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Corporate Governance: By: 1. Kenneth A. Kim John R. Nofsinger and 2. A. C. Fernando

This document discusses creditors and credit rating agencies. It begins by introducing creditors like commercial banks and bondholders who care about a firm's creditworthiness. It then covers credit rating agencies and how they rate bonds on credit quality from high to low. Higher ratings mean lower interest rates and risk, while lower ratings mean higher rates and risk. The document also discusses criticisms of credit rating agencies and different international approaches like Japan's main bank system.

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Maryam Malik
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74 views28 pages

Corporate Governance: By: 1. Kenneth A. Kim John R. Nofsinger and 2. A. C. Fernando

This document discusses creditors and credit rating agencies. It begins by introducing creditors like commercial banks and bondholders who care about a firm's creditworthiness. It then covers credit rating agencies and how they rate bonds on credit quality from high to low. Higher ratings mean lower interest rates and risk, while lower ratings mean higher rates and risk. The document also discusses criticisms of credit rating agencies and different international approaches like Japan's main bank system.

Uploaded by

Maryam Malik
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Corporate Governance

By: 1. Kenneth A. Kim


John R. Nofsinger
And
2. A. C. Fernando
Creditors and Credit
Rating Agencies

Lesson 16
Creditors and Credit Rating Agencies
 Last Lecture Review
◦ Introduction
 Who care about the firm 1. stock holders 2. Creditors

◦ Two types of lenders


 Commercial Banks
 Individual (bondholders)

◦ Credit Rating Agencies (CRAs)


◦ Analysis of the situation having different credit ratings
by different CRAs
Creditors and Credit Rating Agencies
 Lecture Outlines
◦ How did CRAs start?
◦ High credit rating vs. Low credit rating
◦ Another view of credit rating
 New company vs. Mature company

◦ The BIG 3
◦ PACRA
◦ The Ratings
Creditors and Credit Rating Agencies
 Criticisms
◦ Consulting firms
◦ First Amendment Right to CRAs
◦ Mistakes
◦ CRAs as watchman
◦ Relationship with management
◦ blackmailing
 International Perspective
◦ Japan (main bank)
Creditors and Credit Rating Agencies
 How did Rating Agencies Start?
 Moody, John. Manual of Railroad
Securities, 1909. Provided operating statistics
for 200 railroads and their securities.
 1916—Standard Co. began grading bonds.
 1920s—Poor and Fitch began bond rating.
 1941—Poor’s and Standard merged.
 Customers were investors who wanted unbiased,
arms-length financial analysis
Creditors and Credit Rating Agencies
 CRA help investors understand the riskiness of
a bond issued by issuing some grades.

 A high quality rating for a company means that


they can offer a bond at a low interest rate,
having low risk and still easily sell them.

 A lower quality rating would require offering the


bonds at a high interest rate, having high risk
and cost firms millions in interest payment.
Creditors and Credit Rating Agencies

 So, we can conclude it in this way;

Credit rating = Risk related to credit

High Credit rate= low interest rate i.e. low risk

Low Credit rate= High interest rate i.e. high risk


Creditors and Credit Rating Agencies
 So, the bond having high interest rate may be
awarded as low credit rate by the CRA.

 And, the bond having low interest rate may


be awarded high credit rate by the CRA.

 E.g. one lac (100000) worth of bond having


10% interest rate will give the lender 10000
rupees i.e. 100000 x 10/100= 10000
Creditors and Credit Rating Agencies
 Similarly, one lac (100000) worth of bond
having 5% interest rate will give the lender
5000 rupees i.e. 100000 x 5/100= 5000

 So, from the above examples we can


conclude that there is a high risk involved in
the first example having 10 interest rate with
the bond and will get low credit rating from
the CRAs and vice versa.
Creditors and Credit Rating Agencies

 Another view of Credit Rating


New company= low interest on bonds= High credit rate

New company= high interest on bonds=Low credit rate

Mature company=high interest = High credit rate

Mature company= Low interest = Best Credit rate


Creditors and Credit Rating Agencies

 The Big 3
◦ The Big Three credit rating agencies are Standard
and Poor’s, Moody’s Investors Service, and Fitch
Rating. Moody's and Standard & Poor's each control
about 40 percent of the market. Third-ranked Fitch
Ratings, which has about a 14 percent market
share, sometimes is used as an alternative to one of
the other majors.
Creditors and Credit Rating Agencies

 In Pakistan, we have PACRA (Pakistan Credit

rating Agency) and many other private credit

rating agencies.
Creditors and Credit Rating Agencies

 The Ratings
◦ To assess the credit worthiness of companies, the
credit agencies employ financial analysts who
examine the firm’s financial positions, business
plan, and strategies.

