Important Functions of Credit Rating
Credit rating performs the following functions
1. Source of Superior information
Credit rating provides superior information to the investors through a systematic assessment of risks of the investments. Credit rating firms are highly reliable for the following reasons:
- Unlike brokers, financial intermediaries, underwriters who have vested interest in an issue, a credit rating agency is independent.
- Credit rating agencies employ highly trained staff with professional competence. So, they are able to assess the risks in a better way.
- Credit rating agencies have access to confidential information which may not be publicly available.
2. Low cost information source
Credit evaluation is a process which is highly expensive and time consuming. Credit rating agencies collect, analyze, interpret and summarize complex information in a readily understood form. This source of low cost information is highly welcomed by the investors.
3. Basis for a risk and return trade off
A successful investor is one who trades off/risk and return. He wants his investment to fetch maximum possible return at a given level of risk. Credit rating enables the investors to understand the risk associated with the security which he is likely to buy. Thus, the instrument rated by a credit rating agency enjoys higher confidence from investors.
4. Healthy discipline on Corporate borrowers
Financial discipline is a must for any corporate borrower. Only genuine corporate borrowers with good corporate image can succeed in raising funds from among the public. Credit rating enhances the corporate image of the company through higher credit rating.
5. Legal insurance
Credit rating provides legal insurance to the investment trustees. They can guard themselves against any charge of mismanagement of funds by carefully selecting highly rated securities for investment.
6. Aiding public policy formulation
Credit rating facilitates to impose a restriction on nationalized commercial banks, development banks and other public financial institutions about the composition of funds to be invested. In other words, the kinds of securities eligible for inclusion in different kinds of institutional portfolios can be developed with utmost confidence.
7. Monitoring the management actions
Hiring of credit rating agency indicates that the management is prepared to expose its various activities to an independent scrutiny. So, credit rating lends credence to the efficiency of the management.