Credit Rating Agencies in India: An overview and An Analysis in

the Light of Various Acts and Guidelines.

Research Paper Submitted

To the

Journal of Finance

By

Dr. Kalpana Chandraprakash Satija Associate Professor,

Sardar Patel Institute of Economic & Social Research, Thaltej Road, Near Doordarshan Towers,

Ahmedabad, 380 054, Gujarat, India. Phone: +91 79 26850598, 26851428

Fax: +91 79 26851714 Email: Kalpana_cp@yahoo.co.in

Cell (09909140018)

Credit Rating Agencies in India: An overview and An Analysis in the Light of Various

Acts and Guidelines.

Abstract

The banking sector in India underwent an unprecedented transformation in the 1990s with the emergence of a

large number of private as well as foreign multinational banks entering the country increasing rapidly the

number of banks in India due to the economic reforms. So the banking activities increased manifold and

affected a large number of areas of operation of banks, particularly in the field of bank lending. Banks operate

on the pattern of extending credit against security given by its customers associated with the bank. The facility of

extending credit agencies are recognition of the changing times in which banks have to operate in a changing

and ever evolving economic scenario. Growing needs and realisation of higher rate of investments is giving birth

to bank credit in India.

Keywords

Research Papers in Economics, Working papers, Open Library, Articles, Open Archives Initiative, Referred

various Act and Reports.

JEL : E50 - General

Credit Rating Agencies in India: An overview and An Analysis in the Light

of Various Acts and Guidelines.

Dr. Kalpana C Satija

INTRODUCTION

The banking sector in India underwent an unprecedented transformation in the 1990s with the emergence

of a large number of private as well as foreign multinational banks entering the country increasing rapidly

the number of banks in India due to the economic reforms. So the banking activities increased manifold and

affected a large number of areas of operation of banks, particularly in the field of bank lending. Banks

operate on the pattern of extending credit against security given by its customers associated with the bank.

The facility of extending credit is recognition of the changing times in which banks have to operate in a

changing and ever evolving economic scenario. Growing needs and realisation of higher rate of investments

is giving birth to bank credit in India.1 The borrowing capacity provided to an individual by the banking

system, in the form of credit or a loan. The total bank credit the individual has is the sum of the borrowing

capacity each lender bank provides to the individual2. This for even needed to increase the investment on

the country. So a need was felt to have a credit agencies maintaining database on the existing customers as in

the absence of adequate and structured credit information for the banks and other credit providing agencies,

there was always danger of a party obtaining financial accommodation from a large number of banks to an

extent not warranted by his/her means or paying capacity, in such a case there is a chance having of bad

debts (not retuning of credit) creating an added burden on the existing financial resources of banks.

1 According to the Saraiya Commission, "the grant of credit is a business which involves a risk of increasing bad debts if proper care is not taken and banks therefore ascertain the creditworthiness of borrowers from time to time and maintain credit reports on them. The process of grant of credit by banks comprise in the filing in of applications by the borrowers, scrutiny of the applications, assessment of creditworthiness and sanctions of limits by the branch manager or higher authority as well as the follow-up actions on the advances after they have been granted...." For more on the aspect of bank credit see Report of the Banking Commission (1972) under the Chairmanship of Shri R.G. Saraiya, which recommended setting up of a Credit Intelligence Bureau as a statutory body which would furnish adequate and reliable credit information to banks and other financial institutions. Ibid 2 http://www.investorwords.com/402/bank_credit.html as seen on 20th July 2006

The modern rating system dates back to 1909 when John Moody started rating US railroad bonds. 3 In India

in 1962, a Credit Information Division was established in RBI with the view of collection of information

from banks and other financial institutions regarding data relating to the prescribed limits sanctioned by RBI

even the RBI Act was amended into 1962 given powers to collect information in regard to credit facilities

granted by individual banks and notified financial institutions to their constituents and to supply to these

banks and institutions on application the relative information in a consolidated form.4 Apart from all the

above steps, banks constantly keep a check on the customers by obtaining information from all the other

sources pertaining to their customers in any form.5 The Saraiya Commission also suggested the formation of

credit information bureaus on the lines of those prevalent in the US and the UK.6

Credit rating agency means any commercial concern engaged in the business of credit rating of any debt

obligation or of any project or programme requiring finance, whether in the form of debt or otherwise, and

includes credit rating of any financial, obligation, instrument or security, which has the purpose of providing

a potential investor or any other person any information pertaining to the relative safety of timely payment

of interest or principal7;

The credit information8 bureaus in the US and the UK used to provide information on the history of the

business concern, ownership and changes in the business concern, digest of statements of assets and

liabilities, results of investigations in the trade, fire records, etc9. Credit Rating Agencies is different from a

mercantile credit agency, which usually supplies general information on corporates for the purpose of selling

goods on credit.

3 http://rbidocs.rbi.org.in/sec5/12606.doc - Fourth Prof. Nagaraj Memorial Lecture delivered by Dr.Y.V.Reddy, Deputy Governor, Reserve Bank of India at Osmania University Arts College Seminar Hall, Hyderabad on April 8, 2000. Dr.Reddy is thankful to the valuable assistance provided by Dr.A.Prasad. 4 See Chapter III-A, Sections 45-C and 45-D of the Reserve Bank of India Act, 1934. By an amendment in 1974, Section 45-A was amended whereby the term "credit" was expanded so as to include means, antecedents, history of financial transactions and the creditworthiness of any borrower or class of borrowers and other relevant information. 5 Newspaper cuttings related to a particular customer, examination of financial statements (for studying current ratio, acid test or quick ratio, sales ratio, debtors ratio, net return ratio, debt/equity ratio, debtor/creditor ratio, solvency ratio and inventory turnover ratio). 6 M/s Seyds in England and M/s Duns and Bradstreets in the US along with M/s Equifax Venture Infotek, M/s Experian and M/s London Bridge Software (ASPAC) Pte., Ltd. at some other places are examples of credit information agencies. 7 http://cenexcisenagpur.nic.in/ServiceTax/stdef.htm 8 Credit Information Scheme thus evolved by the Bank in 1962 was discontinued in 1995 for the following reasons: inordinate delay in submission of information by banks; the information furnished by the banks was often outdated and incomplete; the demand for such information from banks was very insignificant. 9 One of the most influential credit scoring system in the US is the FICO score, devised by the Fair Isaac Corporation; 75% of all retail credit disbursals hinge on an applicant's FICO score. The FICO score changes as changes occur on the part of the borrower in handling of credit. If there have been credit problems in the past, their impact on the score lessens over time. Lenders in the US generally gaze at a borrower's latest FICO score. Source: "Keep Credit in check", THE OUTLOOK MONEY, June 15, 2005.

