A credit rating agency is a company that grades how likely a company, a government or a particular bond is to repay its debt on time. The grade is called a credit rating. In India, credit rating agencies must be registered with SEBI.
A rating is written in letters. Indian agencies use a scale from AAA, the safest, down to D, which means that the borrower has already defaulted. Ratings of BBB- and above are called investment grade. Many funds, pension funds and insurers may buy only investment-grade bonds, or only small amounts of anything rated lower.
The rating sets how much interest a borrower must pay. A bond is a loan that investors make to a company or a government. Say two companies each want to borrow ₹500 crore for five years by issuing bonds. The company rated AAA may pay about 7.5% a year. The company rated A may have to pay about 9.5%, because investors want more interest for taking more risk. On ₹500 crore, that gap of 2% costs ₹10 crore a year.
How does an agency decide? Its analysts study the borrower's accounts, its debt, its cash flow and its industry. They also meet its managers. A rating committee then votes on the grade. After that, the agency keeps watching the borrower and changes the grade if its position changes. A rating does for a company what a credit score does for a person. But it is decided by a committee of analysts, not calculated by a formula.
Ratings are used in many places. Lenders that bundle many loans together and sell the bundle to investors usually have each bundle rated. This is called securitisation. Every rating appears on a financial data terminal. A fund's investment management system uses ratings to check the fund's limits. A fixed deposit and bond platform shows the rating next to every bond that it sells to ordinary investors.
The large agencies also sell risk analytics. These are data and models that banks use to measure the risk of their loans. Banks also use the ratings of agencies accredited by the RBI to work out how much capital they must hold against their loans to rated companies. They report these capital figures to the RBI in their regulatory reporting.