Updated Jan 31, 2022

What Do Rating agencies Do?

What do rating agencies do?

A rating agency evaluates a company's or government entity's financial strength, particularly their ability to make principal and interest payments on their loans. A credit rating provided to a debt shows an agency's belief in the borrower's ability to meet its debt commitments as agreed.

Rating Agency

Each agency uses its letter-based assessments to determine whether a debt has a low or high probability of default. The risk of a company, industry, financial institution, or entire economy collapsing or failing is referred to as RiskSystemtic. It is the possibility of a catastrophic financial system failure, in which capital providers lose faith in capital users and the issuer's financial health, resulting in a crisis. Sovereign nations, local and state governments, special purpose institutions, businesses, and non-profit organizations are all possible debt issuers. 

Credit bureaus came under fire during the 2008 Global Financial Crisis for granting high credit ratings to debts that later turned out to be high-risk ventures. They failed to detect dangers that would have alerted investors to avoid certain obligations, such as mortgage-backed securities. Mortgage-backed security (MBS) is a type of financial instrument that is backed by a mortgage or a group of mortgages. An MBS is an asset-backed security that allows investors to profit from the mortgage business and is exchanged on the secondary market.

Rating agencies have also been chastised for alleged conflicts of interest with securities issuers. Because rating agencies are paid by the individuals who pay their salaries, they may be hesitant to award very poor ratings to securities issued by the persons who pay their salaries.

The Big Three Credit Rating Agencies

The credit rating business is dominated by three large agencies, which control 95% of the market. Moody's Investor Services, Standard and Poor's S&P –is a financial intelligence firm based in the United States that is part of S&P Global. S&P and Fitch Group are market leaders in the (S&P) and Fitch Group, respectively. Moody's and S&P are both headquartered in the United States, and they control 80% of the global market. Fitch has offices in both the United States and London, and it controls around 15% of the global market.

Morningstar Inc. has been steadily increasing its market share in recent years, and it is predicted to be among the "top four rating agencies" shortly. The top three agencies were designated as the Nationally Recognized Statistical Rating Organizations (NRSRO) by the US Securities and Exchange Commission (SEC) in 1975.

Following the global financial crisis, the top three agencies came under fire for assigning good ratings to insolvent institutions like Lehman Brothers. They were also criticized for failing to spot hazardous mortgage-backed securities, which contributed to the collapse of the US housing market.

The main three rating agencies were accused of being accomplices of the 2008 financial catastrophe in a report named "Financial Crisis Inquiry Report." To counter the big three's market dominance, Eurozone governments have pushed financial institutions and other businesses to conduct their credit assessments rather than depending on the big three rating agencies.

Rating Agencies' Role in Capital Markets

The credit risk of individual debt securities and borrowing entities is assessed by rating agencies. In the bond market, a rating agency assesses the creditworthiness of debt securities issued by governments and enterprises on an independent basis. One or two of the top three rating firms assign ratings to large bond issuers. In the United States, agencies are held liable for losses incurred as a result of faulty or misleading ratings.

The ratings are used in asset-backed securities, mortgage-backed securities, and collateralized debt obligations, among other structured finance transactions. Collateralized Debt Obligation (CDO) is a synthetic financial product that combines multiple loans and is sold in the market by the lender. At the end of the loan period, the holder of the collateralized debt obligation can theoretically collect the borrowed amount from the original borrower. To assess structured financial products, rating agencies look at the type of pool underpinning the asset and the intended capital structure. Rating agencies are paid by structured product issuers to not only assess the products but also to advise them on how to arrange the tranches.

Sovereign borrowers, who are the largest in most financial markets, are also rated by rating agencies. National governments, state governments, municipalities, and other sovereign-supported entities are examples of sovereign borrowers. A rating agency's sovereign ratings indicate a country's ability to repay its debt.

Governments in emerging and developing countries can use the ratings to sell bonds to domestic and international investors. Governments sell bonds to raise funds from other governments and Bretton Woods institutions like the World Bank and IMF.

Benefits of Rating Agencies

Banks use the agency's ratings to establish the risk premium to be imposed on loans and bonds at the consumer level. A bad credit rating indicates that the loan has a greater risk premium, which leads to an increase in the interest rate given to people and businesses with bad credit. Borrowers with a strong credit rating can readily borrow money at a lower interest rate from the public debt market or financial institutions.

Companies wanting to issue security must choose a rating firm to rate their debt on a corporate level. The rating service is provided for a fee by rating organizations such as Moody's, Standard and Poor's, and Fitch. Investors use ratings to determine whether or not to purchase a company's securities.

While financial intermediaries' ratings can be relied on by investors, a financial intermediary is an institution that works as a mediator between two parties to effectuate a financial transaction. Commercial banks, investment banks, mutual funds, and pension funds are examples of financial intermediaries. And underwriters, ratings supplied by international agencies are deemed more reputable and accurate since they have access to a wealth of information that is not publicly available.

Investors rely on credit rating firms' ratings to make investment decisions at the country level. Many countries sell their securities on the international market and having a strong credit rating can help them gain access to high-value investors. Other types of investments, such as foreign direct investments, may be attracted to a country with a positive ranking.

Furthermore, a low credit rating or a country's relegation from a high to a low credit rating can deter investors from buying the country's bonds or making direct investments. The European sovereign debt crisis was exacerbated in 2010 when S&P downgraded Greece, Portugal, and Ireland.

Credit ratings are also beneficial to the growth of financial markets. Rating agencies calculate risk for a variety of companies, allowing investors to assess the credit risk of various borrowers. Institutions and government entities can obtain loans without having to undergo extensive assessments by each lender.

Rating agencies also act as a reference point for financial market laws. Certain public entities are now required by law to hold investment-grade bonds with a rating of BBB or above.

Conclusion

Rating agencies are corporations that specialize in evaluating the credit risk of both public and private companies that use capital markets to finance themselves. The ratings are used to assess the solvency of these businesses and the possibility that they will be unable to meet their financial obligations. The rating also serves as a standard for investors, allowing them to assess the risk involved with their decisions and, as a result, the amount of compensation they can seek.