The Role Of Rating-Agencies Essays Example
Credit rating is the assessment of the creditworthiness of debt instruments based on credit rating agencies’ assumptions, analytical models, and expectations. It reflects the agency’s subjective judgment of the issuer’s management and business. In that respect and given that modern business and finance world is subject to numerous risk factors, rating agencies are becoming crucial players in the capital and financial markets. That owes to their ability to analyze the bulk and complex information necessary to provide a judgment on instruments or business risk. In that view, this discussion seeks to demonstrate that rating agencies can help to overcome the problems caused by asymmetrical information in various markets. To achieve that objective, the discussion covers the functions of the rating agencies and explains the relationship that exists between various players before the contract. The discussion also explains the users of the agencies information, who pays for the information and whether the system is adequate in allocating roles. Finally, the discussion explains the asymmetric information problem that the agencies face with recommendation of how the problem can be addressed.
The function of rating agencies in the capital market and the relationships between the different actors in the market.
The aim of credit rating industry is to offer valuable investors information about firms which need financing. Because of the asymmetric information between the investors and firms, credit rating always has a pivotal impact on the company`s financing outcomes. In ha view, credit rating agencies provides global investors with a well-informed analysis of the risk related to debt securities. These securities include certificates of deposit, government bonds, corporate bonds, collateralized securities, preferred stock, and municipal bonds, such as mortgage-backed securities and collateralized debt obligations. The investment riskiness of these securities is determined by the probability that the debt issuer; be it a bank-created, entity corporation, local government or sovereign nation, will not make timely payments on the interest on the debt. (Alessi, C. Wolverson & Aly, 2011) The agencies also have key functions including the critical role ha was played in the marketing of risky mortgage-backed securities, like collateralized debt obligations, which resulted in bringing the U.S. financial system to its knees. The credit rating purpose is, therefore, to reduce informational asymmetry between the investors and issuers of a debt instrument and to improve the capital allocation. That is because the rating process constitutes of qualitative, legal analysis and quantitative and CRAs use discrete rating categories to express their credit ratings. (He, Qian, & Strahan, 2011)
With increasing complexity and volume of financial markets - for instance with the increase of structured finance products like the collateralized debt obligations - the reliance of both regulators and investors on credit ratings has rapidly grown over the last years. The issuance of rated debt instruments globally increased enormously from roughly US$ 3,500 to US$ 8,000 billion in the year 2002 to the year 2006 - whereas structured finance products contribution was a 27% compound annual growth in that period. In that view, the agencies condense huge amount of information into a single symbol, which is determined primarily by the expected loss of a debt instrument. (Deb, Manning, Murphy, Penalver & Toth, 2011) They use qualitative analysis that considers the issuers’ competitiveness within its industry, quality of management, the expected growth of the industry, and its vulnerability to regulatory changes, technological changes, and labor relations. The main concern with quantitative analysis is the financial analysis of the issuer. (Kiff, Nowak & Schumacher, 2012)
For capital markets, credit ratings are an important component and have functioned effectively for almost a century in the United States. The purposes of credit ratings are also flourishing and growing several countries abroad with the global capital markets development. Credit ratings help the market to assess efficiently and effectively and evaluate credit risk, benchmark issues, price debt securities, and for those issues create a robust secondary market. Hence, CRAs seem to have enormous market influence like on the investor’s informative value and merits for debt issuers since otherwise there would be no importance for debt issuers to use the money for expensive rating fees. However, in the recent past, CRAs have once in a while been criticized for their in transparent rating procedures, for publishing inaccurate credit ratings and have been involved in corporate and financial scandals many times. (Krantz, 2008)
The agencies also have a role in the supervision of financial institutions thus serving a
Public function; both in the US and EU. In order to cover various risks in EU,
Financial institutions have a requirement for holding a minimum amount of their financial resources. These requirements insure against unexpected losses thus protecting depositors as well as contributing to overall financial system’s stability. The ability of credit rating to critically serve the key capital market is its meeting the greatest standards of integrity, credibility, objectivity, transparency, independence, and quality. In conclusion, the agencies’ role is underlined by the fact that central banks usually require assets to have a minimum rating acceptable as the collateral for the financial institutions in their borrowing from the Central Bank. For instance, European Central Bank has had a requirement for marketable assets to have a minimum of one BBB- credit rating from among the four accepted rating agencies. (Arezki, Candelon & Sy, 2011)
Users of the information provided by rating agencies and those who pay for the service they provide at the moment and adequacy of the roles allocation.
