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Ratings agencies — Why they are important

09 Jul 2015 - {{hitsCtrl.values.hits}}

In the past, a few companies engaged a credit rating agency as they dealt with what they knew. Banks would lend to companies who they were familiar with or to local households, whose behaviours they could easily understand and predict, despite not knowing them individually. Most individuals bought financial products from companies and governments from their own country in their own currencies.

Today, the opinion of a credit rating agency plays an important role in financial markets due to the growth in capital markets, credit derivative markets, globalization of capital markets and an increase in regulatory use of ratings. Any mistake in the credit rating process has an immediate and significant impact on buyers and sellers of credit. Thus, it can affect the overall performance of the financial markets.

Growing importance of rating agencies
The key role of credit rating agencies in financial markets is to help reduce information asymmetry between lenders and investors and also assess creditworthiness of companies and countries. Their role has expanded with financial globalization and the development of Basel II, which incorporates the credit ratings into the rules for setting weights for credit risk. As financial markets become more complex, there was a growing need for investors in financial securities to make sense of the multitude of risks and its interconnectivity.

There are three major rating agencies, which are Moody’s, Fitch and S&P (Big Three) and they wield tremendous power. The threat of a downgrade by one of these agencies can have a significant impact on a country and as an individual. A poor sovereign rating of a particular country can affect the country’s currency, stock markets, government bond prices, the rate at which it can borrow from the international market and overall confidence in the market.

Criticisms of credit rating agencies
The lack of competition in the financial rating industry allows these agencies to charge substantial fees from its issuers. There are more than 150 rating agencies worldwide. However, companies need at least one of the Big Three to add credibility. Rating agencies have been blamed for contributing to financial turbulence by underestimating risks. For example, high ratings been given to low quality assets such as risky mortgages, which have contributed to credit market bubbles that have collapsed in the crisis. This is a result of rating agencies been funded by the companies that they rate which creates a conflict of interest. This is because it gives the agency an incentive to give businesses the rate they want and would not question the risks they take or the accuracy of their accounts.

Independence is a necessary criterion for rating agencies and has received criticism due to the issuer paying for their rating. The issuer is likely to become a subscriber and pay for future ratings if they receive a high rating today. Furthermore, policies on advising clients on the impact of different management strategies on the company’s rating would further deteriorate independence.

Rating decisions are based on fixed documented standards and their evaluations are essentially opinions. These opinions are difficult to verify by court as they are based on non-verifiable, non-auditable information. Rating agencies have been criticized for their lack of diligence and bad decisions over the past few years. As regulators and institutions depend on these ratings, rating agencies are less likely to downgrade especially during a crisis.

Ratings are ‘hardwired’ into several regulatory and investment judgments, in other words any change in ratings tend to cause a ‘herding’ effect where small shifts in a rating can give rise to a significant increase in sales or worsening of an unfortunate situation. Thus, there are significant dangers in the current system.

Conclusion
Therefore, regulators need to take steps to eliminate the issuer-pay business model in order to reduce conflict of interest. One of the best ways to deal with this conflict is to improve transparency of their rating methodology and performance. Furthermore, investors should decide how they want to use the ratings.
However, smaller firms would find it difficult to deal with this new arms-length approach to rating agencies due to the lack of in house resources and expertise to do their own analysis. Thus, it is important that rating agencies improve their quality of work as firms and individuals depend on their opinion to take investment decisions. Promotion of competition is also good. However, that may require policy action at national and international level to encourage the establishment of new agencies and to channel business generated by new regulatory requirements.

(Cathrine Weerakkody is a graduate in financial management from the UK and a CIMA passed finalist)

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Ratings agencies — Why they are important

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