Are Credit Rating Agencies useful?


Essay, 2018

8 Pages, Grade: 69%


Excerpt

Credit rating agencies are defined by Dittrich (2007) as companies which provide an opinion about the credit worthiness of a particular company, security or obligation by rating them on the basis of several parameters which are traditionally not publicly known. They also rate bonds issued by governments and municipal bonds specifying their ability to service their debts. On the contrary, according to Partnoy (2017) they usually provide an alphabetical letter score, which symbolises the forward-looking opinion of the credit rating agency on the credit worthiness of the rated obligor on a specific date. Therefore, the credit rating agencies are able to reduce information asymmetry by providing useful information to participants in debt markets and potential investors, which makes the credit rating agencies highly important as claimed by Utzig (2010). This transparency of information would otherwise not be available. On the other hand, Benmelech (2017) describes credit rating agencies as reputational intermediaries that bridge the information gap between issuers and investors by their ability to produce and accumulate credible information about debt issues. The score awarded by rating agencies enables the investor to decide whether or not to invest their money. The credit rating agency market is, as pointed out by Benmelech (2017), dominated by three big players as an oligopoly. Research by Partnoy (2017) and ESMA (2016) discovered that Moody's Investors Service Plc. and S&P Global Ratings Inc. (S&P) control the market with around 80 percent market share followed by Fitch Ratings Inc. which controls a further 15 percent.

Moreover, findings by Benmelech (2017) show that credit rating agencies play a main role in corporate financial policies and debt markets. Financial regulation has empowered the credit rating agencies, as stated by White (2010), by setting capital requirements for different risk classes of assets. However, the process of assessing a credit rating has become more unclear and highly ambiguous over time. Various downgrades of asset-backed securities raise a question about how they are derived, analysed by Benmelech (2017). Therefore, the author investigated all corporate credit rating actions issued by S&P between 1985 and 2015 to figure out on which parameters S&P based their corporate ratings. As a result, rating decisions made by S&P moved from being qualitative to being highly quantitative again in the last few years. Due to this fact, Benmelech (2017) has discovered that, generally S&P ratings are highly quantitative and can be forecasted with a high degree of accuracy using company characteristics. The author’s analysis suggests that credit rating decisions by S&P can be replaced by an algorithm that uses only ten quantitative financial variables which are publicly accessible. The result of this algorithm is very similar to those ratings issued by S&P, as illustrated by Benmelech (2017). The credit rating decisions of S&P rely, as studied by Benmelech (2017), heavily on financial data, which in some years account for more than 70 percent of the variation in the rating that can be predicted from the ten variables. Also, the author has discovered that credit ratings become more stringent over time. Conservatism in credit ratings exists and continued through 2015. His results show that rating standards were kept more lenient during the global financial crisis, and it is possible that ratings were insincerely held up to avoid even further downgrades. According to Benmelech (2017), there is a lack of competition among credit rating agencies which raises serious concerns about their working as the presence of only three credit rating agencies puts them in a position to lead the credit rating market.

Furthermore, Partnoy (2017) argued that credit rating agencies have an important role in financial markets because regulatory reliance on credit ratings effectively makes rating valuable as a sort of financial license which unlocks access to the market. He has the opinion that alphabetical letter ratings, as usually provided, are a crude instrument for information intermediation. Therefore, credit ratings provide little or no informational value, as found by Partnoy (2017). The author refers to studies which express scepticism about whether market participants can process complex financial information. Further, the author highlights that decades of regulatory reliance have perverted this potentially valuable function of credit rating, which is filtering, processing, sorting and condensing information. Credit rating agencies are a cautionary example of regulatory stickiness, meaning that trusting in ratings has proven difficult to undo. There are a few regulations, which partially addressed this regulatory licence problem, like Doff-Frank in the United States of America. However, many market participants continue to trust mechanistically on credit ratings, as Partnoy (2017) explains. According to Partnoy (2017) analysis of the global financial crisis of 2007 and 2008 reveals that credit rating agencies played a key role in initiating the crisis; they cleared the way for major financial institutions to use difficult and complex transactions to take significant exposure to subprime mortgage markets by giving risky financial instruments the best credit ratings. He discovered that credit ratings are still uninformative, as they were before the financial crisis. They have not changed much according to Partnoy (2017). The three credit rating agencies are rewarded handsomely and work as an oligopoly with special regulatory treatment. This oligopoly power allows extraordinary return rates. Partnoy (2017) specifies that these firms remain among the most powerful and profitable institutions in the world. The author suggests that neither regulators nor investors should rely on such crude and uninformative methodologies. Investors should respond by decreasing their reliance on credit ratings.

