EFFECTIVENESS OF CORPORATE CREDIT RATING – STAKEHOLDERS' PERSPECTIVE

Abstract

Credit Rating Agencies (CRAs) are key participants in the banking and financial system for estimating risk and its location and distribution. CRAs communicate credit rating as an opinion on the credit quality of the underlying instrument or the issuer, which communicates the relative degree of risk associated with the timely payment of interest and principal on a debt instrument. The key stakeholders for credit ratings are – Credit Rating Agencies (CRAs), Investors, Issuers or Corporates, and Regulators. CRAs assist investors in their decision making as well as facilitate corporates. Through literature review, it was found that from investors' and regulators' perspectives, credit ratings should be objective, accurate, and timely to aid in appropriate decision-making. Forward-looking information incorporated in credit rating changes is also an important consideration for investors. For CRAs', reputation is important, which in turn depends on the credibility of credit ratings. For corporates, a credit rating should help access capital at competitive rates, which would also influence corporate decision-making. However, there have been several past instances due to which credit rating effectiveness has come into question. Given that credit rating is an essential consideration for different stakeholders, the study focuses on the effectiveness of credit ratings assigned by CRAs. The scope of the study is primarily on Indian credit rating agencies and their credit rating actions. The study focuses on examining the effectiveness of credit rating for investors by investigating the informational value of credit rating changes and whether credit rating changes indicate the future financial performance of a firm. The study utilizes the operating profit as a proxy of future financial performance to understand how it changes following a change in the firm's credit rating. The study finds that a firm's operating profit witnessed a relative decline in the year after a credit rating downgrade, supporting the assertion by CRAs that they incorporate forward-looking and

v non-public information about the firm in their credit rating actions. The findings confirm the long-term effectiveness of the credit rating for investors. The study also investigates the effectiveness of credit rating in enabling investors to manage the short-term risk of abrupt events. The analysis compares the responsiveness of credit rating viz a viz stock prices post unanticipated external events. The study findings allow investors to observe the lack of sensitivity of credit ratings to external shocks and understand the need to be more vigilant in managing sudden risks and not rely solely on credit ratings. It also helps the investor understand the relative responsiveness of stock prices compared to credit ratings due to external events. The study also examines the factors impacting the effectiveness of credit rating through a literature review. The study finds the competition among CRAs as one of the drivers of issues plaguing the credit rating industry. The study uses quantitative techniques to check the impact of competition on a firm's credit rating. The study finds that CRAs inflate a firm's credit rating due to competition from other CRAs. Rating shopping is also evident in the credit rating industry, driven by competition between CRAs to gain new clients. The study's findings also indicate that increased competition for large-size firms business leads to CRAs showing leniency when rating such firms. Overall, the study helps researchers understand the importance of credit rating for stakeholders. It demonstrates the effectiveness of credit rating changes for investors as an indicator of future performance. However, the study showcases the credit ratings' inability to react to sudden changes, even if those are of greater significance for corporates. It shows the reduced effectiveness of credit rating due to the competition between CRAs for business. The study highlights the importance of credit rating actions for investors and managers. It enables them to understand the nature and extent of forward-looking information incorporated in a rating

vi change. The study has implications for regulators and policymakers for actively monitoring and controlling the competition among CRAs to ensure the accuracy of credit ratings.