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PACRA REGULATORY MECHANISM
The Pakistan Credit Rating Agency Limited
History:
The trend of establishing local rating agencies started only in the
1970s. Prior to this, the two international rating agencies, namely
standard and poor’s, and Moody’s investor service, dominated the
rating world. However, since the establishment of first known local
rating agency, the Canadian Bond Rating Services in 1972, local
rating agencies have proliferated across the globe, both in the
developed markets (Australia, France and Japan), and also in a large
number of emerging markets. Currently, there are 17 emerging
markets (Argentina, Brazil, Chile, Columbia, India, Israel, Korea,
Malaysia, Mexico, Pakistan, Peru, Philippines, Portugal , South Africa
, Thailand , Tunisia, Venezuela) were duly recognized local rating agencies are in operation. Of these
countries Pakistan joined the club in 1994, with the establishment of PACRA. It is interesting to note that
in several other important emerging markets including Turkey, East European countries and republics of
the former Soviet Union, rating agencies still have to be established or are in the process of being
established. The main motivation for the establishment of local rating agencies is the recognition of their
critical role in promoting or other fixed income securities markets. At the same time there is increasing
realization that rating agencies are likely to impart efficiency to the financial and capital markets.
PACRA stands for Pakistan Credit Rating Agency. It was first credit rating Company established in Pakistan.
It was established in 1994 between the joint venture of IBCA Limited (the international credit rating
agency), International Finance Corporation (IFC) and the Lahore Stock Exchange. The primary function of
PACRA is to evaluate companies’ willingness to fulfill its debt obligations. PACRA is geared to provide a full
range of credit rating services. This includes the rating of corporate entities and fixed income instruments.
The ownership and management structure of PACRA ensures complete independence from any direct or
indirect control of the Government, any private sector business group or financial institution. A rating
assigned by the rating committee, which includes senior management of PACRA, reflects PACRA's
objectively formed opinion of credit risk. Other rating reviews carried out by PACRA include Financial
Strength ratings of modarabas, Mutual Fund ratings and Insurer Financial Strength (IFS) ratings for
insurance companies.
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PAKISTAN CREDIT RATING REGULATORY FRAMEWORK
Establishment of PACRA in 1994 represents an important milestone in
the development of financial infrastructure in Pakistan. More
significantly, this signifies the fulfillment of all the ingredients
considered necessary for the establishment of local bond (TFC) market
in the country. In order to establish the sanctity and credibility of credit
ratings in the country, the regulators moved quickly for prescribing the
eligibility criteria for the establishment of credit rating companies and
also assumed the legal authority of monitoring the functioning of such
companies on a regular basis. This dual purpose which was achieved by the Corporate Law Authority
through an amendment in the Security and Exchange ordinance 1969, and notification of “Credit Rating
Companies Rules 1995”. The most significant eligibility condition for registration of a credit rating
company is a joint venture arrangement or technical collaboration with an internationally recognized
credit rating institution. PACRA having satisfied all the requirements under the rules stands duly registered
with the CLA. In order to provide to investors in fixed income securities (including TFC’s), the CLA has
made it mandatory for all such securities to be rated if the instrument is to be offered to the general public
and listed on the stock exchange.
Meanwhile, the SBP also recognized the potential benefit of credit rating in terms of augmenting the
supervisory role of SBP for monitoring the performance of the financial sector. It was therefore, made
mandatory for all Modarbas (an Islamic financial institution), leasing companies, as well as investment
bank to obtain credit rating. Under current regulations prescribed by the CLA – all Modarbas issuing COMs,
(CERTIFICATE OF MUSHARIKA) and all the leasing companies issuing COIs (CERTIFICATE OF
INVESTMENT)require to be rated on a continuing basis.
Mission of PACRA
To be accepted as the leading credit rating agency in the country
through highest standards of professionalism and ethics.
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Risk Evaluation
PACRA ratings reflect an independent, professional opinion of
the credit quality denoting the credit risk associated with a
particular debt instrument or a corporate entity. By providing
a measurement of risk, PACRA’s ratings facilitate investment
decisions. However, PACRA’s rating is not the
recommendation to purchase, sell or hold a security, in as
much as it does not comment on the security’s market price or
suitability for a particular investor.