There are five Credit rating agencies in India, namely,

1. Credit Rating Information Services of India Limited (CRISIL)

2. Investment Information and Credit Rating Agency of India (ICRA)

3. Credit Analysis & Research Limited (CARE)

4. Duff & Phelps Credit Rating India Private Ltd. (DCR India)

5. ONICRA Credit Rating Agency of India Ltd.

1. CRISIL:

The concept of credit rating in India was initiated by the Credit Rating Information Services of India

Limited (CRISIL). CRISIL was established in 1987 and started operations in January 1998. Currently, five

rating agencies are in operation in India, rating bonds, time deposits, CP (Commercial Paper) and structured

obligations. All the four Indian rating agencies have tie ups/alliances with international rating agencies.10

CRISIL is India's leading rating agency, and is the fourth largest in the world. Its business model

comprises of three divisions - Debt Rating, Crisil Research and Information Services (CRIS) and Crisil

Advisory Services (CAS). Standard and Poor`s (S&P), which holds a 9.6 per cent stake in the company,

assists it on developing new rating methodologies for newer securities.

With over a 70% share of the Indian Ratings market, CRISIL Ratings is the agency of choice for issuers and

investors. It is a full service rating agency that offers a comprehensive range of rating services and it also

provides the most reliable opinions on risk by combining its understanding of risk and the science of

building risk frameworks, with a contextual understanding of business.

CRISIL has rated over 6,797 debt instruments worth Rs.13.53 trillion (over USD343 billion)11 issued by over

4,600 debt issuers, including manufacturing companies, banks, financial institutions (FIs), state governments

and municipal corporations. It is the only rating agency to operate on the basis of a sectoral specialization,

which underpins the sharpness of analysis, responsiveness of the process and large-scale dissemination of

opinion pieces. CRISIL Ratings also offers technical know-how overseas. For instance, it has provided

assistance and up ratings agencies in Malaysia (RAM) and Israel and in the Caribbean . In March 2004,

CRISIL took up an equity stake of about 9% in the share capital of the Caribbean Information & Credit

Rating Services Limited (CariCRIS), with an investment of US $ 300,000.

10 CRISIL with S&P, ICRA with Moody’s, CARE with Fitch IBCA and DCR (India) Pvt. Ltd. with Duff & Phelps. 11 1 USD= INR 39.435 on Dec. 31, 2007

2. ICRA:

ICRA Limited (formerly, Investment Information and Credit Rating Agency of India Limited) was

incorporated on January 16, 1991 and launched its services on August 31, 1991, by leading

financial/investment institutions, commercial banks and financial services companies as an independent

and professional investment information and credit rating agency. ICRA is a public limited company with

its shares listed on the Bombay Stock Exchange and National Stock Exchange. It is an independent and

professional company providing investment information and credit rating services. ICRA’s major

shareholders include Moody's Investors Service and leading Indian financial institutions and banks. As the

growth and globalisation of Indian Capital markets have led to an exponential surge in demand for

professional credit risk analysis, ICRA has actively responded to this need by executing assignments

including credit ratings, equity gradings, and mandated studies spanning diverse industrial sectors. In

addition to being a leading credit rating agency with expertise in virtually every sector of the Indian

economy, ICRA has broad-based its services to the corporate and financial sectors, both in India and

overseas, and presently offers its services under three banners namely:

1. Rating services

2. Information services

3. Advisory service

3. CARE:

Credit Analysis & Research Ltd. (CARE Ratings) is a full service rating company that offers a wide range of

rating and grading services across sectors. It was established in 1993. CARE has an unparallel depth of

expertise. CARE Ratings methodologies are in line with the best international practices. It has completed

over 3850 rating assignments having aggregate value of about Rs 8071 billion (as at December 2007), since

its inception in April 1993. It has been recognized by statutory authorities and other agencies in India for

rating services. The authorities/agencies include: Securities and Exchange Board of India (Sebi), Reserve

Bank of India (RBI), Director General, Shipping and Ministry of Petroleum and Natural Gas (MoPNG),

Government of India (GoI), National Housing Bank (NHB), National Bank for Agriculture and Rural

development (NABARD), National Small Scale Industries Commission (NSIC). CARE Ratings has also

been recognized by RBI as an Eligible Credit Rating Agency (ECRA) for Basel II implementation in India.

It was promoted by major Banks/FIs (financial institutions) in India. The three largest shareholders of

CARE are IDBI Bank, Canara Bank and State Bank of India.

CARE Ratings is well equipped to rate all types of debt instruments like Commercial Paper, Fixed Deposit,

Bonds, Debentures, Hybrid instruments, Structured Obligations, Preference Shares, Loans, Asset Backed

Securities(ABS), Residential Mortgage Backed securities(RMBS) etc.

CARE Ratings has significant presence in all sectors including Banks / FIs, Corporate, Public finance.

