Credit Discipline Article from SMERA ratings

1. CREDIT DISCIPLINE – THE WAY FORWARD
Author: Parag Patki - Chief Executive Officer
Foreword
The role of credit rating agencies (CRA) in assessment of credit risk and its
mitigation is universally recognised. CRAs have played and continue to play a
critical role in the development of debt markets. This role has led global banking
regulators to advocate the use of rating systems by banks for assessing credit risk.
One such regulation is the Basel Accord, which requires banks to use external
credit ratings in assessing credit risk. As a result, the relationship between credit
ratings by rating agencies and credit assessment by banks has deepened. Banks
are now increasingly relying on external credit ratings for making lending decisions.
Credit discipline is an important factor considered while assessing the ability or
intention of the borrower/issuer to honour debt obligations in a timely manner.
The norms in evaluating credit discipline are stringent and require a rating agency
to closely monitor the repayment track record of a borrower. This article explains
the challenges of credit discipline and highlights the need to inculcate better credit
discipline amongst borrowers.
Differing perceptions on credit discipline
Credit discipline broadly implies timely repayment of debt obligations. While this
definition is simple, a dichotomy emerges in adoption of default definition by CRAs
and banks. A bank would declare a borrower as a non-performing asset (NPA)
account (often viewed as default as per the borrowers’ understanding) only after he
is unable to service his interest and principal payment over a sustained period of
time, whereas credit rating agencies would assign default rating to a borrower if he
has missed payment even by a single rupee or a single day for long-term loans and
a fixed period for short-term loans. For instance, under banking, an asset is treated
as non-performing asset (equated with default) only when a scheduled payment
remains overdue for a period of more than 90 days.
While each of these approaches has merits, the impact on the borrower differs. Risk
management systems of banks are often geared to manage and mitigate losses
arising from NPAs; hence, the early warning systems in banks are geared towards
NPA reporting. Consequently, banks exert greater pressure on a borrower to repay
as the account moves closer to NPA. While NPA denotes a loss sustained by the
bank as a result of continuous default by borrower, a lower or a default rating by a
CRA implies that a bank has taken a higher risk on its book and hence needs to set
aside higher capital for contingency. This is the fundamental tenet on which the
Basel accord is based. Thus, NPAs have a loss implication and defaults have a
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2. CREDIT DISCIPLINE – THE WAY FORWARD
Author: Parag Patki - Chief Executive Officer
capital implication for banks (see table 1). Moreover, due to differences in defining
defaults, it is probable that borrowers that have been assigned default category
rating may not fall under NPA classification of banks.
Table 1: Key differences between NPAs recognition by banks and default
recognition by CRAs
Earlywarning systems of CRAs Earlywarning systems of Banks currently being
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DEFAULT (CRAs) NPA (Banks)
Missing payment by a single rupee
or a single day in servicing a
scheduled debt obligation.
Continuous default for a sustained
period (continuous non-payment of
dues for 90 days).
Implication for providing capital
against the risk.
Ensuring loss provisions are made
against a risk.
Globally recognised definitions of
default, adopted by RBI.
RBI defines prudential regulations
with respect to NPA recognition.
Consistently applied across global
banks and debt markets.
Applied only in the Indian banking
system.
Direct implications for financial
systems.
Implications on financial systems
through banking channels.
More forward-looking. More historical analysis based.
Infographic 1: How Default and NPA are different from a systemic perspective
1 day
delay
DEFAULT
used
Stretched liquidity,
weakning economic
scenario, increasing
debt
30-60
day
delay
Earlywarning now being suggested by RBI for use in banks (Discussion Paper on
Early Recognition of Financial Distress - Link)
Higher systemic risk Higher banking risk
http://www.rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=715
90 day
delay
NPA
The infographic above indicates that ‘default’ is an early warning signal of a stress
in the account as compared to NPA. Differing definitions of default prevailing
currently could delay meeting the end objective of Basel accord viz. scientific
allocation of risk based capital in the banking system. RBI, in its recent papers,
has also underscored the importance of early identification of default risks. Hence,
it can be fairly assumed that the banking system could see, sooner than later,

