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Background to credit rating agencies (CRAs)

Join this course to consider credit rating agencies (CRAs) and how they form a key part of the financial ecosystem.
Credit score report concept

Credit rating agencies (CRAs) form a key part of the financial ecosystem.

They traditionally provide an independent assessment of the ability of a borrower to pay back debt by making timely principal and interest payments and the likelihood of default. They review the vast amount of data available to investors today – some of it valuable, some of it not –and play a useful role in helping investors and others sift through this information and analyse the credit risks they face when lending to a particular borrower or when purchasing an issuer’s debt and debt-like securities. Issuers seek ratings – and pay for them, in order to broaden their investor pools or simply to establish risk benchmarks. It is an iterative process which requires close collaboration between the CRA and the issuer for a rating(s) to be delivered. Frequent company visits and communication with a dedicated team within the issuer is typical. The issuer will choose which CRA to work with and how many individual CRAs to provide their risk opinions.

Investors typically have investment parameters that dictate the risk the fund owners are comfortable to take. They use the ratings in their decisions to buy, sell or hold securities by helping them to assess the risk of investing in debt securities. The assigned risk score will affect the pricing that lenders will offer and investors will require to participate in any offering.

Credit risk ratings can apply to individual companies, countries, corporate bonds, mortgage-backed securities, credit default swaps and collateralised debt obligations. They can be assigned separately to both short-term and long-term obligations. Long-term ratings analyse and assess a company’s ability to meet its responsibilities with respect to all of its securities issued. Short-term ratings focus on the specific securities’ ability to perform given the company’s current financial condition and general industry performance conditions.

Credit ratings

The three major credit rating agencies are Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings. These agencies use a standardised scale to rate the creditworthiness of issuers, with AAA being the highest rating and D being the lowest. The rating given can be used to determine whether the security is an investment or a speculative risk. Thus, AAA is seen as the industry standard as the highest rating, and AAA, AA, A and BBB are widely seen as investment-quality securities and ratings of BB or below are speculative grades which denote a higher credit risk or risk of default in the underlying security, but this often comes with a potentially higher return on an initial investment.

While they use alphabetical ratings, CRAs will often not give a numerical probability to the risk of default such as 10%, 20% or 30%. Instead, they will use statements such as ‘the obligor’s (borrower’s) capacity to meet its financial commitments on the obligation (to repay the lender) is extremely strong’.

The table below compares how the different CRAs assign their own long-term and short-term rating scores. There is a degree of consistency between each of the three CRAs which makes it easier for investors and other stakeholders to consider the ratings from different CRAs. The simplicity and comparability of the CRAs’ grading systems, with broad swathes of analyses condensed into a few pieces of data combined with their analytical strength and independence make CRAs indispensable for a range of different stakeholders.

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Source: Researchgate.net

Regulations

Effective regulation of CRAs is necessary to encourage high-quality credit ratings and increased accountability for CRAs.

Before the passage of the Dodd–Frank Wall Street Reform and Consumer Protection Act in 2010, securities regulations required funds to maintain certain ratings supplied by nationally recognised statistical rating organisations (the formal designation regulators have given CRAs). Many believed this led to a “captive market” in which the issuer-pay business model of traditional CRAs created potential conflicts of interest. Critics believe these conflicts led to credit ratings that were flattering issuers who were paying for them —in return for repeat assessment business and higher fees rather than an accurate assessment of credit and default risk.

As a result, regulators in many jurisdictions including the US, the EU and the UK have taken steps to address these concerns:

• made CRAs liable for faulty ratings

• removed statutes and regulations requiring use of credit ratings

• increased oversight of internal controls

• increased transparency about ratings methodologies and performance.

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