Coverage of CARE Ratings has extended to more than 1075 entities over the past decade and is widely

accepted by investors, issuers and other market participants. It has evolved into a valuable tool for credit

risk assessment for institutional and other investors, and over the years CARE has increasingly become a

preferred rating agency.

4. Duff & Phelps Credit Rating India Private Ltd. (DCR India):

Fitch Ratings India Private Limited, formerly known as Duff & Phelps Credit Rating India Private Ltd. prior

to 2001, is a wholly-owned subsidiary of the Fitch group that started operating in India since 1996.

5. ONRICA:

ONRICA Credit Rating Agency of India Limited was incorporated in 1993. It is an established player in the

individual credit assessment and scoring services space in the Indian market. ONRICA is the first in India

to launch commercial services and provide individual credit rating and reporting services to the Indian

financial market. ONICRA has been acknowledged as pioneers of Individual Credit Rating in the Economic

Survey of India 1993-94 issued by Ministry of Finance, Government of India and its services have been

hailed by the financial sector and in the media. It delivers objective and reliable pre and post disbursement

credit validation and information on credit takers and have been successfully doing the employee screening

for wide gamut of requirements. It provides Dynamic Customer-Focused solutions that bridges the gap

between principals and their prospective / existing customers. It provides spectrum of services which

include the services like Credit Rating, Associate Rating, Employee Screening, SSI/SME Rating, Customer

Verification, Lifestyle Analysis and Royalty Retention. Currently, it cater to clients in major business

segments such as Telecom, Banking, Automotive, Consumer Finance, IT and other Service Industries.

CHAPTER 1

COMPARISON OF REGULATIONS RELATED TO CREDIT RATING AGENCIES IN INDIA

AND OTHER COUNTRIES

1.1 INDIA

The RBI prescribes a number of regulatory uses of ratings. The RBI requires that a NBFC must have

minimum investment grade credit rating if it intends to accept public deposits. Furthermore, unrated or

underrated NBFCs in the category of equipment leasing and hire purchase finance companies are required

to disclose the fact of their being unrated, to the public, if they intend raising deposits. Finally, as per

money-market regulations of RBI, a corporate must get an issue of CP rated and can issue such paper

subject to a minimum rating. In the area of investments, SEBI stipulated that ratings are compulsory on all

public issues of debentures with maturity exceeding 18 months. SEBI has also made ratings mandatory for

acceptance of public deposits by Collective Investment Schemes. If the size of the issue is larger than Rs.100

crore, two ratings are required. Pension funds can only invest in debt-securities that have two ratings, as per

the stipulations of Government of India.

In India, in 1998, SEBI constituted a Committee to look into draft regulation for Credit rating agencies that

were prepared internally by SEBI. The Committee held the view that in keeping with international practice,

SEBI Act 1992 should be amended to bring Credit rating agencies outside the purview of SEBI for a variety

of reasons. According to the Committee, a regulator will not be in a position to objectively judge the

appropriateness of one rating over another. The competency and the credibility of a rating and CREDIT

RATING AGENCY should be judged by the market, based on historical record, and not by a regulator.

The Committee suggested that instead of regulation, SEBI could just recognise certain agencies for

particular purposes only, such as allowing ratings by Credit rating agencies recognised by it for inclusion in

the public/rights issue offer documents.

In consultation with Government, in July 1999, SEBI issued a notification bringing the Credit rating

agencies under its regulatory ambit in exercise of powers conferred on it by Section 30 read with Section 11

of the SEBI Act 1992. The Act now requires all Credit rating agencies to be registered with SEBI. Since

then, all the four Credit rating agencies in India have been registered with SEBI. SEBI Act now defines

“credit rating agency”, “rating”, and “securities”. Details of who could promote a CREDIT RATING

AGENCY and their eligibility criteria are specified. The Act also mentions about agreement with clients,

method of monitoring of ratings, procedures for review of ratings, disclosure of ratings and submission of

details to SEBI and stock exchanges. Restrictions have now been placed on Credit rating agencies from

rating securities issued by promoters or companies connected with promoters i.e. companies in which

directors of Credit rating agencies are interested as directors.

1.2 OTHER COUNTRIES

Regulators of both developed and emerging markets rely on credit ratings for a variety of purposes. USA

introduced the concept of regulatory use of ratings in 1931. The Office of the Comptroller of Currency

used ratings as a means to determine the basis of valuation of bonds. The use of ratings spread to other

activities such as determination of capital prescription or margin money for brokers/dealers, disclosure

requirements under Securities and Exchange Commission norms, exemption from registration and

regulation for certain issuers of asset-backed securities, etc. The National Association of Insurance

Commissioners (NAIC), which determines insurance company’s regulatory capital charges, also relies on

ratings. Japan promoted credit ratings in 1974 and regulators used the ratings of Japan Bond Research

Institute (a rating agency) as one of the eligibility criteria for bond issues in the 1980s. The Ministry of

Finance relies on ratings in a variety of ways, including regulation of money reserve funds. In 1993, the

European Community stipulated capital requirements for market risk for banks and security houses based

on ratings. UK adopted rating based Capital Adequacy Directives in 1996. Favoured treatment is also

accorded to firms engaged in securities business based on rating. France, Italy, Australia, Switzerland,

Canada, Argentina, Chile, Mexico, Indonesia, Korea, Malaysia, Philippines, Taiwan Province of China and

Thailand are other countries that have regulatory uses for ratings. In fact, the adoption of rating based

regulations was the main force leading to the creation of rating agencies in emerging markets in Latin

America and Asia.