◦ This means that the analysts carefully review public


financial statements by the companies.
Creditors and Credit Rating Agencies

◦ To assist in their investigations, the SEC has granted the


agencies an exemption from disclosure rules so that
companies can reveal non-public or sensitive
information to the agencies in confidence.

◦ Companies have no obligation to reveal special


information but they often do so to convince the
agencies that their debt issues (bonds) should be rated
highly.
Creditors and Credit Rating Agencies

◦ Credit analysts can often question CEOs and other

top executives directly when conducting reviews

because of the importance of credit ratings.


Creditors and Credit Rating Agencies
 Rating of Bond Safety and Example Bond Yields
Ratings Moody’s Standard & Example bond Yield,%
Poors
Best Qty Aaa AAA 6.4
High Qty Aa AA 6.9
Upper Medium A A 7.1
Grade
Medium Grade Baa BBB 7.8
Non-Investment Ba BB 9.9
Grade
Highly Speculative B B 10.5
Defaulted or close Caa to C CCC to C 20 to 90
Creditors and Credit Rating Agencies

 Explanation

◦ Consider two companies that want to borrow $1 billion by issuing

bonds. The rating company rates the first company in the “high

quality” category. This firm will have to pay 6.9% (or 69 million) in

interest every year.

◦ The second firm is rated “non-investment grade” and would have

to pay $99 million annually.

◦ These amount differ substantially riskier companies pay higher

interest.
Creditors and Credit Rating Agencies

 If a company becomes stronger financially stronger

over time, then the bond rating will also improve .

 When a firm begins to struggle financially, credit

agencies downgrade the ratings on its securities

i.e. from AAA to AA or even A.


Creditors and Credit Rating Agencies

 Criticisms

◦ 1. consulting businesses (Conflict of interest)

 being both consultants and credit raters creates a conflicts of

interests similar to the one that occurred when auditing firms were

also consultants for a company.

◦ 2. First Amendment Right to CRA

 According to this right, companies can’t sui any CRA and makes

credit agencies nearly invincible.


Creditors and Credit Rating Agencies

◦ 3. Mistakes while “Rating”

 CRA play vital role while rating different firms. Giving wrong credit rate

(high as well as low) can put the company as well as investors in chaos.

◦ 4. CRA as Watchman (independent monitor)

 CRA are not blameless in the corporate scandals. Indeed, their special

relationship with companies allow them to obtain private information

and can detect fraud and warn investors.


Creditors and Credit Rating Agencies

◦ 5. Relationship with management

 One of the biggest criticisms on CRA i.e. having relationship with

the management. So how the investors would rely on credit ratings.

◦ 6. Blackmailing for new businesses

 New businesses normally required moral as well as financial

support to sustain. So CRA can blackmail them to get good credit

ratings for their businesses to sustain.


Creditors and Credit Rating Agencies
 International Perspective (Japan Main Bank System
during 1980s)
◦ In most countries, bank debt is the primary form of
corporate borrowing and even the primary source of new
financing due to lack of a sophisticated public debt
market.

◦ Although Japan is a developed market but still rely heavily


on bank debt, having long-term relationships with banks,
usually with each firm having a “main bank”.
Creditors and Credit Rating Agencies
◦ These main banks usually own equity and place its
own personnel into important management
positions (including directorships) of the borrowing
firms.
◦ Positive aspects of “main bank”
 Active monitor of the Japanese firms.
 Firms don’t care about the cash reserves as they have
“main banks”.
 “man bank” was always there to help in any financial
crisis.
Creditors and Credit Rating Agencies

◦ Negative aspect of “main bank” (Japanese market


crash in 1990)
 Too much influence on management.
 Pressurising firm for profit stabilization rather than
profit maximization in order to protect their claims as
the firm’s largest creditors.
 But if the banks faced financial difficulties, might led
their client firms in financial troubles
Creditors and Credit Rating Agencies
 Summary
◦ Introduction
 Who care about the firm 1. stock holders 2. Creditors

◦ Two types of lenders


 Commercial Banks
 Individual (bondholders)

◦ Credit Rating Agencies (CRAs)


◦ Analysis of the situation having different credit ratings
by different CRAs
Creditors and Credit Rating Agencies
◦ How did CRAs start?
◦ High credit rating vs. Low credit rating
◦ Another view of credit rating
 New company vs. Mature company

◦ The BIG 3
◦ PACRA
◦ The Ratings
Creditors and Credit Rating Agencies
 Criticisms
◦ Consulting firms

◦ First Amendment Right to CRAs

◦ Mistakes

◦ CRAs as watchman

◦ Relationship with management

◦ blackmailing

 International Perspective
◦ Japan (main bank)

The End

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