the growth of the capital market and primary market. By providing credit ratings, it facilitates the flow of capital by attracting investors and promoting investment in debt instruments.

Capital Absorption: Credit rating plays a crucial role in ensuring capital absorption by investors. It provides information on the safety and profitability of investments, which is especially important for small and gullible investors. By protecting the interests of investors, credit rating enhances investor confidence and participation in the market.

Capital Allocation: Credit rating helps in maximizing capital allocation by identifying high-rated credit instruments. Investors can allocate their capital more effectively by considering the credit ratings of different debt instruments, thereby promoting efficient capital allocation in the market.

Flotation Cost Reduction: High-rated securities have their own advertising value, which reduces flotation costs for corporations. By assigning high ratings to securities, credit rating agencies enhance their marketability and reduce the costs associated with issuing and marketing these securities.

Risk Assessment: Credit rating serves as a tool for evaluating credit risk. It provides an expert opinion on the ability and willingness of the borrower to make timely payments. Investors can use credit ratings to assess the relative credit quality of various debt instruments and make informed decisions based on the safety, liquidity, and profitability indicators provided by the ratings.

Key Qualities Of Credit Rating

Investor Focus: The credit rating system is primarily designed to provide information to non-professional investors. It helps them assess the creditworthiness and reliability of corporate entities and various types of securities, enabling them to make informed investment decisions.

Investment Grading: Credit ratings are specifically calculated to grade different types of investments, such as bonds, debentures, government municipal bonds, commercial paper, and public deposits. The ratings reflect the quality and risk associated with these investment instruments.

Reliability Assessment: Credit rating evaluates the issuer’s reliability in fulfilling specific obligations related to the securities being rated. It assesses the likelihood of timely payment of principal and interest on debentures, preference shares, fixed deposits, or other short-term instruments.

Gradation System: Credit rating provides lenders and investors with a straightforward system of gradation. It assigns ratings based on the issuer’s creditworthiness, indicating the level of risk associated with the investment. This helps investors compare different securities and make decisions accordingly.

In conclusion, credit rating plays a crucial role in informing investors about the creditworthiness and reliability of issuers and their securities. By providing a standardised assessment, it enables investors to evaluate the risk associated with their investment choices. The credit rating system enhances transparency, facilitates decision-making, and contributes to the overall efficiency and stability of the financial markets.