An important issue is the criteria for recognising a credit rating agency for use of its ratings in regulation. It

is now commonly accepted that criteria are : assured continuous objectivity in methodology; independence

from outside influences; credibility, though this should not be an entry barrier; access to all parties with

legitimate interest; and adequacy of resources. Most regulators stipulate a list of recognised agencies whose

ratings can be used to satisfy rating requirements. Broadly, there are three areas where extensive use is made

of ratings in the regulatory process, viz., investment restrictions on regulated institutions; establishing capital

requirements for financial and disclosure as well as issuance requirements. The issues faced by regulators in

use of ratings include reconciling divergent ratings by different Credit rating agencies and deciding cut-off of

level of ratings. In the aftermath of the Asian crisis and the scathing criticism on the failure of Credit rating

agencies to predict the crisis and later on its role in precipitating it through downgrades, the role of credit

rating agencies has been placed under microscopic scrutiny. The merits and demerits of regulating credit

rating agencies and the issue of rating the rating agencies have been discussed in many international forums.

There is no international regulatory authority overseeing rating agencies. Whether they are regulated or not

depends on specific country circumstances. In general, however, countries impose a modest regulation over

Credit rating agencies. In USA, Securities and Exchange Commission gives recognition to Credit rating

agencies as Nationally Recognised Statistical Rating Organisations (NRSO) for specific purposes. The main

form of regulation is USA is in officially recognising a credit rating agency. Thereafter, there is hardly any

regulation. Similarly in UK, recognition as a rating agency is required from the Financial Services Authority

(FSA). So is the case in Japan, Australia, France and Spain.

CHAPTER 2

RBI DRAFT AND SEBI RULES AND REGULATIONS

RBI has the powers to determine the policy of the credit information companies with regard to their

functioning. RBI shall give directions to the credit information companies, wherever it thinks it is in public

interest, or in the interest of credit institutions, specified users, banking policy and proper management. The

use of the words “as it deems fit” gives a lot of discretionary powers to RBI.12 The duties of the officials of

the company formed under the Act have also been specified like the auditors has been entrusted with the

task of ensuring that the credit information company furnishes all the relevant documents to RBI and RBI

has simultaneous powers to instruct for an audit of the company under certain circumstances. This audit has

been termed as a special audit under the Act. Section 14 of the Act enumerates in substantial detail the

functions to be performed by a such company, like collection of information pertaining to the financial

standing of borrowers, providing credit information to other companies, the relevant provision of credit

rating to be done, research activities and any other work as directed by RBI.13 Directions are also in store for

the credit institutions which are to become members of the credit information companies such as

requirement of registration and the period within which it is to be obtained for prospective as well as

existing credit institutions. The credit information company has been given powers to refuse registration at

12 No method of credit scoring has been specified in the provisions of the section and thus there remains a wide gap in the application and expectation part of the Act in terms of credit scoring. 13 RBI has the right to receive a copy of the order of rejection of the credit information company. A credit institution can appeal against the order of the credit information company to Reserve Bank of India. Time period providing for extension of appeal period has also been provided at the discretion of RBI.

RBI’s discretion and in due observance of natural justice and other administrative principles law.14 The

problem is that the order of RBI has been given unprecedented finality in terms of its implementation thus

taking away the jurisdiction of ordinary civil courts as well as tribunals. The credit information company has

been given powers to ask for credit information from its members as and when it thinks necessary, the

information being provided to the specified user only and the information so obtained by the credit

information company is not to be disclosed to any other person and this applies with equanimity on the

specified user as well.

The Act was passed with a view to regulating credit information companies and to facilitating efficient

distribution of credit and for matters concerned or incidental to it. The Credit Information Companies

(Regulation) Act, 2005 required Rules and Regulation to be notified under the Act. The Central

Government was empowered to make the Rules while the Reserve Bank was empowered to make the

Regulations to carry out the purposes of the Act. Therefore the RBI has prepared the Regulations for

implementation of the Credit Information Companies (Regulation) Act, 2005 and placed them on the

website for feedback.

2.1 SUMMARY OF DRAFT RULES AND REGULATIONS

Rules:

(i) The Rules enumerate the procedure for appeal and other incidental matters when an aggrieved

credit information company whose application for certificate of registration has been rejected or whose

certificate of registration has been cancelled have the power to approach the Appellate authority designated

by the Central Government. (Rules 3 to 19 of Chapter II) 15

(ii) Rules provide that the credit information company should formulate appropriate policy and

procedure duly approved by its board of directors, specifying the steps and security safeguards in regard to

(a) collecting, processing and collating of data relating to the borrower; (b) steps for security and protection

of data and the credit information maintained at their end; and (c) appropriate and necessary steps for

maintaining an accurate, complete and updated data. Moreover the credit institution or the credit

information company should ensure that the credit information is accurate and complete with reference to 14 The only fallacy with the above procedure of dispute settlement is that the arbitrator may not be having any knowledge of banking and financial matters and thus parties may be at a loss when it comes to determination of rights and obligations of the parties. The proviso attached to the section is a useful one as it provides for the arbitrator to be of the parties' choice. 15 Press Release: April 5, 2006, 2005-2006/1284

the date on which such information is furnished or disclosed to the credit information company or the

specified user as the case may be. (Rules 20 to 28 of Chapter III and IV)

(iii) The specified user should consider and decide such requisite steps for ensuring and verifying the

accuracy and completeness of data received from a credit information company and protect the data from

unauthorised access; formulate and adopt an appropriate policy and procedure in this behalf duly approved

by its board of directors. (Rule 29 and 30 of Chapter IV and V)

(iv) The credit information company or credit institution or specified user shall adopt all reasonable

procedures to ensure that their managers, officers, employees are obliged to fidelity and secrecy in respect of

credit information under their control or to which they have access (Rule 31 of Chapter VI).

(v) The credit information company should maintain a high standard of customer service by

maintaining help desk, attending to complaints, feedback, queries, etc., in speedy and efficient manner. (Rule

32 of Chapter VII).