PACRA’s Product of Rating:
PACRA’s spectrum of rating covers:
Instrument Rating
Structured Finance Rating
Entity Rating
Insurer Financial Strength Rating
Project Grading
Fund Stability Rating
Star Ranking /Fund Performance Ranking
Capital Protection Rating
Asset Manager Rating
Instrument Rating:
Instrument rating covers all non-equity instruments including TFC’s (long and short term), convertibles, debentures and redeemable certificates. PACRA’s rating process assumes that the return offered on such instruments (expected profit, makeup etc) is in the nature of a fixed obligation. Thus, in the case of TFC’s even though the issuing document refers to the return as ‘expected profit’, PACRA, in consonance with the shared perception of the issuer and the investor, deems this to be a contractual obligation for purpose of credit rating.
Structured Finance Rating:
PACRA has also developed the expertise of rating securities or structured finance debt instruments. Such instruments could have varying credit enhancement characteristics for reducing the default risk, the investment risk, or both. Structured Finance ratings focus mainly on evaluating the specific cash flows identified for meeting the repayment obligations and also the security arrangements. PACRA’s ratings are contingent on examining all the underlying documentation that gives effect to the purposed features of the instrument.
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While all ratings follow an interactive process, the degree of interaction between the client and PACRA is considerably more in such ratings than in standard instrument ratings. Consistent with international practice, PACRA is also prepared to review various options of credit enhancement and advise the client on the preferred option for achieving the desired rating.
Entity Rating:
Entity rating signifies the entity’s level of credit risk and the capacity for timely payment of financial commitments to senior unsecured creditors. The risk level is indicated by the long and short term ratings.
Insurer Financial Strength Rating:
The insurer financial strength (IFS) rating represents an opinion of an issuer’s financial strength and
business continuity from a policy holder's prospective. IFS rating capture the relative ability of the insurer
to meet policy holders' obligations. However, the rating provides no guarantee against default but offers a
well-researched opinion as to the likelihood of the issuer to fail to fulfill its obligations towards policy
holders. IFS rating is applicable to insurance obligations insofar as these are in compliance with the
company's stated policies and procedures.
Project Grading
The Project Grading (PG) is an opinion on a specific project being managed by any real estate entity. PG
differentiates projects on the basis of their individual attributes; the concept is that projects of the same
developer could have different grading; Although DG and PG have a high probability of linear relationship,
this could break to merit a different rating for the project depending upon its unique characteristics.
Fund Stability Rating
This is an opinion on the prospective relative stability in a fund’s return. The rating provides an objective
measure as to the main areas of risk to which the income and money-market funds are exposed. The risk
factors are: Credit Risk, Market Risk, Liquidity Risk, Returns Volatility, and Quality of Management and
Support Systems.
Star Ranking /Fund Performance Ranking
The Star Ranking measures performance of funds in a risk and returns combination, and then ranks the
funds accordingly on the basis of their performance. The ranking is a quantitative measure and funds are
rated within their respective categories. A fund’s particular ranking is computed with reference to its
category and consequently, rankings are comparable only in the same category.
Capital Protection Rating
Capital Protection Rating (CPR) is another rating class for mutual funds. CPR captures the relative extent
to which principal invested in the fund is secure from loss at the time of maturity. CPR is not a view on the
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fund performance; it is concerned with the fund performance only insofar as it is imperative to meet the
redemption of the principal amount at maturity.
Asset Manager (AM) Rating
Asset Manager (AM) Rating provides investors with an independent opinion on the quality and expertise
deployed by an asset management company and potential vulnerability to operational and investment
management failures. AM Rating differs fundamentally from credit ratings, which refer to the ability to
meet debt obligations. The focus of AM rating is to gauge the fund management capability of the asset
manager, as reflected from its operating platform, human resource base and the infrastructure that it has
erected. AM rating gives a view on whether the asset manager meets or exceeds the overall investment
management best practices, the benchmarks and standards in all criteria under review.
Rating Methodologies
PACRA‘s rating evaluation is reflected in its rating scale which is applicable to long-term and short-term ratings and is internationally recognizable. Fundamentally, the rating scale represents a decreasing order of risk. In determining the level of risk, a diverse range of complex data is collected and analyzed. This data is gathered primilary from the potential issuer or client and supplemented with strategic information obtained from outside independent, reliable sources. The rating process covers analysis of both quantitative and qualitative aspects including operations, finance, management and strategy. The factors considered by PACRA while forming its opinion include:
Industry Risk:
Industry risk is measured by the strength of the industry within the economy and relative to economic trends. This also includes the ease or difficulty of entering the industry, the diversity of earning base and role of regulation and legislation. The specific issues covered include:
Economic importance of the industry Potential for support Employment significance Industrial relations record Significance of legislation: protective and harmful, relationship with Govt. Maturity of the industry International competition Barriers to entry Competitive situation domestically: monopoly, oligopoly, fragmentation Nature of the industry: capital intensity, product life spans, marketing requirements Cyclic factors: demand, supply, implications for price volatility Industry cost and revenue structure: susceptibility to energy prices, interest rate levels, Govt.
