A credit rating is an assessment published by a credit rating agency of the creditworthiness of a financial entity (issuer rating) or a particular financial instrument (issue rating). Users of credit ratings typically include institutional and individual investors, lenders, and public regulators. Credit ratings are not to be confused with credit scores assigned by consumer reporting agencies to represent the creditworthiness of individual consumers. Credit rating agencies assign credit ratings to private entities (corporations and financial institutions) and public entities (municipalities, states, sovereign governments, and supranational entities) operating domestically or internationally. Rated instruments include, among other things, bonds, commercial paper, bank deposits, loans, and structured debt instruments.
The value added of credit rating agencies is to produce independent credit analysis. Credit ratings are calculated as the likelihood of a default occurring over a short-term or long-term period, and they are expressed as alphanumerical grades on an ordinal scale. The rating scales used by major credit rating agencies display rating grades in inverse order of default likelihood, from lowest (“AAA”) to highest (“C” or “D” according to the rating nomenclature) (see Table 1).
Table 1 Credit Rating Agencies’ Rating Scales
Since their emergence in the early 20th century in the United States, credit ratings have spread internationally to every corner of the financial world to become pivotal reputational intermediaries for private and public (including sovereign) financial entities. This entry first gives a brief history of credit ratings since they originated in the United States in the early 20th century. It then discusses rating methodologies and credit rating agencies’ business models. Finally, it examines the significance of ratings in regulatory frameworks.
Brief History of Credit Ratings
The roots of credit ratings can be traced back to commercial ratings, a form of credit information provided by U.S. mercantile agencies, the 19th-century precursors of credit rating agencies. In the mid-19th century, these agencies (e.g., Bradstreet’s, Dun) collected information about the ability of merchants to pay their debts and made a profitable business of converting this information into ratings. The ratings were then compiled into “reference” books and sent to agency subscribers.
As quantified measures of business reputation, commercial ratings possessed many desirable qualities: They were simple to understand, unambiguous, comparable, and built on systematic procedures of data collection. This form of credit information was eventually imported into the bond market when John Moody published the first credit rating in 1909. The first ratings by Moody’s were applied to railroad securities. Moody’s later expanded its rating coverage to include public utilities, municipals, and industrials in 1914. Poor’s in 1922 and Standard Statistics and Fitch in 1924 began issuing credit ratings for all four industries. From the mid-1920s, most large issues were rated by these four ratings agencies. After 1941, when Standard Statistics merged with Poor’s, creating Standard & Poor’s, three ratings were typically available.
The emergence and development of credit ratings during the interwar period is the by-product of several important changes affecting the structures of the U.S. capital market. The rise of securities markets in the early 20th century contributed significantly to transforming the scope and nature of investment practices. Securities markets, which often implied making investments “at a distance,” inevitably created problems of trust and information asymmetry between lenders and borrowers. For investors, bonds and securities also demanded a continuous process of information gathering: In addition to placing money, trading shares, and hoping for a profit, investors had to keep a steady eye on market fluctuations and price variations. Therefore, this new market environment increased the propensity of market actors to use credit ratings in lending and borrowing transactions as a means to ascertain economic facts and maintain trust and transparency in trading networks.
After 30 years of exponential growth, ratings eventually lost their appeal during the postwar era. Stable exchange rates and strict capital controls imposed under the Bretton Woods system of monetary management (1944–1971) contributed to make the bond business more predictable. With the retrenchment of international capital transfers and the virtual elimination of systemic risk, the demand for ratings decreased. For three decades, credit rating agencies stopped issuing sovereign ratings except for a handful of highly creditworthy countries, and the number of corporate rating issuances decreased significantly compared with pre–World War II issuance levels.
Rating Methodologies and the Business Models of Credit Rating Agencies
In the mid-1970s, the demand for ratings began to grow again, in the United States and internationally, due to the conjunction of several factors. First, the opportunities associated with deregulation precipitated borrowers with poor or no credit history into the pool of new market entrants and contributed to reopening the market for high-yield (“junk”) bonds, which had been closed for nearly three decades. Second, the issuance of complex financial instruments resulting from a securitization process meant that investors possessed little information about the underlying quality of securitized loans. Third, the revival of international capital markets brought about the problem of informational asymmetries typical of investment decisions made at a distance. With these trends (deregulation, disintermediation, and technological change) converging in the early 1980s, investors began (once again) to care about the ratings given to the securities they purchased.
Today, some 130 credit rating agencies assess the trustworthiness of hundreds of thousands of debt instruments in more than 100 countries and representing as much as $30 trillion of debt issued. Three credit rating agencies (the “big three”) dominate the multibillion-dollar industry. Standard & Poor’s and Moody’s are the two largest agencies, with 41% and 38% of the market share, respectively. Fitch comes a distant third (14%) and often serves as a tiebreaker when Standard & Poor’s and Moody’s issue similar ratings.