Regulations:

(i) The Regulations indicate which companies can obtain credit information as specified users

(insurance company, cellular/phone company, rating agency, broker, trading member, SEBI, IRDA etc.) in

addition to those provided under section 2(l) of the Act. (Regulation 3 of Chapter II).

(ii) The Regulations also deal with submission of application, grant of certificate and the form in which

application can be submitted and certificate can be issued. (Regulations 4 and 5 of the chapter III).

(iii) The Regulations provide for the form of business in which credit information companies can engage

in addition to those provided under section 14(l) of the Act. (Regulation 6 of Chapter IV).

(iv) The Regulations give the format in which a credit information company can issue notice to the credit

institutions or other credit information companies for calling for the information. (Regulation 7 of Chapter

V, Form-C).

(v) The privacy principles which will guide the credit Information companies, credit institutions and

specified users have been indicated in the Regulation. These encompass accuracy, security, secrecy,

adequacy of data collected as also limitation on the use of data, that is, the purpose for which the Credit

Information Reports can be made available and the procedure to be followed by specified uses for getting

reports. (Regulation 9 of Chapter VI)

(vi) Regulations provide that the maximum amount of fees leviable to specified users should not exceed

Rs.500 for individuals and Rs.5000 for non-individual borrowers. Further, the fees charged to the credit

institutions or credit information companies for admission of a credit information company should not

exceed Rs.15,00,000. (Regulation 12 of Chapter VIII)

(vii) Regulations provide for the principles and procedures relating to personal credit information in

respect of manner and purpose of collection of personal data, solicitation of personal data, accountability in

transferring data to third party, protection of personal data etc. (Regulations 14 to 18 of Chapter IX)

(viii) Regulations provide that an individual can file a complaint against a credit information company,

credit institution or a specified user for contravening any provision of the Act. (Regulation 19 of Chapter

IX)

2.2 SECURITIES AND EXCHANGE BOARD OF INDIA (CREDIT RATING AGENCIES)

REGULATIONS, 1999

Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 was passed which made

even the SEBI keep a watchful eye on the Credit Rating Companies in India with the help of various

regulation needed for it. The Securities and Exchange Board of India (Credit Rating Agencies) Regulations,

1999 contains:

1. Regulation regarding the registration of credit rating agencies regulating the application for grant of

certificate eligibility criteria for promoter of credit rating agency, furnishing of information, clarification and

personal representation by the promoter, grant of certificate of the SEBI its conditions validity period,

clauses of its renewal, and procedure for refusal of certificate and its effect.

2. General obligations of credit rating agencies regulating the Code of Conduct, Agreement with the

client, Monitoring and process of ratings and the Procedure for review of rating, Appointment of

Compliance Officer and compiling the letter circulars of the SEBI, maintaining of proper book of Accounts

and having regular audits,

3. Restriction on rating of securities issued by promoters or by certain other persons regulating the

securities issued by promoter, certain entities, connected with a promoter or securities already rated,

4. Procedure for inspection and investigation regulating SEBI’s right to inspect after a due notice and

obligations to be fulfilled by taking actions on the inspection or investigation report,

5. Procedure for action in case of default fixing the liability of the credit company.

CHAPTER 3

CREDIT INFORMATION COMPANIES AND CRITICAL PROPOSITION OF THE CREDIT

INFORMATION COMPANIES (REGULATION) ACT, 2005

The formation of the Act is a step in the right direction and is in line with the earlier efforts of RBI in

collection of information. The Credit Information Companies (Regulation) Act, 2005 allows the creation of

credit information agencies or companies which will enable banks to readily access the full credit history of

the borrower. A credit information bureau or a credit information company is an institution set up by

lenders i.e. banks and credit card companies which maintain records of credit histories on individuals and

business entities. Its membership may comprise of a banking company or companies, non-banking financial

companies (NBFCs), public financial institutions (FIs), State financial corporations, housing finance

companies (HFCs), companies engaged in business of credit cards and companies dealing with distribution

of credit.

A credit information company indulges in the activity of credit scoring which may be beneficial for the

consumer on the one hand and for the banks and financial institutions on the other. This means that on the

basis of the individual credit information report of each borrower, a score is given to the borrower which

indicates his/her reputation in the credit market. A good score means lower interest rates and other

preferential treatment at the time of granting of credit. The establishment of a credit information company

is a step towards evolving a credit-rating model that will reward borrowers with a good credit history and

penalise those with a poor record16. The lender before extending the loan checks the credit profile of the

borrower and the yardstick before him is the information on the borrower in the form of the credit

information report to find out the creditworthiness of the borrower. The nature of the information includes

full credit history i.e. previous borrowings, default in payment, repayment record, information on other

lenders. This information is applicable on all loan products, credit cards and card withdrawals. CIBIL

currently has information on loans advanced by member banks, financial institutions, housing finance

companies and credit card companies. Before this Act the laws relating to banking secrecy prevented banks

from sharing any information pertaining to their customer with any third party. Information of a default

became public only when the bank filed a suit for recovery of loan.

16 The purpose of CIBIL is to become a trusted partner of every credit grantor in every credit decision by offering the best possible solutions. It uses state-of-the-art technology to provide the highest standards of security and service and has a committed team to provide quality customer service meeting each and every customer's expectation of credit grantors. It forges effective collaborations and builds strategic alliances, wherever necessary and strives for excellence in credit reporting. For details www.cibil.org as seen on 14th July 2006.

