Credit ratings are opinions about credit risk. They express the Credit Rating Agency’s opinion about the ability and willingness of an issuer, such as a corporation or state or city 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 factor in anticipated ups and downs in the business cycle that may affect the company’s creditworthiness.
Ratings opinions are not intended as guarantees of credit quality or as exact measures of the probability that a particular issuer or particular debt issue will default. Instead, ratings express relative opinions about the creditworthiness of an issuer or credit quality of an individual debt issue, from strongest to weakest, within a universe of credit risk.
Investors most often use credit ratings to help assess credit risk and to compare different issuers and debt issues when making investment decisions and managing their portfolios. Businesses and financial institutions, especially those involved in credit-sensitive transactions, may use credit ratings to assess counter-party risk, which is the potential risk that a party to an agreement may not fulfill its financial obligations.
In Indian scenario, credit rating is prevalent in case of bank facilities as RBI necessitates the borrowers to take rating for their credit facilitates availed from banks. Whereas ratings pertaining to debt securities (e.g., bonds, non-convertible debentures, commercial papers, etc.) are less prevalent. Banks have their own elaborate internal risk evaluation process and rely on external credit rating as a validation, and to meet regulation plus capital allocation norms. In contrast, most of the debt capital market investors (like Mutual Funds, Pension Funds, Corporate) depend primarily on rating agencies for evaluation of risk and monitoring. Though this situation is set to change as corporate bond market expands in India. Noteworthy, currently corporate bond market in India remain very nascent at 6-7% of total debt securities outstanding versus almost 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 bank and NBFCs. Participation of other investors have been negligible. One of the main reasons is unavailability of product compliant to debt capital markets. For issuing a debt capital market instrument, an issuer needs to get a rating of the portfolio (necessary but not mandatory), legal & tax opinion among other regulatory requirements. Thus, rating becomes an important component. While for a single obligor (i.e., where credit risk depends on one single entity) it is reasonably straight forward but when it comes to a portfolio of small entities like a pool of dealers, retail loans etc., the rating process is fairly complex.
In India, rating of pools comprising of commercial vehicle loans, micro finance etc., has been in fashion since mid 90s and now fairly regular issuance being done by banks, NBFCs, MFIs etc. However rating of supply-chain portfolio is very nascent. The first two instruments in supply-chain were done as late as 2020. Unlike MFI and commercial vehicles, supply-chain pools are short-term in nature. Moreover, unavailability of historical data makes difficult to draw any credit behavioural trends. Some of the other factors which makes rating difficult are complicated regulations, complex product structures.
Technology and Data gathering
Technology can effectively address some of the above bottlenecks. Historical data will get addressed largely through digitization of supply-chain processes like e-invoicing and acceptance. API integration of various platforms and data sources would facilitate under-writing. For instance, GST network is a very rich source of data that can used to validate sales ledger.
Some of the other developments like investors’ preference on diversifying into other debt products, governments focus on increasing funds availability to MSMEs through regulation changes such as factoring act, trade credit insurance, will accentuate supply-chain backed debt instruments going forward.
Calling it a tip of the iceberg may not be hyperbole after all. Grist for advent of rating in supply-chain are many but it will unfold when all the above factors come together.
Author: Shantanu Bairagi ~ Co-Founder, Director