What is a Rating Agency?

A rating agency is a private organization that evaluates the financial strength or weakness of companies and government establishments. A rating agency provides an assessment of the creditworthiness of debt securities in private and public companies, that is the agency assess the credit risk of debt securities of companies. This assessment include the ability of companies to pay principal and interest on their debts. A credit risk means a risk of default on debt as a result of failure of borrowers to make required payments. The rating also assesses a companys position in honoring debts obligations.

How Do Rating Agencies Work?

A rating agency is the same as a Credit Rating Agency, CRA, this agency identify credit risks through the assessment of companies abilities to meet principal and interest payments on debts. These agencies also examine the low or high default risk of debts and the stability of debt issuers.However, the financial crisis of 2008 gave rise to diverse criticism of credit rating agencies which include their failure to identify credit risks and high-risk investments. As a result of the financial crisis, conflict of interest between rating agencies and debt issuers or issuers of securities were also criticised.

Who are theCredit Rating Agencies?

Three Credit rating agencies dominated the rating industry, these are Moodys Investor Services, Standard and Poors (S&P), and Fitch Group. These three agencies take up to 80% of the global market. In 1975, these three dominant agencies were globally recognized by the U.S. Securities and Exchange Commission (SEC). This recognition gave the big agencies a new identity, they became the Nationally Recognized Statistical Rating Organizations (NRSRO), in that same year. Despite their reputations, the big agencies were heavily criticized for giving favorable ratings to institutions such as Lehman Brothers who are regarded as insolvent, meaning they were unable to pay debts owed. They were blamed for global financial crisis, failure to detect risky investments and credits as well as the 2008 financial meltdown. Rating agencies play huge roles in capital markets, these markets serve as avenues where suppliers and buyers raise capital through shares, bonds and other investments. CRAs are responsible for assessing and rating debt securities issued by governments and corporations as well as the solvency of companies who the credits are issued to. Financial institutions depend on the ratings of these agencies in making financial decisions such as asset-backed securities, mortgage-backed securities, and collateralized debt obligations. Due to the significant roles of rating agencies, credit or debt issuers pay these agencies to rate companies and also give professional advice. Rating agencies also account for losses that stem from inaccurate ratings. Rating agencies are beneficial not only for capital markets but also to a country and diverse sectors of a nations economy. A good rating enable borrowers to access loans from public debt institutions and other financial markets. A poor credit rating however signifies a high-risk loan and this results in increase of debts interest that issuers charged. For a corporate company that want to issue securities, it is important that a credit rating agency rates its debt. Also, investors rely on the ratings of CRAs before they make investments or securities decisions. The benefits of rating agencies are enormous as they serve as a benchmark for financial decisions.