Skip to main content

Seminar: Dynamic Credit Rating Standards- Why do they vary over time?

Date : 7th January, 2011

Speaker: Dr. Puneet Prakash

Biography of the speaker:

Dr. Puneet Prakash is an Assistant professor, 2005 – current, at Virginia Commonwealth University. He has done his Ph.D in Risk Management and Insurance from Georgia State University. He completed MBA from IIFT, Delhi, PG Diploma in Development Policy (IGIDR), and M.Sc. (5-year Integrated) from IIT, Kanpur. He is also a visiting faculty to IIT Kanpur, Fall 2009.

Abstract of the talk:
In the paper mentioned, it is examined as to why credit rating standards change over time. Drawing upon the literature on certification intermediaries, it is argued that rating standards are related to the economy-wide credit quality distribution, and as the distribution changes, so do the standards. Empirical tests verify this predicted relationship. In particular, with a rise in economy–wide dispersion of the distribution of credit quality, rating standards become more stringent. However, an increase in mean probability of economy wide default risk has the opposite effect. These findings are robust to not only alternative specifications of measures of location and dispersion of the economy-wide credit quality distribution, but also to the stickiness in ratings.



Dr. Puneet started the discussion by explaining the motivation of the CRAs (Credit Rating Agencies). He explained that the topic has a keen association with the long-term debts. When a firm seeks for some investors, investing companies want to know the credit-worthiness of these issue companies. He then explained the role of CRAs in the society in this context. He explained that a Credit Rating Agency acts as:
a) An information intermediary to come in and analyze Balance Sheet of the issuer. It removes information asymmetry between the issuer (firm seeking for debt) and the investors
b) A monitoring unit: It charges a fee for the service it offers in this respect
c) A Certificate intermediary: It provides an assurance of quality for the issuer.

He next moved on to mention that a credit rating agency takes into account, how much money of its own the issuer is putting into a debt. CRAs have a role of increasing social welfare, collecting information and disseminating it.

The next major topic that he discussed was CRAs and the current crisis they are facing. He explained that in the current scenario, many companies are frequently changing their standards to maintain their market shares. He indicated that these companies have started ignoring interest rate changes in the economy. And as a result, CRAs also ignored interest rate risks. As of now, though, CRAs are regulated much strictly.

Next he came to the main Research Question. He explained a few concepts with the help of three research papers, as enlisted below:
• Blume M., F. Lim and A C MacKinlay (BLM), 1998, “The declining credit quality of U.S. Corporate Debt: myth or reality?”, Journal of Finance, 4, 1389-1413
o Rating Standards become stricter over 1975-1995
• Zhou, 2001, “Credit Rating and Corporate Defaults”, The Journal of Fixed Income , Vol. 11, No. 3: pp. 30-40
o Rating Standards become lag over 1981-1998
• Gordy and Heitfield, “Estimating Default Correlations from Short Panels of Credit Rating Performance Data”, 2002
o Rating standards are time-varying, to explain rating through the cycle

Dr. Puneet followed Gordy and Heitfield (as highlighted above), as the base paper to next explain as to why do CRAs vary their standards over time? He explained that standards are dynamic because they are tied to the underlying economy wide credit risk distribution. So, one should not expect any trend over time. He mentioned that when the average quality of companies as a whole declines, standards are lowered (market share argument). In this case, the CRAs believe that if they do not lower their standards, they will lose their market share. This is due to the fact that the client may get a good rating for more defaults from another CRA in this case. He also argued that as the dispersion of the distribution of credit quality rises, standards are tightened (reputation argument). As its implication, it becomes evident that rating standards have no trends. Instead, these are tied to the underlying risk distribution.