The Credit Information Bureau (CIBIL) set up by HDFC and State Bank of India with Dun & Bradstreet of

the US provides information on retail borrowers which is available to banks which share information in

respect of their own borrowers. Lenders are provided with a credit information report for the purposes of

informed decision-making. The financial sector reforms with the advent of economic liberalisation in the

1990s led to opening up of the economy at all fronts, including the banking sector. The banking sector

reforms have converted banking services into commodities with a large number of schemes being offered to

the Indian banking consumer. Availability of adequate and reliable information on the prospective borrower

is vital for taking decisions in relation to sanctioning of credit. In the case of lending by banks, the basis for

the credit decision is the information furnished by borrowers; for a corporate customer, availability of

audited balance sheet, income and expenditure and other audited financial statements bestow certain

amount of authenticity to the information furnished, which facilitate an objective and commercial decision

with regard to sanctioning of credit facilities. In the case of retail customers such as, small retail traders,

individuals, professionals, etc. the availability of information becomes all the more important to validate,

save for certain documents such as, salary certificates, income tax returns, etc.

Absence of reliable information on the existing as also the prospective borrowers has often been cited as

one of the major causes for financial crises. With the financial sector becoming more complex and with the

blurring of distinction between various financial intermediaries, the need for adequate, full and reliable

information has been felt by credit institutions time and again. Credit information acts as a tool of risk

management. A credit report summarises historical financial information collected to determine an individual's

or an entity's creditworthiness, that is, the means and willingness to repay an indebtedness. Financial

institutions utilise credit reports to gauge credit reputation, and thus determine whether to extend credit, and

on what terms. With this in mind, the Credit Information Bureaus (India) Ltd. was set up in the year 2001 in

the form of a company registered under the Companies Act, 1956 with a view to provide timely, accurate

and relevant information to the members.

3.1 Application of the Act: There are places where the Act leaves a open questioned unanswered, the Act

has its definitions clause throwing light on various aspects of the extent of operation of the legislation, there

is a needs to be highlight here the definition of borrower in Section 2(b) which states "any person" or

"client" inclusive of companies, persons, individuals, partnership firms, HUFs but is silent on State

Government entities, PSUs and public corporations.

3.2 Importance of credit rating for assessment purposes: Fundamentally credit rating implies evaluating

the creditworthiness of a borrower by an independent rating agency. Here the objective is to evaluate the

probability of default. As such, credit rating does not predict loss but it predicts the likelihood of payment

problems. Credit rating agency helps in forming an opinion of the future ability, legal obligation and

willingness of a bond issuer or obligor to make full and timely payments on principal and interest due to the

investors. Banks do rely on credit rating agencies or companies to measure credit risk and assign a

probability of default. Credit rating agencies generally slot companies into risk buckets that indicate

company's credit risk and is also reviewed periodically. Associated with each risk bucket is the probability of

default that is derived from historical observations of default behaviour in each risk bucket.

3.3 Formation of credit information companies: A credit information company formed under the Act is

subject to regulations framed by RBI in the prescribed manner while the existing companies before the

commencement of the Act need to get themselves registered within 6 months from commencement of the

Act.17 The Act allows for the formation of multiple credit information companies. Generally, the powers of

determining the number of credit information companies at any given time vests in RBI which is subject to

further review as required and it also holds powers to cancel registration upon the satisfaction of certain

conditions as accorded in Section 6 of the Act.18 Prescribed limit on issued capital is 20 crores and minimum

paid-up capital is 75% of the issued capital.19

3.4 Management of a credit information company: The management of a credit information company is

under a whole time chairperson and a part-time chairperson who can be of a non-executive nature. The

Board of Directors shall be constituted of persons having special knowledge in the fields of public

administration, law, banking, finance, accountancy, management and Information Technology. RBI has

powers under the Act to supersede the Board under certain circumstances which shall affect the structure of

the credit information company in a considerable manner.20

3.5 Dispute settlement and applicable law: There is remedy available under the Act for settlement of

dispute by the modes of conciliation or arbitration as per the Arbitration and Conciliation Act, 1996. The

dispute settlement is available by credit information companies, credit institutions, borrowers and clients

associated with the business of credit information in any other manner. The arbitrator should be appointed

by RBI and the matter has to be resolved by the arbitrator within three months.21

17 For number of credit information companies, see CICRA, 2005, Section 5(3). Coming to Section 6 of the Act, its provisions are offset by the subsequent section which provides appeal against the order of Reserve Bank 18 Section 8 of the Act provides for the minimum authorised capital which a credit information company should have and provides further for issued capital requirements as well as minimum paid-up capital at any given point of time. 19 See CICRA, 2005, Section 9 20 For more on the kind of directions that may be issued by RBI, see sub-section (3) of Section 11 of the Act. Simultaneously apart from the powers of issuing directions, it has the powers of inspecting a credit information for the purposes of the Act. 21 For penalties, see CICRA, 2005, Section 23.

3.6 Credit information and the privacy concern: The Act deals with the critical areas of security and

accuracy of credit information thereby facilitating the provision of information to the users or members of

such companies and at the same time maintenance privacy of the consumer. The data relating to the credit

information being provided by the them has to be fully accurate, complete and duly processed and protected

against any loss or unauthorised access or use, it is the responsibility of the credit information company.

Section 20 of the Act provides for the privacy principles which should be applicable on the credit

information company, credit institution and the specified user so it is applicable for the purposes of

recording, processing, preserving and protecting the information or data. The privacy of the consumer or

the borrower extends to the purposes of the information provided by the credit information company. The

significance of the privacy of the consumer or the borrower with regard to the credit information is gauged

by the fact that a heavy penalty of Rs 1 crore has been specified in sub-section (2) of Section 23.22.

3.7 Furnishing of documents and prescribed punishment and penalties: The act mandates proper

furnishing of documents to the relevant authorities and any violation of it imposes strict penalties upto of

Rs 1 crore can be imposed23. Even Individual penalties can be imposed on the officials of a credit

information company or other associated officials in their official capacity.24 The basic idea underlying

offences and penalties prescribed under the Act is to prevent the circulation of false information amongst

the credit information companies, credit institutions, specified user, and amongst themselves. Such an act is

prohibited if done by commission or omission. With regard to powers of the court with regard to dealing

with offences, its powers are subject to complaint made by the officer of credit information company or

RBI. Apart from the prescribed mechanism of courts, RBI also has been given powers to impose

punishment as it thinks fit to so.