policies Important developments and trends in the industry
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Market Position:
Market position covers the company’s market share in its major
activities and the historical protection of its position and projected
ability for the future. It also covers the company’s historical operating
margins and its ability to maintain and improve them. The specific issues
covered include:
Competitive position within the industry: size, market share & trend, price setting-ability
Major product importance
Product lives and competition
Degree of product diversification
Significance of R&D expenditure and of new product development
Geographic diversity of sales and production
Ownership and Support:
The ownership structure of the company, financial strength of the owners, potential for support and other tangible benefits are covered in this area. The specific issues covered include:
Ownership of the entity
Relationship with owners
Financial strength of owners
Potential for support or for funds with drawls
Structure of relationship
Other benefits: access to technology products
Access to capital markets
Management Evaluation
Management evaluation covers the record to date in operations and financial terms, corporate goals, attitude to risk, control system, experience and record control to peers. The specific issues covered include:
Record to date in financial terms
Corporate goals and outlook: aggressive stance, attitude to risk
Experience, background, credibility
Depth of management: key individuals, succession
Record compared with peers
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Accounting Quality:
This area covers an overall review of the accounting policies employed and consistency in their application. The specific issues covered include:
Reporting and disclosure requirements
Auditors and audit opinions
Revenue recognition policies: long-term projects
Stock valuation policies
Fixed asset valuation method
Goodwill and intangible treatment
Undervalued assets , such as free hold property
Debt/Equity hybrid instruments
Depreciation methods, rates , lives
Foreign currency treatment
Deferred taxation policy
Accounting for pension obligations
Treatment of finance cost
Contingent liabilities
Overall aggressiveness or prudence of accounting presentation
Unusual accounting policies , movements on reserves
Changing in accounting policies
Changes in group composition
Rating Process
Credit rating is an interactive process relying primarily on information and interaction with the rater. It
is supplemented with information obtained from outside independent sources. The entire process is
aimed at evaluating financial strength of an entity to timely meet its financial obligations. PACRA follows
a rigorous, objective and structured rating process at the onset of rating relationship to arrive at a rating
opinion. The rating process, subscribes to rigorous quality standards. PACRA has developed
comprehensive methodologies for different segments of entities – Banks, NBFCs, Insurance, AMCs, and
Corporate. We evaluate and analyze both qualitative and quantitative aspects and captures factors
affecting the entity in the short-term and long-term. Our analyses broadly focus on ownership and
governance structure of the organization, its management and control environment and evaluation of
business and financial risks.
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Steps in Rating Process
PACRA’s ratings process is designed to ensure that all ratings are based on the highest standards of
independence and transparency. At beginning of a new relationship, PACRA attempts to facilitate
understanding of the rating process by sharing concise overview of PACRA and all steps involved in the
process. The rating process progresses as follows – one step following the other until the finalization of the
rating opinion:
Mandate Letter
Following a request from the entity / issuer for a rating, a mandate letter is sent to the client. Usually the
processing time for sending the mandate is 1-2 working days on receipt of the request. Upon signing,
mandate letter becomes a contractual agreement between the entity / issuer to be rated and PACRA to
undertake a rating assignment. It has two separate mandates i.e.
1. Entity Rating Mandate
2. Fee Mandate
These mandates explain all the terms and conditions governing the rating relationship. The mandate is
perpetual in nature and valid unless terminated by either party with an advance notice.
Rating Assignment Allocation
The entity is allocated to one of PACRA's rating teams, each headed by a Unit Head. The Unit Head takes
the responsibility of supervising the rating assignment and designate it to its rating team. The initial
introductory letter or email is exchanged briefing the time line for completion of the rating assignment and
other modalities. Meanwhile, both PACRA and rate furnish contact information on the designated liaison
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person (s) for ensuring smooth and speedy communication. The respective sub team manager and analyst
take care of all aspects of the rating assignment as per the PACRA's guidelines.
Preliminary Analysis & Information Solicitation
A Preliminary study is conducted with a careful review of an entity's published information. From this
review, analysts determine what additional information and data are needed. A detailed questionnaire is
sent to the client for soliciting the required financial & non-financial information over and above that
provided in their financial statements and the notes to their accounts. Upon receipt of the information, an
initial rating assessment is made and discussed internally based on findings of the rating team. This would
be followed by a site visit and management meeting, preferably at entity's head office.