Investment banks are key users of the agencies information. In the past, collections of individual mortgages have been bundled by investment banks, which is hard to trade in baskets that can be bought and sold as any bonds. The financial instruments are sold to investors with investment banks counting on receiving stellar ratings from the agencies. For the securities, commanding a top price isn't the only focus, high ratings have been crucial in allowing the banks easily sell them. For example, many money fund markets only agree to invest in debts that fit the highest rating categories. (Bank for International Settlements, 2005)
Borrowers and lenders are also key users of the agencies information. The rating agencies compresses large variety of information needed to be known in evaluating the creditworthiness of bonds and other financial instruments issuers. Thus, the agencies contribute to solving the principal-agent problem by helping the lenders address the asymmetric information surrounding lending relationships while helping the borrower tackle the information. (Arezki et al., 2011)
Investors are also significant users of the agencies’ information. In making investment decisions, the agencies’ ratings reports and industry trend reports are useful tools that provide investors with crucial information about businesses and investment options as they may offer alternative points of view to those of financial advisers. The agencies ratings enable comparison of risks among investments in portfolios. By considering scores of multiple agencies, is useful as they may offer different views on an investment’s creditworthiness. In general, the agencies ratings act as a supplement and not a replacement for investors’ analysis, research and judgment in determining whether investments satisfies their needs. That is because he ratings only address credit risk and do not address several other risks including interest rate risk, liquidity risk, and market risk. (Krantz, 2008)
Thus, a crucial role is played by ratings in financial markets as investors make use of them to determine the credit risk of financial instruments. Specific knowledge is needed for the assessment of these instruments and is highly time-consuming, making it attractive for individual investors to depend on the CRAs. The ratings have a crucial influence on the rate of interest that borrowers have to pay. A higher interest rate on loans may result from downgrading. Benchmarking of portfolio manager performance is often checked against standard indices that are mainly constructed on the credit rating basis. This implies that immediate liquidation is triggered by a downgrade to below the investment-grade threshold resulting in herd behavior. Market volatility may be increased by this kind of behavior and may also even result in a sustaining-downward-spiral of asset prices with probability of negative impacts on financial stability. In that respect, the information is crucial for investors and fund capital market managers decision-making. (Adelson e al., 2009)
Other users include lenders that have granted credit and from who credit is being sought; cell phone, telephone, and utility companies which may provide services to firms and individuals. In addition, prospective employers and insurance companies that may issue or have issued an insurance policy may use the ratings while government agencies going through organizations financial status for the benefit of government may rely on the agencies information. Finally, anyone else and parties with a business need for information that is legitimate such as banks where businesses seek to open checking accounts. (Bank for International Settlements, 2005)
Payments For Agencies For Their Services
Different business models are used by credit rating agencies to generate revenue for the services they provide hence determining who pays for the information. The models include the Issuer-payer model is what one is known as and the other as the subscription model. (Fulghieri, Strobl & Xia, 2010 )
Issuer-Pay Model: The business model used by agencies such as the Standard & Poor`s under the issuer-pay model. Under the model, rating agencies charge structured finance arrangers and issuers a fee for providing credit ratings. These rating agencies obtain information from issuers as part of the rating process and incorporate into their opinions of quality of credit. The information might be unavailable to investors and other market community members. Since the issuer pays the rating, the agencies can make the ratings widely accessible to the market without charge. (Taibbi, 2013)
Subscription Model: Subscription model is used by some rating agencies and charges investors and other participants in the market a fee for access to their agencies’ ratings.
