Credit rating agencies

Credit rating agencies
Name	Credit rating agencies
Formation	18th–20th centuries
Type	Financial services
Headquarters	Global
Services	Credit ratings, research, surveillance

Credit rating agencies provide independent assessments of credit risk for issuers and debt instruments, influencing pricing, investment mandates, and regulatory capital across international finance. Major agencies produce ratings for sovereigns, corporations, European Central Bank, International Monetary Fund, and structured finance, affecting markets such as New York Stock Exchange, London Stock Exchange, and Tokyo Stock Exchange. Their opinions inform investors including BlackRock, Vanguard Group, Pension Protection Fund, and sovereign wealth funds like Government Pension Fund of Norway.

Overview

Agencies assign letter-grade opinions that signal default probability and relative creditworthiness for entities such as United States Department of the Treasury issuers, Republic of Italy, Kingdom of Spain sovereigns, municipal borrowers like City of Chicago, and corporate issuers such as Apple Inc., General Electric, and Toyota Motor Corporation. Ratings affect regulatory treatment under frameworks like Basel III, Dodd–Frank Wall Street Reform and Consumer Protection Act, and instruments traded on venues such as NASDAQ or in over-the-counter markets intermediated by dealers tied to Goldman Sachs, JPMorgan Chase, and Morgan Stanley. Major customers include asset managers, insurers like AIG, and central banks such as the Federal Reserve System.

History

The practice traces to merchant brokers in the 18th century and formalized with agencies like Moody's Investors Service (founded 1909), Standard & Poor's (successor to Poor's Publishing, consolidated 1941), and Fitch Ratings (1913). Growth of corporate debt markets, the expansion of Eurodollar markets, and postwar securitization triggered institutional reliance during periods including the Great Depression and the Global Financial Crisis of 2007–2008. Regulatory shifts from the Securities Act of 1933 and the Securities Exchange Act of 1934 to later acts such as Sarbanes–Oxley Act of 2002 and Dodd–Frank Act affected statutory roles and liability.

Methodology and Ratings Scale

Agencies publish methodologies that combine quantitative models and qualitative judgment, using financial statement analysis (ratio metrics for firms like Ford Motor Company), sovereign metrics (debt-to-GDP for Hellenic Republic (Greece)), and collateral evaluation for structured products like mortgage-backed securities and collateralized debt obligations. Scales include investment-grade (e.g., AAA/Aaa from top-tier agencies) to speculative-grade (e.g., BB/Ba and lower), with modifiers such as pluses, minuses, or numerical sublevels. Surveillance entails ratings transitions (upgrades, downgrades) driven by events such as restructurings seen in Argentine debt restructuring or fiscal changes in Portugal. Methodologies reference accounting standards like International Financial Reporting Standards and Generally Accepted Accounting Principles.

Market Structure and Major Agencies

The market is concentrated with a few dominant firms: Moody's Investors Service, Standard & Poor's, and Fitch Ratings; other notable participants include Morningstar, Inc. (via DBRS Morningstar), Kroll Bond Rating Agency, and regional firms such as Japan Credit Rating Agency and China Chengxin International Credit Rating. Clients span institutional investors (e.g., State Street Corporation, Northern Trust) and issuers such as Berkshire Hathaway or sovereign borrowers including Brazil and India. Interactions occur across infrastructure like Clearing House Interbank Payments System and over regulatory venues including European Securities and Markets Authority.

Criticisms and Controversies

Agencies have faced allegations of conflicts of interest when issuers pay for ratings, highlighted during disputes involving Lehman Brothers and the Global Financial Crisis of 2007–2008. Critiques include model failures in rating structured finance products tied to subprime mortgage pools, delayed downgrades in sovereign crises such as the Greek government-debt crisis, and legal settlements like actions brought by the United States Department of Justice and state attorneys general. Additional concerns involve the oligopolistic market power of the Big Three, potential procyclicality affecting banks under Basel II rules, and the role of ratings in episodes like European sovereign debt crisis.

Regulation and Oversight

Regulatory frameworks designate agencies as Nationally Recognized Statistical Rating Organizations in jurisdictions like the United States under rulemaking by the Securities and Exchange Commission. In the European Union, oversight is exercised by the European Securities and Markets Authority and national regulators in member states such as France and Germany. Reforms after crises included transparency requirements, internal control mandates, and measures to mitigate conflicts of interest, with legislation influenced by debates in bodies like the United States Congress and international standards from the Financial Stability Board and the International Organization of Securities Commissions.

Impact on Financial Markets

Ratings influence interest rates, capital allocation, and risk-weighted assets for banks under Basel III capital frameworks, affecting lenders such as Deutsche Bank and HSBC. Downgrades can trigger forced selling by funds subject to mandates from trustees like CalPERS or regulatory constraints in jurisdictions overseen by Prudential Regulation Authority. Conversely, upgrades may lower borrowing costs for issuers like South African Reserve Bank-regulated entities. The interplay between ratings, derivatives traded on platforms connected to Intercontinental Exchange, and investor behavior contributes to liquidity dynamics during stress events such as the 2008–2009 recession and episodic contagion across sovereign and corporate sectors.

Category:Financial services Category:Credit risk