Site Visit
The respective rating team conducts entity's head office and/or plant visit. The objective of which is to
develop a better understanding of the organizational structure, and quality of the process, and conduct
interview of key department heads and establish a sense of control environment prevailing in the entity. A
detailed itinerary in advance is sent for the said visit.
Management Meeting
The purpose of Management Meeting is to assimilate the strategic view of the entity’s top management The
meeting is wide-ranging, covering the entity's ownership, governance, financial position, future prospects,
the economic environment and many other issues that can have a bearing on the rating. The participants
of the meeting include the respective rating team, Unit Head and members of apex rating committee from
PACRA and the senior management of the client including the Chief Executive Officer. Before heading for
the management meeting, a formal agenda is sent, highlighting the areas where we expect to have the views
and opinions of the entity’s top management. We expect to have a formal presentation for this meeting
covering, at a minimum, those areas highlighted in the agenda.
Draft Rating Report Review
Subsequent to the management meeting, a draft detailed rating report is sent to the entity's management
for their feedback on completeness and accuracy of the information contained in the report. If the report
containing anything which is confidential, the client is also expected to communicate the same. The
feedback is expected from the entity within five working days.
Rating Committee
A multi-layered, decision-making process is followed in assigning a rating. In finalizing the rating, the
relevant team prepares a rating proposal based on the information gathered through the questionnaire
and discussion at the Management Meeting and head office/site visit. This is presented to the rating
committee, comprising at least one apex, two permanent members and the rating team. The RC is usually
conducted within one week following the management meeting.
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Pre-Publication Review
Subsequent to the Rating Committee, PACRA provides rated entities with draft press release and one page
summary report in advance for pre-publication review. This is to avoid issuing any credit analyses that
contain misrepresentations or are otherwise misleading as to the general credit worthiness of an entity /
issuer.
Notification
Once the rating has been finalized, it is formally notified to the entity / issuer. The rating notification is
usually accompanied by a final set of rating report and press release.
Standard Rating Scale & Definitions
ASSET MANAGER RATING SCALE & DEFINITIONS
AM1: Asset manager meets or exceeds the overall investment management industry best practices and
highest benchmarks in all criteria under review.
AM2: Asset manager meets very high investment management industry standards and benchmarks with
noted strengths in several of the rating factors.
AM3: Asset manager meets high investment management industry standards and benchmarks.
AM4: Asset manager demonstrates an adequate organization that meets investment management industry
standards and benchmarks.
AM5: Asset manager does not meet the minimum investment management industry standards and
benchmarks.
CAPITAL PROECTION RATING SCALE & DEFINITIONS
AAA (cp): Exceptionally Strong certainty Capital Protection.
AA (cp): Very strong certainty of capital protection.
A (cp): Strong certainty of protection.
BBB (cp): Adequate certainty of capital protection
BB (cp): weak capital protection
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DEBT INSTRUMENT RATING SCALE & DEFINITIONS
LONG TERM RATINGS
AAA: Highest credit quality. ‘AAA’ ratings denote the lowest expectation of credit risk. They are assigned only in case of exceptionally strong capacity for timely payment of financial commitments. This capacity is highly unlikely to be adversely affected by foreseeable events. AA: Very high credit quality. ‘AA’ ratings denote a very low expectation of credit risk. They indicate very strong capacity for timely payment of financial commitments. This capacity is not significantly vulnerable to foreseeable events.
A: High credit quality. ‘A’ ratings denote a low expectation of credit risk. The capacity for timely payment of financial commitments is considered strong. This capacity may, nevertheless, be more vulnerable to changes in circumstances or in economic conditions than is the case for higher ratings. BBB: Good credit quality. ‘BBB’ ratings indicate that there is currently a low expectation of credit risk. The capacities for timely payment of financial commitments are considered adequate, but adverse changes in circumstances and in economic conditions are more likely to impair this capacity. This is the lowest investment grade category. BB: Speculative. ‘BB’ ratings indicate that there is a possibility of credit risk developing, particularly as a result of adverse economic change over time; however, business or financial alternatives may be available to allow financial commitments to be met. Securities rated in this category are not investment grade. B: Highly speculative. ‘B’ ratings indicate that significant credit risk is present, but a limited margin of safety remains. Financial commitments are currently being met; however, capacity for continued payment is contingent upon a sustained, favorable business and economic environment. CCC, CC, C: High default risk. Default is a real possibility. Capacity for meeting financial commitments is solely reliant upon sustained, favorable business or economic developments. A‘CC’ rating indicates that default of some kind appears probable. ‘C’ ratings signal imminent default.