3. CREDIT DISCIPLINE – THE WAY FORWARD
Author: Parag Patki - Chief Executive Officer
policy level changes towards instilling early warning systems in recognising stress
for risk based allocation of capital.
Need for borrowers and lenders to acknowledge default in stringent terms
The ‘one day one rupee’ default criterion is in line with Basel regulations, which
derive credit risk weights and probability of default from globally accepted practices
(see box 1 for the risk weights suggested by Basel II). These practices have been
consistently applied in debt markets across all countries. The criteria are stringent,
universally accepted and consistent. Default definitions across markets follow the
‘single rupee; single day norm’, which means that a borrower will be classified as a
defaulter even if he misses a term loan repayment by a single rupee or a single day.
Over time, the definitions of default have evolved to become stringent because of
the need to identify early warning signals of financial stress. This identification
gives time to the policy makers to enact proactive regulations to prevent stress and
thus protect the financial system (see box 1 for default definition prescribed by
RBI). The relevance of early warning signals has only increased after the financial
crisis of 2008 given the integrated nature of the global financial system. The crisis
has brought forth the need for relooking at regulatory oversight in the financial
system (including rating agencies) and a closer scrutiny of lead indicators of stress.
Credit rating by CRAs is a 360-degree evaluation of the borrower’s credit profile.
These ratings factor in industry risk, business risk, financial strength and
management capabilities of the borrower. Thus, credit rating is not only an opinion
on default but also an indication of the borrower’s overall creditworthiness. A rating
not only fulfills a regulatory requirement but also gives the banker an independent
opinion on the borrower’s credit profile. Consequently, banks attach importance to
credit ratings while extending credit. Borrowers thus need to be aware of the
implications of external credit ratings for the sustainability and growth of business
given the evolving regulatory landscape in an increasingly integrated financial
world.
Why credit discipline is a step in the right direction for borrowers:
As financial system integration increases, the need for consistency in approach to
risk (globally accepted) also increases. Hence, a move towards stringent globally
accepted default definitions is a step in the right direction. Moreover, borrowers are
diversifying their sources of finance and are increasingly tapping capital markets
for funding needs (see chart 1)
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4. CREDIT DISCIPLINE – THE WAY FORWARD
Author: Parag Patki - Chief Executive Officer
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15.0%
14.0%
13.0%
12.0%
Chart 1: Corporate debt and CP to GDP (at
current prices) India
2010-11 2011-12 2012-13 2013-14
http://www.sebi.gov.in/sebiweb/ and SMERA research
The above chart implies that diversity in funding sources is increasing in India.
Also, as increasing number of Indian entities seek international funding; it becomes
prudent for borrowers to adopt international standards of credit discipline.
Availability of different funding sources is important from two perspectives viz.
availability of funds and cost of funds. India is witnessing rapid growth in sources
of funding, be it private equity, SME exchanges, country specific funds,
multilaterals or foreign investors. This implies that supply of funds is getting broad
based and credit evaluation standards are becoming stringent and globally aligned.
Thus, credit ratings play a critical role in risk assessment, and more so if the
default definitions are based on global standards. The opinions by CRAs are
already enabling local borrowers to access funding from diverse sources. This is
facilitated by publicly available independent opinion, which a prospective lender
can easily access from the CRA’s website.
Accordingly, whether it is from a regulatory or a funding diversity perspective,
credit discipline (as enunciated by globally accepted standards) is fast becoming
the norm. Consequently, companies which exhibit credit discipline often tend to
have an edge as compared to others.

5. CREDIT DISCIPLINE – THE WAY FORWARD
Author: Parag Patki - Chief Executive Officer
BOX 1: REGULATIONS WITH RESPECT TO DEFAULT AND RISK WEIGHTS
Default definition as laid down by RBI vide communication no. DBOD.BP.N/5378/
21.06.007/ 2012-13
 For the facilities having a pre-defined repayment date/due date, the definition
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of 'one day one rupee' may be adhered to.
 For revolving facilities like cash credit, CRAs may allow, as of now, grace
period up to the maximum of 30 days from the date of overdrawal, beyond
which an entity would be considered to be in 'default'.
 After the default is cured and the loan facility is regularized, the CRAs should
upgrade the rating only if the rated entity shows satisfactory track record for
at least of 90 days i.e. three months from the date of default. Generally in such
cases, the rating would move to non-investment grade after curing.
Proposed risk weights as per BASEL II
Rating Basel II – Probability of
default
AAA and AA 0.1
A 0.3
BBB 1.0
BB 7.5
B 20

6. CREDIT DISCIPLINE – THE WAY FORWARD
Author: Parag Patki - Chief Executive Officer
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Business development contacts:
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Ratings Sales
Tel: +91-22-6714 1193
Cell: +91 98191 36541
Email: sanjay.kher@smera.in
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Tel: +91-22-6714 1177
Cell: +91 99300 74009
Email: virendra.goyal@smera.in
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Operations
Tel: +91-22-6714 1107
Cell: +91 98192 93790
Email: ashutosh.satsangi@smera.in
Umesh Nihalani – Head, Corporate Ratings,
Tel: +91-22-6714 1106
Cell: +91 98336 51336
Email: umesh.nihalani@smera.in