Although credit rating agencies have seen their business grow significantly since the 1980s, the information input that they use to generate credit ratings has changed only marginally since the interwar period. As stated in credit rating agencies’ official rating methodologies, corporate ratings reflect the purposeful combination of business and financial risk factors, and the ratings of public entities include, in addition to information reflecting macroeconomic fundamentals and prospects, a qualitative assessment of government resolve and credibility. However, notwithstanding the relative stability in rating criteria, the process by which credit rating agencies compute and publish ratings has evolved significantly into an ever more complex system of weights, ramps, mathematical procedures (for structured debt instruments), and market signals to warn subscribers that there is a possibility of a short-term rating change (commonly referred to as “credit watches”).
Another important change affecting the rating industry was during the 1970s, when credit rating agencies decided to charge the entity seeking a credit rating for itself or for its debt issues rather than imposing a fee on investors. Until then, investors had paid credit rating agencies to access rating information. Several reasons contributed to this transition from an investor- to an issuer-payer business model, one of which being the “free-riding” problem coinciding with the introduction of information-sharing technologies (e.g., fax machines and photocopiers), which made it easier for nonsubscribers to access the rating material that subscribers had paid to acquire. While this change in business models contributed to make the rating business profitable again, it also created conflicts of interests between credit rating agencies and issuers.
Finally, a last important development affecting the role of credit ratings as reputational intermediaries has been their utilization in regulatory frameworks. Since the 1970s, financial regulators in the United States and abroad have increasingly relied on ratings to carry out their tasks of market surveillance. Today, the practice of using ratings in market regulations is so widespread that it has become a tacit rule. Because credit ratings are hardwired into regulatory frameworks, a broad variety of market actors therefore feel compelled, and are often legally complied, to use ratings in market transactions. Thus, credit ratings are not simply information intermediaries between issuers and borrowers; they are also means of market governance that regulators use to monitor financial processes.
Regulatory Reliance on Credit Ratings
This section provides a selective overview of regulatory reliance on ratings in the United States, focusing on provisions pertaining to (a) the regulation of capital reserve requirements, (b) limitations of economies of scale, (c) restrictions on the types of investments, (d) the computation of differential disclosure requirements, (e) central banking operations, and (f) the use of ratings in private contracts.
- Regulators use rating-implied formulas to adjust capital reserve requirements to credit risk exposure. For instance, banks are required to set aside more capital against their holding of noninvestment-grade securities, but they can also receive a discount on their capital reserve requirement if their securities have a high credit rating.
- Regulators also use ratings to control economies of scale. For instance, banks are permitted to establish financial subsidiaries only if they have a high rating.
- Regulators use ratings as risk-sensitive restrictions on the types of investments financial institutions are permitted to issue or make. For instance, in structured finance, regulators impose rating eligibility conditions on the issuance of complex financial instruments. In addition, financial institutions whose activities are deemed sensitive for the public interest (e.g., pension funds and insurance companies) are obliged to invest only in the instruments with the highest ratings.
- Regulators use rating-based formulas to compute differential disclosure requirements and modulate the imperative of transparency according to creditworthiness, as measured by credit rating agencies. This means that the SEC can require a financial institution with risky investments to disclose more information about its operations in its quarterly reports than a firm with a lower risk profile would be required to disclose.
- Finally, regulators have also found in ratings a method for introducing conditional features in monetary policies. In the United States, the Federal Reserve System uses ratings to place limits on the liquidity it can either inject or absorb when conducting open-market operations. For instance, for assets other than U.S. treasuries and securities issued or guaranteed by government agencies, the Federal Reserve System accepts or buys in its open-market operations only AAA-rated securities.
- Another form of legal use of ratings lies in the extensive use of rating triggers in private contracts, notably in the over-the-counter derivatives markets. Rating triggers can force a borrower to post additional collateral if the borrower subsequently fails to maintain its rating.
Credit ratings are pivotal reputational intermediaries for private and public financial entities. The 2008 financial crisis has, however, revealed numerous problems affecting credit rating agencies, including corruption, conflicts of interest, and profit-driven behaviors, all of which have contributed significantly to undermining the informational quality of ratings. In the run-up to the financial crisis, these structural problems resulted in credit rating agencies bestowing generous ratings to debt instruments that were defaulting at a much higher rate than anticipated.
The recent crisis also highlighted several important problems associated with the regulatory reliance on ratings. The incorporation of ratings into financial regulation creates a market distortion that artificially boosts the value of obtaining a rating. In other words, it is regulatory compliance, and not informational content, that often makes ratings valuable for investors and borrowers. This, in turn, has the pernicious effect of reducing credit rating agencies’ incentives to “get it right” and publish accurate ratings.
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