SHORT TERM RATINGS
A1+: Obligations supported by the highest capacity for timely repayment. A1:. Obligations supported by a strong capacity for timely repayment. A2: Obligations supported by a satisfactory capacity for timely repayment, although such capacity may be susceptible to adverse changes in business, economic, or financial conditions. A3: Obligations supported by an adequate capacity for timely repayment. Such capacity is more susceptible to adverse changes in business, economic, or financial conditions than for obligations in higher categories. B: Obligations for which the capacity for timely repayment is susceptible to adverse changes in business, economic, or financial conditions.
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C: Obligations for which there is an inadequate capacity to ensure timely repayment. D: Obligations which have a high risk of default or which are currently in default.
FUND STABILITY RATING SCALE & DEFINITIONS
AAA (f): A fund showing a consistently outstanding performance with very strong capacity to respond to
future opportunities or stress situations.
AA (f): A fund consistently outperforming its peers with strong capacity to respond to future opportunities
or stress situations.
A (f): A fund with stable performance generally in line with its peers with adequate capacity to respond to
future opportunities or stress situations.
BBB (f): A fund with performance comparable to peers but showing a relatively higher volatility and lower
capacity to respond to future opportunities or stress situations.
BB (f): A fund with a below average performance and limited capacity to respond to future opportunities
or stress situations.
INSUERER FINANCIAL STRENGTH (IFS) SCALE & DEFINITIONS
AAA – Exceptionally Strong. Insurers assigned this highest rating are viewed as possessing
exceptionally strong capacity to meet policyholder and contract obligations. For such companies, risk
factors are minimal and the impact of any adverse business and economic factors is expected to be
extremely small.
AA-Very Strong. Insurers are viewed as possessing very strong capacity to meet policyholder and
contract obligations. Risk factors are modest, and the impact of any adverse business and economic
factors is expected to be very small.
A -Strong. Insurers are viewed as possessing strong capacity to meet policyholder and contract
obligations. Risk factors are moderate, and the impact of any adverse business and economic factors is
expected to be small.
BBB -Good. Insurers are viewed as possessing good capacity to meet policyholder and contract
obligations. Risk factors are somewhat high, and the impact of any adverse business and economic
factors is expected to be material, yet manageable.
BB - Moderately Weak. Insurers are viewed as moderately weak with an uncertain capacity to meet
policyholder and contract obligations. Though positive factors are present, overall risk factors are high,
and the impact of any adverse business and economic factors is expected to be significant.
B -Weak. Insurers are viewed as weak with a poor capacity to meet policyholder and contract
obligations. Risk factors are very high, and the impact of any adverse business and economic factors is
expected to be very significant. CCC, CC, C -Very Weak. Insurers rated in any of these three categories
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are viewed as very weak with a very poor capacity to meet policy holder and contract obligations. Risk
factors are extremely high, and the impact of any adverse business and economic factors is expected to
be insurmountable.
A 'CC' rating indicates that some form of insolvency or liquidity impairment appears probable. A 'C'
rating signals that insolvency or a liquidity impairment appears imminent.
DDD, DD, D -Distressed. These ratings are assigned to insurers that have either failed to make
payments on their obligations in a timely manner, are deemed to be insolvent, or have been subjected
to some form of regulatory intervention. Within the DDD-D range, those companies rated 'DDD' have
the highest prospects for resumption of business operations or, if liquidated or wound down, of having
a vast majority of their obligations to policyholders and contract holders ultimately paid off, though on
a delayed basis (with recoveries expected in the range of 90-100%). Those rated 'DD' show a much
lower likelihood of ultimately paying off material amounts of their obligations in a liquidation or wind
down scenario (in a range of 50-90%). Those rated 'D' are ultimately expected to have very limited
liquid assets available to fund obligations, and therefore any ultimate payoffs would be quite modest (at
under 50%)
REAL ESTATE PROJECT GRADING SCALE & DEFINITIONS
PG1: Very strong project execution capacity. The prospects of execution of the real estate project as per
plan are the most promising and the ability to transfer ownership as per terms is the highest.
PG2: Strong project execution capacity. The prospects of execution of the real estate project as per plan
and the ability to transfer ownership as per terms are highly promising. PG3 Good project execution
capacity. The prospects of execution of the real estate project as per plan and the ability to transfer
ownership as per terms are good. Project execution capacity can be affected moderately by changes in
the real estate sector prospects.
PG4: Adequate project execution capacity. The prospects of execution of the real estate project as per
plan and the ability to transfer ownership as per terms provide adequate comfort. Project execution
capacity can be affected severely by changes in real estate sector prospects.
PG5: Weak project execution capacity. The prospects of execution of the real estate project as per plan
and the ability to transfer ownership as per terms are poor.