Why the role of rating agencies is vital?

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Credit ratings are opinions on credit risk. They express the opinion of the credit rating agency on the ability and willingness of an issuer, such as a company or a state or municipal government, to meet its financial obligations in full and on time. .

Rating agencies evaluate available current and historical information and assess the potential impact of foreseeable future events. The agency may take into account expected ups and downs in the business cycle that may affect the company’s creditworthiness.

Rating opinions are not intended as guarantees of credit quality or as exact measures of the likelihood that a particular issuer or particular issue of debt will default. Instead, ratings express relative opinions of an issuer’s creditworthiness or the credit quality of an individual debt issue, from highest to lowest, within a universe of credit risk.

Investors most often use credit ratings to assess credit risk and compare different issuers and debt issues when making investment decisions and managing their portfolios. Companies and financial institutions, especially those involved in credit-sensitive transactions, can use credit ratings to assess counterparty risk, which is the potential risk that a party to an agreement will not fulfill not its financial obligations.

In the Indian scenario, credit rating is prevalent in case of bank facilities as RBI requires borrowers to take a rating for their credit facilities obtained from banks.

While ratings relating to debt securities (e.g. bonds, non-convertible debentures, commercial paper, etc.) are less common. Banks have their own elaborate internal risk assessment process and rely on external credit rating as validation and to meet regulatory and capital allocation standards. In contrast, most debt capital market investors (such as mutual funds, pension funds, corporations) rely primarily on rating agencies for risk assessment and monitoring. Although this situation is set to change as the corporate bond market develops in India. It should be noted that currently, the corporate bond market in India remains very nascent at 6-7% of total debt securities outstanding compared to nearly 40% in developed economies.

Role of credit ratings in supply chain finance

How is the above relevant to supply chain finance? Traditionally, supply chain finance has been funded largely by banks and NBFCs. The participation of other investors was negligible. One of the main reasons is the unavailability of debt capital markets compliant products. To issue a debt capital market instrument, an issuer must obtain a portfolio rating (required but not mandatory), legal & tax advice among other regulatory requirements. Thus, the notation becomes an important element. Whereas for a single obligor (i.e. when the credit risk depends on a single entity) it is reasonably straightforward, but when dealing with a portfolio of small entities like a pool dealerships, retail loans, etc., the rating process is quite complex.

In India, the rating of pools comprising commercial vehicle loans, micro-finance, etc. has been in vogue since the mid-1990s and issuances are now quite regular by banks, NBFCs, MFIs , etc. However, the supply chain portfolio rating is very nascent. The first two supply chain instruments were completed through 2020. Unlike MFIs and commercial vehicles, supply chain pools are short-term in nature. In addition, the unavailability of historical data makes it difficult to draw behavioral trends in credit. Some of the other factors that make scoring difficult are complicated regulations, complex product structures.

Technology and data collection

Technology can effectively solve some of the bottlenecks above. Historical data will be handled largely through the digitization of supply chain processes such as electronic invoicing and acceptance. API integration of various platforms and data sources would make it easier to subscribe. For example, the GST network is a very rich data source that can be used to validate the sales ledger.

Some of the other developments, like investors’ preference for diversification into other debt products, governments are focusing on increasing the availability of funds for MSMEs through regulatory changes such as the factoring, trade credit insurance, will accentuate supply chain debt instruments in the future.

Calling it the tip of the iceberg may not be hyperbole after all. The road ahead for the advent of rating in the supply chain is many, but it will unfold when all of the above factors come together.



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Disclaimer

The opinions expressed above are those of the author.



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