What is a Rating Agency?

Ashok, Priya, and Pavan are friends.

One day, Ashok asks Priya for a loan. Priya gives him the money. However, Ashok is not able to repay the loan. Priya loses her money.

A few months later, Ashok asks Pavan for a loan. Pavan does not know about Priya’s loss and therefore he also ends up lending money to Ashok (and losing it).

Along comes Suma. She tells the children of the colony that she will collect the information of these loans and if someone wants to check that information, they can do that.

Now, Suma knows who has repaid whom and who has not.

She starts giving them badges. For example, if a child always returns the money within a week or so, he is a Golden bade holder. Someone who returns in about 10 days is a silver badge holder, and so on.

What Suma has done is called rating.

She checks the transactions of every child and gives a rating that tells other children who reliable s/he is.

Since she is an independent person – neither a borrower nor a lender – everyone trusts her.

This is called a rating system.

The Case of the Hoopin Fixed Deposit

There is a small company called Hoopin.

They want to raise some money.

The bank tells them that they can borrow money, but at 14% interest.

So, Mr. Sharma, the CEO of Hoopin, decides that he will take the money from the public and offer them 8% interest per annum on their deposits. This is 2% higher than what they might earn in a fixed deposit, and 6% less than what Hoopin would have to pay a bank. A case of win-win, apparently.

But, is Hoopin to be trusted?

Their deposit issue is checked and rated by an independent organisation. The organisation can check many things and finally give a rating. This rating tells the investors whether their money is safe in this fixed deposit.

The independent body that comes and does this checking is called a rating agency.

Rating is a very specialised job because many people depend on that rating to make financial decisions. It is also a job that requires that the agency should be independent.

Which is why rating is done only by specific organisations who are qualified to do this work.

CRISIL, Moody’s, Standard & Poor’s, Fitch are some of the important rating agencies.