CONCLUSION

The Credit Information Companies (Regulation) Act, 2005 is a tool of credit risk management whereby

information stored about various consumers is stored for the purposes of retrieval, thereby reducing the

uncertainty of bad debts and loan amount recovery. Collection of information has now become easy as

compared to the past and therefore the functioning of credit information companies has become even more

significant. The functioning of the company formed under the Act is subject to the powers of Reserve Bank

of India and cannot act in accordance with its own whims and wishes of the various Bank. This is mainly

done after the series of co-operative bank failures in Gujarat. RBI acts as the custodian on policy matters

22 Credit Information Companies Rrgulation Act, 2005: "Prevention Is Better Than Cure"by Kshitij Dua & Karn Gupta Cite as : (2006) PL April 13 see http://www.ebc-india.com/lawyer/articles/2006_apr_13.htm 23 See sub-sections (4) and (5) of CICRA, 2005, Section 23. 24 See CICRA, 2005, Section 32.

concerning the Credit Information Companies Act, 2005 and provides future guidelines and directions for

the functioning of a credit information company. The success of a credit information company depends on

the credit market in a country or the penetration of credit in the market, for India it is huge because of the

development in the industrial, housing and agricultural sector. Therefore with large amount of money supply

in the market by way of loans and advances by banks and financial institutions is increasing, it becomes

imperative to have a system for tracking down the existing as well as prospective borrowers. Thus the act

can be a facilitator in creating a strong credit culture in our country where the money of banks is not lost

which effects the common man who are the investors in the bank. RBI should take care that the common

man can also take the advantage of these company. Like these companies should be advertised so all

become aware of these and thus can keep a check on the progress of their respective creditors. Moreover

RBI should make it compulsory for financial institution, banks and other companies giving high amount of

credit in any form to make use of credit information company so that can have a secure future.

The Credit Information Companies (Regulation) Act, 2005, State Bank of India Act, 1955, Banking

Regulation Act of 1949, Banking Regulation Act of 1949 and Securities And Exchange Board of India

Guidelines work together for regulating the credit system in India. Section 45-E, sub-section (2) has been

inserted in the Reserve Bank of India Act which facilitates the disclosure of any credit information under the

Credit Information Companies (Regulation) Act, 2005. 25 The change made in the Banking Regulation Act of

1949 allows a banking company to form a subsidiary company to carry on the business of credit information

as per the Credit Information Companies (Regulation) Act, 2005.26 Similarly, the impact of the State Bank of

India Act, 1955 has been lessened as Section 44(3), after the new amendment law provides that the section

shall not apply to the credit information company operating under the Act. In the same manner, the Act

also amends other laws thereby calling for their non-application. The Credit Information Companies

(Regulation) Act, 2005 gives powers to RBI for determining the fees for providing information to the

relevant persons authorised under the Act and at the same time guides on the aspect of disclosure of

information and maintenance of secrecy in certain circumstances.27

Although the credit rating in India is governed by Credit Information Companies (Regulation) Act, 2005,

State Bank of India Act, 1955, Banking Regulation Act of 1949, Banking Regulation Act of 1949 and

Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999 even then few important

aspects of credit rating system are untouched, like:

25 After sub-section (3) of Section 19, the amendment made. 26 From the Judgment of the Delhi High Court in FA(Os) No. 43 of 2001 : 2002 PTC 641 27 The Schedule appended to the Act amends the Reserve Bank of India Act, 1934, the Banking Regulation Act, 1949, the State Bank of India Act, 1955, etc

1. Sometimes the regulation imposed on the Credit rating agencies becomes to much that its independence

of ratings becomes questionable and destroys the basic purpose of its existence.

2. Credit rating agencies should be made accountable for the ratings given by them.

3. There even have been cases of Credit rating agencies manipulating the credit to increasing the volatility of

capital flows from market leading to major financial crises28. This is even done to forces on certain portfolio

managers to sell.

The results of studies are not uniform leading to uniformity in the ratings of the Credit rating agencies.

Apart from these, also there are various issues related to the credit rating industry in India. The credit ratings

are being institutionalized into the regulatory framework of banking supervision. This raises four important

issues that need to be looked into. These are – the quality of credit rating in India, the level of penetration of

credit rating, lack of issuer ratings in India and last but not the least, the effect of the credit rating scheme on

Small and Medium Enterprises (SMEs) and Small Scale Industry (SSI) lending. The credit rating industry in

India presently consists of five agencies: Credit Rating Information Services of India Limited (CRISIL),

Investment Information and Credit Rating Agency of India (ICRA), Credit Analysis & Research Limited

(CARE) and Fitch India and ONRICA.

These agencies provide credit ratings for different types of debt instruments of short and long terms of

various corporations. Very recently, they have also commenced credit rating for SMEs. Apart from that,

ICRA and CARE also provide credit rating for issuers of debt instruments, including private companies,

municipal bodies and State governments.

The four issues that need to be looked into, are:-

1. Credit Rating quality: The literature on India’s credit rating industry is scanty. However,

the few studies available point to the low and unsatisfactory quality. In Gill (2005),ICRA’s performance in

terms of credit rating and provision of timely and complete information on the rated companies has been

studied. Analysing the ICRA ratings for the period 1995-2002, the study finds that many of the debt issues

that defaulted during the period were placed in ICRA’s ‘investment grade’ until just before being dropped to

the ‘default grade’. These were not gradually downgraded, rather they were suddenly dumped into ‘default

grade’ at the last moment from an ‘investment grade’ category.

