Credit Rating Agency – Definition

Cite this article as:"Credit Rating Agency – Definition," in The Business Professor, updated April 9, 2019, last accessed October 19, 2020, https://thebusinessprofessor.com/lesson/credit-rating-agency-definition/.

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Rating Agency Definition

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 company’s position in honoring debts obligations.

A Little More on What is a Rating Agency

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 Moody’s Investor Services, Standard and Poor’s (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 nation’s 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.

References for Rating Agency

Academic Research on Rating Agency

The effect of bond rating agency announcements on bond and stock prices, Hand, J. R., Holthausen, R. W., & LEFTWICH*, R. W. (1992). The journal of finance, 47(2), 733-752. Rating agency announcements on bonds and stock prices are identified to have effects on stock returns as a negative or abnormal stock returns can occur in two days. This paper seeks to examine the significant changes associated with daily excess bond returns based on rating agency announcements. The study also finds out that announcements of additions to Standard and Poor’s Credit Watch List, and downgrades by both Moody’s and Standard and Poor’s also affect stock returns. This paper also examines the additions based on Reliably nonzero average excess bond returns, whether they are needed or not. It studies the effects of rating agency announcements of bond price effects.

Private ordering of public markets: The rating agency paradox, Schwarcz, S. L. (2002). U. Ill. L. Rev., 1. The roles of rating agencies in ordering financial markets or public markets are examined in this paper. Despite that rating agencies are private institution that are unregulated, they have significant influence on capital markets, investments, financial securities and public markets at large. This paper highlights the profound economic impacts of credit rating agencies on global finance.  However, regardless of the fact that rating agencies have influence on the global economic system, they have been subjected to diverse criticisms. In summary, this paper discusses the regulation of rating agencies and whether the regulation is needed or not. The ability of nations to regulate these entities is also examined.

The role of rating agency assessments in less developed countries: Impact of the proposed Basel guidelines, Ferri, G., Liu, L. G., & Majnoni, G. (2001). Journal of Banking & Finance, 25(1), 115-148. The Basel guidelines are international frameworks and sets of reforms in response to credit crisis that are aimed at improving the regulation, supervision and risk management within the banking sector. This paper examines the role of rating agencies assessments and the impact of the Basel guidelines in less developed countries. This includes the assessment of the impacts for less developed countries or NHICs in bank capital asset requirements as proposed by Basel guidelines. It also examines how corporate ratings in non-high-income countries (NHICs) are linked to their ratings.

 

Rating risk after the subprime mortgage crisis: a user fee approach for rating agency accountability, Manns, J. (2008). NCL Rev., 87, 1011. Part of the criticisms against rating agencies is the fact that there is conflict between their interest and those of debt issuers. Also, the absence or regulations and accountability is also levied against rating agencies. This paper examines how the above listed points are factors that cause false assurance on risks posed by subprime mortgage-securities and collateral debts. It also studies the effects of SEC-administered user fee system in exchange for enforceable rights. Plausible suggestions for an effective reform for rating agency that will positive impact the primary beneficiaries of risk rating are also presented in this paper.

What Standard of Care Should Govern the World’s Shortest Editorials?: An Analysis of Bond Rating Agency Liability, Husisian, G. (1989). Cornell L. Rev., 75, 410. Rating agencies do not like being held responsible for the shortcomings of their ratings, but after the global financial crisis that occured in 2008, rating agencies could not longer avoid rating liability. This is an analysis of bond rating liabilities touching on their effects on bond returns as well as stock prices.

Rating agency actions and the pricing of debt and equity of European banks: what can we infer about private sector monitoring of bank soundness?, Gropp, R., & Richards, A. J. (2001). Economic Notes, 30(3), 373-398. Using a survey of European banks, this paper studies the actions of rating agencies and their effects on the pricing of debt and equity of these banks. In a previous paper, The Basel committee suggested that external assessment of the credit risk of bank’s assets be conducted. For this assessment to occur, external rating agencies need to come on board. Tis paper studies the rating change announcements by international rating agencies using samples from European banks. This study also examines the effects of unexpected rate changes in equity prices and bond bond returns.

Rating agency actions around the investment-grade boundary, Johnson, R. (2004). The Journal of Fixed Income, 13(4), 25-37. As a result of the 2008 global financial crisis, many companies lost trust in the abilities of credit rating agencies to identify risky investments and financial insolvency of borrowers. The failures of US big rating agencies however compounded the existing trust and competence issues against rating agencies. This gave rise to questions whether rating agencies are slow to spot firms’ problems or they are largely incompetent to do so.  This paper examines and compares rating data from nationally recognized statistical rating organizations (NRSROs) and from a non-recognized agency. The findings of the study are highlighted in this paper.

The Rating Game: Explaining Rating Agency Failures in the Buildup to the Financial Crisis, Dennis, K. (2008). U. mIAmI l. rEv., 63, 1111. This study gives explanation to rating failures by credit rating agencies and how these failures contributed to the global financial crisis. The study identifies that rating agencies tend to underestimate the risks of mortgage-backed securities and how they are responses to legal, regulatory and capital incentives. The rating game exhibited by rating agencies between 2001 and 2006 are studied. This paper studies the impacts of rating inaccuracies and failures in credit and financial institutions. The study aso highlights global financial crisis were preceded by rating behaviours exhibited by these agencies.

Downgrading rating agency reform, Manns, J. (2013). Geo. Wash. L. Rev., 81, 749. Given the shortcomings of rating agencies, discussions on how to reform and enhance the accuracy and accountability of the agencies emanated. The Dodd-Frank Act was passed with its promises to cause a reform in the rating agency but disappointingly, two years after the passage of the act the reform expectations are unmet. This article examines how a cogent concern in the rating industry which is the need to design an alternative for the issuer-pays system that addresses the conflicts of interest between rating agencies and debt issuers is left unaddressed. This article presents approaches and methodologies that the Securities and Exchange Commission can employ to enhance accountability, competency and accuracy of rating agencies.

Rating agency adjustments to GAAP financial statements and their effect on ratings and bond yields, Kraft, P. (2010). Unpublished working paper, New York University. This paper examines how credit rating agencies have adjusted to the financial statements of GAAP (Generally Accepted Accounting Principles) and the effects of such adjustments on ratings and bond returns. The quantitative adjustments of these firms are discussed. Aside from adjusting to GAAP statements, rating firms also adjusted to Moody’s credit rating process. This paper examines the Moody’s hard and soft rating adjustments and how they are related to higher or flatter credit spreads. The levels or ratios of the adjustments are also examined.

Credit rating agency downgrades and the Eurozone sovereign debt crises, Baum, C. F., Schäfer, D., & Stephan, A. (2016). Journal of Financial Stability, 24, 117-131. The Eurozone debt crisis refers to the European debt crisis which has been occurring in E.U since the end of 2009, though, it’s impact was felt between 2010 and 2012. Downgrades and negative outlook announcements create rating shocks between currency value and sovereign bond yields. This paper examines rating agency downgrades and how this constituted to a debt crisis in EU. How downgrades and negative outlook announcement impacted the Euro value are considered. The reaction of the Euro’s value on the rating announcements from Moody’s, S&P and Fitch CRAs during the Eurozone debt crisis were also analysed.

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