Roles allocation efficiency
Proponents of the subscription model maintains that since these agencies are paid by investors primarily rather than issuers, they are not subject to any conflict of interest during their credit risk assessment they are hence could be an efficiency role allocation model. On the other hand, where the issuers pay for the information, there is a big incentive for agencies to "bend their standard to gain business. Ha is the case especially the structured debt products that are vulnerable to inflation ratings for the businesses sake. If the economy short-circuited, these products would most likely fail, allowing credit-rating agencies the ability to claim that the downturn of the economic changed the facts. Although, from early 1970s, rating agencies have depended on an issuer-pay model, building a conflict of interest; the largest income source for the rating agencies are the fees paid by the very firms that are supposed to be impartially rated by the same agencies. Agencies are then tempted to rate them better than what fundamentals suggest, as pointed out by many during the recent subprime crisis. (Fuchita & Litan, 2006)
Further, issuer-pay model critics of maintain there is a potential conflict of interest when payments are received by rating agencies from the issuers whose evaluation on security are been done. In addition, the models critics, however, point out that many investors who subscribe to a rating service, mostly the sizable investors like hedge funds who have short and long positions in a several of securities, may have an undue influence on the rating results of agency since it is the interest of investors to have the ratings support their strategy for investment. Furthermore, subscription model critics assert that the ratings are available only to subscribers who are paying, who are mainly large institutional investors. Rating agencies that use the subscriptions model may have higher limited access to issuers. Management Information can be helpful when giving forward-looking ratings. (Fulghieri, Strobl & Xia, 2010 )
Problem of asymmetrical information that rating agencies face after contract conclusion with potential to challenge them in fulfilling their duties and how it can be solved.
When there is existence of credit quality asymmetry information, the promised cash payment can be used by the issuer to signal its cash flow and credit quality expectations. In particular, in the presence of costly bankruptcy and information asymmetry, firms with stronger cash flow expectations can commit to higher interim payments to differentiate themselves from those with weaker cash flow expectations, which cannot afford to commit to payments of higher coupon. It has been analytically shown that; in equilibrium, the information asymmetry presence makes fixed-coupon bonds more preferable than zero-coupon bonds, because of the unfavorable market beliefs that arise on the issue of credit quality of firms that offer zero-coupon bonds. Likewise, models were created where issuers use contract terms, involving the payment structure, showing mechanisms when credit quality information asymmetry exists.
They were someimes create models that are complex to calculate the default probability for individual mortgages and for the securitized products these mortgages make up. Raters deem that many of these so-called "structured" products were achallenge in top-tier triple-A housing boom period for several years and only worked to downgrade them when the market collapsed to below investment grade status. (Alessi, C. Wolverson & Aly, 2011)
On other cases, individual analysts made the rating decisions, not rating committees and compensation of the analyst could be based on their ratings. As for the issuer-pays system criticisms, the agencies maintained that the suffering of the subscriber pays rates was from their conflicts of interest. Investors may pressure for lower rating by the rating agencies because if the securities are deemed riskier, may pay higher yields. Negative rating may also benefit short-sellers financially. The Big three argued that the real issue then was not whether the system was subscriber-pays or issuer-pays, but how rates were transparent with the models they used. (Alessi, C. Wolverson & Aly, 2011)
There is also a classic mistake by the credit-rating agencies in thinking recent financial history likely to repeat therefore analyzes that rely on a lot of the recent past. The asymmetrical problem also entails uncritical profit incentive as well as over-reliance on ratings. (Schwarcz, 2002)
Uncritical profit incentive: Companies pay the credit-rating agencies that issue debt hence providing incentives for agencies to bend their rules to gain business. In case the economy short-circuits, these products would most likely fail, giving the credit-rating agencies ability to claim that downturn of the economy changed the facts. (Taibbi, 2013)
Over-reliance on ratings: Over-reliance on investors is one of the biggest reasons credit ratings hold so much sway. Many investors rather than doing their due diligence simply look at the ratings. Although that is a problem, they often have little alternative with many of the debt products were so complicated, and access to the individual loans portfolios details was is difficult. Additionally, two agencies had 86% of CDOs ratings, making them be perceived as more credible when they scored top ratings, Griffin says. (White, 2001)