28 As Asian crisis when many commentators argued that the downgrading of the crisis-hit countries during a crisis might have worsened rather than help the situation. Rating agencies argue that ratings are not intended to predict the exact timing of default or when a crisis would occur and that change in rating would occur if the new information received so warranted. Credit rating agencies point out that most of the lending in East Asia was done by big banks with their own analytical capacity.

Further some defaulting issues were continuously reaffirmed as investment grade. In previous studies,

Raghunathan and Varma (1992; 1993) evaluated the ratings published by CRISIL in India and found that

CRISIL ratings not only do not adequately reflect the financial ratios of the rated entity, but also are

internally inconsistent. In these studies, CRISIL ratings were found to be very liberal by international

standards. Further, companies rated in the same category by CRISIL reflected a wide variety of credit-

worthiness, implying the lack of discriminatory power of the ratings vis-à-vis the credit-worthiness of the

entities in the same rating category.The literature on credit rating identifies lack of ‘unsolicited’ rating as an

important factor leading to poor quality of credit rating. In India all ratings are ‘solicited’, i.e. all ratings are

paid for by the rated entity. This creates a conflict of interest on the part of the rating agency since it is

dependent on the fees of the rated entity for its business. Thus, credit rating industry in India is driven

mostly by the rated entities. Under the presentsystem, issuers of bond/debt instruments may go to any

number of agencies for a rating of their bonds/debt instruments and have the right to accept or reject the

rating. Further, the rating cannot be published unless accepted by the issuer.

In addition to this, RBI’s recommendation for use of only

solicited ratings causes some concern, owing to the problem of moral hazard.

2. Low penetration of Credit Rating: The second important issue in India’s credit rating industry is the

low penetration of credit rating in India. A study in 1999 revealed that out of 9,640 borrowers enjoying

fund-based working capital facilities from banks, only 300 were rated by major agencies. As far as individual

investors are concerned, the level of

confidence on credit rating in India is very low. In an all-India survey of investor preference in 1997, it was

found that about 41.29 per cent of the respondents (out of a total number of 2,819 respondents) of all

income classes were not aware of any credit rating agency in India; and of those who were aware, about 66

per cent had no or low confidence in the ratings given by credit rating agencies.29 The legitimacy brought

about by Basel II for credit ratings of borrowers will definitely increase the penetration of the industry.

However, until such time, most loans will be

given 100 per cent risk weightage (since an unrated claim gets 100 per cent weightage); thus leading to no

significant improvement of Basel II over Basel I.

3. Issuer Ratings: Presently credit rating in India is restricted to ‘issues’ (the instruments) rather than to

‘issuers’. Ratings to issuers become important as the loans by corporate bodies and SMEs are to be weighted

29 Gupta et al. 2001

as per their ratings. Of late agencies like ICRA and CARE have launched issuer ratings for corporations,

municipal bodies and the State

government bodies. Further, all agencies, with direct support from the Government of India, have launched

SMEs rating. Until such efforts pick up rapidly, issuers will be assigned 100 per cent weightage, leading to

no improvement in the risk-sensitive calculation of the loans. Thus, in this account too, the implementation

of Basel II would not lead to significant improvement over Basel I.

4. Effect of the Credit Rating scheme on Small and Medium Enterprises (SMEs) and Small Scale

Industry (SSI) lending: Besides agriculture and other social sectors, Small Scale Industry is treated as a

priority lending sector by RBI. SSI accounts for nearly 95 per cent of industrial units in India, 40 per cent of

the total industrial production, 35 per cent of the total export and 7 per cent of GDP of India. In spite of its

importance on Indian economy, SSI receives only about 10 per cent of bank credit. As banking reforms

have progressed, credit to SSI has fallen. The SSI sector in India is so far out of the reach of the credit rating

industry. Under the proposed Basel II norms, banks will be discouraged to lend to SSI that is not rated

because a loan to unrated entity will attract 100 per cent risk-weight. Thus, bank lending to this sector may

further go down.

As an incentive to get credit rating, Government of India currently provides a subsidy of 75 per cent of the

rating fees to SMEs who get a rating. Net of this subsidy, the rating fees for SMEs with annual turnover of

less than Rs. 50 lakh are as follows: Rs. 19,896 for a rating by CRISIL, Rs. 19,896 for a rating by ICRA, Rs.

7,400 for a rating by CARE and Rs. 22,141 for a rating by Fitch India. Without the subsidy, the fees are: Rs.

40,000 for CRISIL, Rs. 40,000 for ICRA, Rs. 29,600 for CARE and Rs. 42,000 for Fitch India.

According to the Third All India Census of SSI conducted during 2001-02 by the Ministry of Micro,

Small and Medium Enterprises, average output per unit of SSI in India in 2001-02 was about Rs. 4 lakh.

Thus, with the subsidy, SSI units will have to spend 2-5 per cent of their output as fees for credit rating.

Without the subsidy, the percentage of fees to output is in the range of 7-11 per cent. This additional

cost of credit rating is bound to affect the economic viability of a large number of SSI units. While

introduction of credit rating for the SMEs (including SSIs) may, in the long run, improve the accounting

practices of the SSI, there is also a possibility that SMEs will continue to rely on the existing system of

informal credit as formal credit is likely to become more expensive due to the credit rating requirement

of Basel II.

BIBLIOGRAPHY

Books and Reports Referred

Saraiya Commission Report

Report of the Banking Commission (1972)

"Keep Credit in check", THE OUTLOOK MONEY, June 15, 2005.

Statutes referred

The Banking Regulation Act, 1949

The Companies Act, 1956

The Credit Information Companies (Regulation) Act, 2005

The Reserve Bank of India Act, 1934

The Securities and Exchange Board of India (Credit Rating Agencies) Regulations, 1999

The State Bank of India Act, 1955