The role of the credit rating agencies
(A blessing or a curse)
This report is examining the role of credit rating agencies and in further details arguments in its favor and against its favor are examined. In the beginning the role of credit rating agencies is defined and later methodological approaches to this topic are discussed, and afterwards, an analysis of pros and cons of credit rating agencies is conducted. To the end recommendations and suggestions to credit rating agencies for better performances are listed. Generally, credit rating agencies are playing vital role in markets and they united dispersed information comprehensively. Through this approach it is easier for investors or issuers to understand the real position of different concerns before taking any final decisions, beside this fact it is also in observation that credit rating agencies have some flaws which need to be addressed, like favoritism and unsolicited credit rating issuance. It is recommended to have transparency, scheduled active ratings and strict follow up with regulated authorities.
This report explores the role of credit rating agencies and their pros and cons on the financial industry. Further a detailed discussion on different arguments by different critics in the favor and against the role of credit rating agencies is provided. Some critics argue that credit rating agencies play vital role in the economy and some say that they are responsible for crisis, well these issues are explained in this report. In methodology pros and cons are listed along with analysis through various discussions by authors and analysts.
Still the mystery of credit rating agencies is under cover and it is not understandable that how their work is being evaluated and how markets perceive information issued by these agencies. But, the role of credit rating agencies increased over the time rapidly in last years’ due to the regulation of global capital like Basel II and Nationally Recognized Statistical Rating Organizations. These regulatory authorities keep the rating agencies under rules regarding ratings for investments and lending. In the recent years many research projects gathered different stylized facts about the process of rating assessments and their influence on investment decisions, but theoretically there are still many areas to be discussed.
In the practical world there are three major raters, which are; Moody’s, Standard & Poor and Fitch. These three agencies are comparatively more reliable than other small and medium credit rating agencies. Their ratings are acceptable by regulatory authorities. There is statement by Thomas Friedman (1996): “There are two superpowers in the world today. There is the United States and there is Moody’s Bond Rating Service. The United States can destroy you by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And believe me; it’s not clear sometimes, which’s more powerful.” So, we would say that credit rating agencies not only are providing information to investors but also playing a role as coordination between investors.
In general, CRAs employ various rating methodologies for the purpose to rate debt securities but generally they focus on the type of collateral underlying securities for example mortgages, residential mortgage backed securities (RMBSs), commercial real estate loans, credit card receivables, corporate loans and the proposed capital structure of the issuer trust. After having all this information CRAs assign one lead analyst and this analyst is responsible for the analysis of the above-mentioned data and for formulation of ratings and recommendations for a rating committee. This analysis includes assumptions as to how much “principal amount” would be recovered after a defaulted loan is foreclosed.
The ultimate purpose of all this analysis is to determine specific ratings for obligors under an in-depth analysis taken into observation by analyst. Usually AAA is the only case where default could be recovered 50 % of the principal amount of each loan in foreclosure and risk of default is normally 20%.
The above stated method is used to rate some obligors for investments or borrowings. After rating some obligors CRAs monitor their behavior and they modify ratings time to time according to the conditions of obligors or companies.
Here first argument is discussed in the favor of the role of credit rating agencies and then we will elaborate some cons against the role of credit rating agencies. There are conflicts about rating agencies that they work in favor, in simple they use the concept of nepotism and one example under this nepotism.
WorldCom shared a director with Moody’s and received favorable ratings even though its bonds were under investment grade, but agencies like Moody’s, Standard and Poor and Fitch said that we have managed these conflicts. Furthermore, all these agencies offered consulting services. These agencies adopted policies and procedures to separate their consulting and ratings functions, and Securities and Exchange Commission said that these agencies were selling very well.
According to S & P, “rating agencies played an important role in the development of the market since they were able to develop criteria to size default risk based on rates of the underlying obligors”. This method united the information for investors and made their decisions easier than before. Rating agencies comply strictly with the rules set by regulatory authorities and they issue after deep analysis of the obligor’s financial conditions and they scrutinize them in depth before issue ratings for them.
Credit rating agencies respond to market information carefully after an in-depth analysis of the events and then they respond, because it is difficult to behave upon anomalies in the financial markets and also it changes the volatility, so agencies keep every angle in their knowledge while rating obligors. These agencies often mention that their ratings are more valuable than their opinions as journalists. Three major agencies are offering risk management services, public and private firm credit scoring models, internal ratings systems services, and empirical data on default incidence, loss severity, default correlations, and rating transitions. This shows that these agencies are really active in financial markets and providing useful information to investors and issuers.
Now to discuss some arguments against the favor of the role of credit rating agencies. The most recent argument against the credit rating agencies is that in the last 5 years they performed very poorly and during this period economical crisis was prevailing, because credit ratings do not provide information on risk management among sophisticated market participants. After the poor performance by credit rating agencies the regulations came into power to regulate these agencies properly. There are some conflicts of interest between gatekeepers and top rating agencies are offering additional business services other than ratings and like consultations and these are restricted to small gatekeepers. There is big issue about these agencies that issuers pay them for their ratings instead to charge investors, so regulations are trying to mitigate this massive conflict of interest. Top three agencies are also involved in unsolicited ratings which are issued to issuers, but this is not yet certain that how often these unsolicited ratings were issued, and regulatory authorities are trying to minimize this effect.
- Quote paper
- Muddassar Rasheed Malik (Author), 2011, The role of credit rating agencies. A blessing or a curse, Munich, GRIN Verlag, https://www.grin.com/document/452311