Organizational Structure: Strong operational policies and safeguards lack are in place to assure operational independence of Standard & Poor's credit ratings services, both in appearance and in facts. In addition, strict firewalls were lacking to protect and prevent transmission of confidential information given to credit rating personnel to any non-ratings personnel. (Schwarcz, 2002)
Credit rating fees: As the need for more rating coverage is growing, and surveillance of credit rating costs related to them are increasing. Prior to that, subscription fees are the basis on which Standard & Poor's provided its service of credit ratings, which were not enough to offset increasing costs to maintain in this business a high level of quality. (Krantz, 2008)
Addressing the problem
Return to an investor pay is argued to be the most ancient way of aligning rating agencies incentive. Suggestion by careful analysis of the reforms being discussed currently is that, by themselves, if the model of current issuer-pay is maintained they will have insufficient impact. While returning to the model of pre-1970s investor-pay and free-riding, as well as interest conflict issue, are likely to be solved. Although free-riding is a problem, it is argued that increase in use of the agencies’ ratings by institutions accompanied by rise in speed of information diffusion as well as predominance of electronic trading over last few decades could ensure there are some investors willing to subscribe to the agencies ratings. The government supplementary could also supplement the investor pay revenue to ensure resources are sufficiently available to the rating agencies. For such government subsidy to be funded a ,small tax should be levied at the point of issue or on issuers. Rating licenses should be limited which provide a `right to rate' hence would be auctioned and the winner of the auction be entitled to tax pool portion payable in arrears and linked to the investor pay market share that they manage to achieve. Such a system would align incentives of the rating agencies to investors ensuring rating agency industry are commercially viable and would have suitable impact on primary issuance markets. Other suitable reforms are attempting to increase disclosure norms and regulatory oversight in order to tweak the system of issuer-pay making it more transparent while eliminating the above outlined inherent conflict of interest. Some of the major proposal reforms. (Carron, Dhrymes & Beloreshki, 2003)
The problem would also be addressed through lowering of barriers to entry into the industry, holding he agencies legally liable for their services, funding he agencies with tax payers funds, banning he agencies consulting services and are shopping. Further, all rating personnel should be subjected to McGraw-Hill's Business Ethics Codes and Poor's Credit Market Services as well as Standard Procedures and Guidelines. Finally, there should be standards designed to promote objectivity and independence of the process as well as ethical conduct for addressing perceived or potential conflicts of professional and personal interests. Finally, there should be increased monitoring for compliance with governmental rules and regulations that are applicable as well as enhancing protection of confidential information and avoidance of insider trading. (White, 2001) It is also required by McGraw-Hill's Code of Business Ethics that violations are reported, and Standard &Poor's Guidelines and Procedures affirmation of compliance is required annually. (Moody’s, 2006)
In view, if t he discussion, it is clear that rating agencies play a crucial role in the capital and financial markets. The agencies services are of benefit to various stakeholders hence having national, industrial and organizational benefits. The functions have been need to include compressing asymmetric information for the purpose of evaluating organizations and instruments creditworthiness. That helps businesses, investors and lenders to make guided decisions. On the other hand, the relationship between the parties before the contract signing entails collection of information and compressing it to arrive a suitable range of various aspects relevant to business creditworthiness. In regard to the agencies information users, investors, the instrument issuers, lenders, investment banks, government and other parties interested in accessing businesses and instruments creditworthiness information comprise of the key users. The information is paid for by various parties depending on the pay system applied by the agencies. When the issuers make payment, it presents a challenge as it could be an incentive for the agencies o provide suitable range rather than the actual position. When there is a subscription system, those in need of evaluating the instruments and businesses creditworthiness pay for the information; as system that has been identified as efficient in allocating roles compared to the issuer-pay model. Finally, the asymmetric information faced by the organization present a number of challenges and could affect the agency’s ability to deliver their duties owing to complexity as well as interest conflict. That can be addressed by ensuring suitable market regulation and pay systems in addition to measures such as lowering barriers to market entry and information access. Finally, information confidentiality protection has been identified as crucial.
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