There are a lot of factors which raise questions about the way in which credit rating agencies are operating and their mechanism to issue the credit rating. As stated by Bongaerts (2014), credit rating agencies are paid by issuers which casts a distrust on their credibility as they can be biased towards the issuer when they are getting paid by them. The author suggests that to increase the level of trust placed on credit rating agencies, there should be a change in the system in which they are remunerated. Credit rating agencies should be paid by investors who put their money in securities rated by rating agencies instead of them getting paid by the issuer. A company that wants to get a rating by Standard and Poors (2018) has to pay them 6.75 basis points of the issuing debt with a minimum of 100,000 US-Dollars. The model by Benmelech (2017) is able to predict the score by S&P and therefore, questions can be raised about the credibility of the rating. How the credit rating agencies do business leaves room for conflict of interest, as highlighted by De Haan and Amtenbrink (2011), which is a fundamental problem, explained by Baresa et al. (2012). It arises from the two main objectives of a credit rating which are making profit and market regulation by reducing information asymmetry. As pointed out by Baresa et al. (2012), credit rating agencies are also engaged in providing previous consultancy on the capital structure of companies that are then assigned a credit rating review. The credit rating agency then has the opportunity to earn twice. First, it gives advice on how the issue of such securities will affect the credit rating, and then publishes a rating that confirms their advice. In my opinion, issuer paid credit rating agencies, due to the conflict of interest, should be banned or very tightly regulated. As argued by Utzig (2010) politicians are well aware of this and see the regulations primary objective as being to address the problem of conflicts of interests. Hemraj (2015) pointed out that the aim of regulation is to solve the problem of conflicts of interests. Credit ratings have a significant impact on the functioning of markets and the confidence of investors and consumers, found by Ioana (2014). Therefore, it is essential that credit rating actions are carried out with the principles of integrity, transparency, accountability and good governance to guarantee that credit ratings are independent, objective and of adequate quality. Baresa et al. (2012) stated an example of what the reaction of an investor would be who has bought a wrongly categorised security and realised losses on it. He would not have an opportunity to try to get compensation from the credit rating agency. If I assume different circumstances, the publisher orders and then pays for the credit rating, and earns a good grade, but objectively it is a worse grade. This situation benefits the publisher and the credit agency, but not the investor. According to Ryan (2012) there is a need to strengthen the accurateness of credit ratings and decrease systematic risk. Benmelech (2017) has the opinion that assessing a credit rating has become more unclear and highly ambiguous over time. Greater transparency of the criteria used by the credit rating agencies would make ratings more reliable and also prevent them from contributing negatively, as stated by Iyengar (2012).

Another point of criticism, mentioned by Benmelech (2017), is the lack of competition in the credit rating sector. Partnoy (2017) describes this market as an oligopoly which plays a key role in the financial sector. Strict entry rules make it difficult for new credit rating agencies to enter the market which is not desirable, as argued by Utzig (2010). He suggests that political intervention is required to clear the entry barriers for new participants into the market to promote a healthy competition. In my opinion, the regulator should intervene as soon as possible and promote active and fair competition. Large concentration on three companies in the rating business is leaving no room for new credit rating agencies with other business models and rating methods to enter the market. On the other hand, too much competition in the credit rating market is also not desirable for the quality of the financial market. If a company wants its issued debt to get rated, it has a minimum score in mind. In my view, the company can just go to another credit rating agency if it does not get its intended score. This would not be beneficial for maintaining market standards. The year 2008 illustrates a very good eyample: During the short period of a few months, 14 trillion US-Dollars of highly rated bonds fell into junk status, shocking the global financial system and speeding an economic decline, as found by Scalet and Kelly (2012). In my opinion, this fact is the reason credit rating agencies are considered as the main culprits in instigating the financial crisis of 2007 and 2008. The three big credit rating agencies found themselves under detractors, because of the role they played in the global crisis. They assigned high investment grades to financial institutions that had already begun to drop in 2008, as stated by Baresa et al. (2012). For example, just one month before the collapse of the investment bank Lehman Brothers, the bank was assigned good credit ratings. Besides Lehman Brothers, there were a lot of securities in the market with a very good category, which were related to the subprime loans that were almost worthless. Everyone relied on the ratings, which turned out as faulty in retrospect.

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Excerpt out of 8 pages

Details

Title
Are Credit Rating Agencies useful?
College
University of Strathclyde
Grade
69%
Author
Year
2018
Pages
8
Catalog Number
V426431
ISBN (eBook)
9783668709492
ISBN (Book)
9783668709508
File size
417 KB
Language
English
Tags
Credit Rating Agencies, Credit Rating, CRA
Quote paper
Moritz Meyer (Author), 2018, Are Credit Rating Agencies useful?, Munich, GRIN Verlag, https://www.grin.com/document/426431

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