In a recent communiqué, the UAE’s Securities and Commodities Authority (SCA) reiterated its aim of introducing credit rating regulations as part of UAE’s vision of having a well-developed, investment-conducive and resilient financial system. The proposed regulations are likely to address issues related to licensing and workings of credit rating agencies (CRAs) and contribute in encouraging the local fixed income market.
Credit ratings are considered as an integral pillar of both public and private debt markets and therefore understanding this concept is vital for participants. They are forward looking opinions about the relative credit worthiness of an obligor.
As these ratings are assigned by independent entities, this reflect their judgement on the capacity and willingness of a borrower to honour obligations. These can be issued for a host of different types of borrowers, such as financial institutions, corporations and municipal/provincial as well as state level government entities.
These are termed as issuer level ratings.
Similarly, credit ratings may also be assigned to a specific debt obligation, which would provide an opinion about the credit quality of that debt issue alone. The rating opinion takes into account many macro- and micro-level fundamentals such as economic trends, industry factors, historical performance and an obligor’s exposure to risk factors like credit, market, liquidity, business, etc.
Their relevance is dependent on the nature of entity being analysed. For example, in the case of an FMCG, business risk may be more relevant, while for a commercial bank, credit risk and market risk may carry a higher weightage in determining its credit ratings.
Some of these factors are volatile in the short term, while others may change over a relatively longer term. This brings in the rationale for allocating both short and long term ratings.
Credit ratings are conceptually allocated on point in time or through the cycle basis. The former approach refers to a rating allocation process in which a rating agency is likely to take into account both cyclical and permanent default factors to assess the current repayment capacity of an obligor.
In the latter, agencies are expected to differentiate between transitory trends and permanent factors affecting the default risk.
Credit ratings have the potential to be an extremely powerful tool in channelling funds for UAE-based businesses. A rated entity will have ease of access to external funding, notably from capital markets and thus lowering the reliance on financial intermediaries.
Therefore, presence of a credit rating framework will boost local businesses and enabling them to raise debt capital at a competitive cost. This is not only true for large-scale businesses but small and medium size businesses can also benefit.
Although, at this point it is difficult to speculate about the proposed framework, a mandatory SME rating regime will be beneficial in promoting and disciplining the SME credit market. While more than 90 per cent of the corporate sector comprises of SMEs, a very limited number has access to external credit due to high default likelihood.
An SME rating from an independent CRA will help banking firms to differentiate between lemons and plums and ease pressure on the lending portfolio. Further, this will enable local banks to preserve capital as rated exposures require less capital charge under Basel guidelines.
Therefore, on a larger spectrum, credit rating regulations will complement the recently approved bankruptcy laws in enhancing the economic efficiency of UAE.
Apart from financial institutions, credit ratings are extremely useful for local investors as an indicator of the risk level associated with various instruments. By creating an ordinal scaling of securities and bonds in the market, ratings allow the distinction between “Investment Grade”, “Speculative” and “Junk” categories.
Risk averse investors may prefer to limit their exposures to investment grade instruments, while risk seekers may aim for high yielding speculative securities. The ratings allow investors to compare risk levels of composite securities and financial assets within their portfolio.
In the end, certain caveats should be taken into account. Credit ratings are strictly an opinion and should not be confused as facts. Hence these ratings cannot be labelled as being accurate or inaccurate.
It is also important to recognise they only provide one dimension of risk and are beneficial as a part of the decision making toolkit rather than being the sole criteria.
The writer isDirector of Industry Interface Projects at SP Jain School of Global Management.