Dr. Prakash then went into the theoretical underpinnings of the model used and developed in the research paper. He stated that a Rating agency is a profit maximizing firm. It is also assumed that a market is characterized by information asymmetry. Ultimately, the problem reduces to a Seller’s problem:
Max (θ – c (θ, t) – P); where θ: debt
C: Cost of obtaining θ
t: Efficiency parameter
P: Price a seller pays to the CRA

On the basis of these theoretical Implications, certain Empirical predictions can be stated as:
• t is time varying:
• P is:
o Directly proportional to the mean value of the underlying quality E(t)
o Inversely proportional to the dispersion

Hence, the dispersion of the distribution of credit quality is taken as a scaling parameter.

He further introduced the issues of measurement where certain mathematical models were explained, based on the Merton model. A ‘Rating Agency model’ was introduced as an econometric model. It was mentioned that the rating thresholds represent the standard different CRAs have. For example, a rating of AAA may mean 10 default points for one CRA while 8 for the other.

The last part of the seminar was the Q/A round, where Dr. Puneet addressed to the students’ and faculties’ queries. The seminar closed with a vote of thanks by Dr. Subhash C. Misra, Faculty, IIT Kanpur. The session proved to be very informative for the students, as they become aware of the major forces affecting the functioning of the rating agencies in a free economy.

Prepared By:
Rubal Mehta(rubalm@iitk.ac.in)

Published By:
PR & Media Cell, MBA-IIT Kanpur (prmba@iitk.ac.in)

Comments

Popular posts from this blog

The Dawn of A New Beginning - MBA Batch 2017-19

“Opportunities multiply as they are seized.” -Sun Tzu




‘I am an IITian’, even after two months here at IIT Kanpur this one line still fills our heart with excitement. Each one among the 54 students here who have started the journey into the MBA programme of IIT Kanpur, batch of 2017-19, feels that pride and with that equally realizes the responsibility it carries.
We started our journey here on 20th July. Meeting our batch mates for the first time still feels thrilling. Though we knew each other through the whatsapp/facebook group that was created by our seniors to make our registration process as smooth as possible. We were given several assignments before the registration to give us an inkling of the idea of how life at IIT Kanpur is going to be. Assignments were planned in a way such that we get a hands-on experience on case studies, presentations, group activities and article reading. We began burning the midnight oil as a precursor to actually doing it, and how! These assignments u…

Tips from Top - "Various dimensions of leadership." Mr Amit Kasliwal, India Head - Corporate Sales, Ford India.

Leadership is one of the most desired traits for success in life and MBA students at IIT Kanpur were fortunate to get a fresh perspective on the topic from the top echelon of corporate world, when Mr Amit Kasliwal, India head of corporate sales at Ford India visited the campus to interact with the students.

Sir described leadership as the zeal to identify and solve problems. Citing an example, sir said that India has a myriad of problems and out of those; transportation was one of the major issues. Ford is dedicated to solve this problem. Talking specifically about the corporate sales department, he told that by selling cars to taxi operators, they created entrepreneurs, thereby solving the problem of job creation at that level.   
Further describing leadership, sir claimed that a leader must have a long term view, and should be enthusiastic about other’s agenda, thereby creating opportunities and ‘win-win’ situations. According to sir, and rightly so, sustainable leadership can be …

International Exposure: Japan, Utkarsh Maurya, MBA 2nd Year

JENESYS 2016 from 27th Feb to 7 March 2017. About JENESYS 2016 The Ministry of Foreign Affairs of Japan promotes people-to-people exchanges between Japan and the various nations of the Asia-Pacific, North America, Europe, Latin America, and the Caribbean regions. The Asian and Oceanian regional component of this exchange program is called “JENESYS 2016”- Japan-East Asia Network of Exchange for Students and Youths. Around 250 students and working professionals were invited for the 7th batch of JENESYS 2016 (Theme: Economics) from 12 countries: India, Indonesia, Cambodia, Philippines, Singapore, Timor-Leste, Thailand, Laos, Malaysia, Myanmar, Brunei and Vietnam. The objective is to promote mutual trust and understanding among the people of Japan and participating countries, and regions, to build a basis for future friendship and cooperation. The Indian Delegation 23 youths were selected from India; out of them 15 were students and the rest were working professionals. From IIT Kanpur, 3 stud…