A Credit rating agency (CRA) is a company that assigns credit ratings for issuers of certain types of debt obligations as well as the debt instruments themselves. In some cases, the servicers of the underlying debt are also given ratings.
In most cases, the issuers of securities are companies, special purpose entities, state and local governments, non-profit organizations, or national governments issuing debt-like securities (i.e., bonds) that can be traded on a secondary market. A credit rating for an issuer takes into consideration the issuer's credit worthiness (i.e., its ability to pay back a loan), and affects the interest rate applied to the particular security being issued.
The value of such security ratings has been widely questioned after the 2007-09 financial crisis. In 2003 the U.S. Securities and Exchange Commission submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest. More recently, ratings downgrades during the European sovereign debt crisis of 2010-11 have drawn criticism from the EU and individual countries.
A company that issues credit scores for individual credit-worthiness is generally called a credit bureau (US) or consumer credit reporting agency (UK).
Credit ratings are used by investors, issuers, investment banks, broker-dealers, and governments. For investors, credit rating agencies increase the range of investment alternatives and provide independent, easy-to-use measurements of relative credit risk; this generally increases the efficiency of the market, lowering costs for both borrowers and lenders. This in turn increases the total supply of risk capital in the economy, leading to stronger growth. It also opens the capital markets to categories of borrower who might otherwise be shut out altogether: small governments, startup companies, hospitals, and universities.
The Big Three credit rating agencies are Standard & Poor's, Moody's Investor Service, and Fitch Ratings. Moody's and S&P each control about 40 percent of the market. Third-ranked Fitch Ratings, which has about a 14 percent market share, sometimes is used as an alternative to one of the other majors.
In October 2011, a new collaboration based business model called wikirating was developed by Austrian mathematician Dorian Credé. The online community credit rating platform aims to provide a transparent source of credit rating information, reviewed by a worldwide commnunity. Users can vote on the rating of each country, company and structured product. Voting is limited to one vote each to prevent manipulation.
The rating contains the following five criteria (with weights):
- Public debt (in % of the GDP) — 50% weight
- Account balance (in % of the GDP) — 20% weight
- GDP growth rate — 10% weight
- Inflation rate — 10% weight
- Unemployment rate — 10% weight
The resulting value is adjusted by multiplying it with a "scaling factor", which is composed by the Human Development Index (HDI) (60% weight), the Corruption Perceptions Index (20% weight) and the Political Instability Index (20% weight).
The European Institutions have agreed on a political compromise involving a new EU law on credit rating agencies (CRA), after previous reforms were being criticised of being too weak and unduly worsening the credit status of countries. The presently agreed compromise for a new Directive will bring some important changes to the business of the agencies. However, many really strong measures have not survived the EU law making process. The political compromise between the Council and members of the European Parliament (EP) will have to be finalised on the technical level before being voted on during the Parliament’s plenary in January 2013.
The negotiations regarding the review of the Directive on credit rating agencies have been going on throughout the year. About one year after the European Commission had released its proposal, on 27 November, the EP, the Council of Ministers and the European Commission have finally reached a political compromise in their trilogue negotiations. However, it is not clear yet what the final text will be exactly. The different institutions only released press statements with the core elements of the compromise. The European Parliament, and other sources described it as follows:
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Transparency and sovereign debt ratings: Ratings about the creditworthiness of a country shall not come "out of the blue", at the most inappropriate times, but by fixing three set dates per year when credit rating agencies may issue them and with “due consideration for the specific circumstances of each member state”. The agencies must also reveal the “research and assumptions” underlying the rating. Moreover, new refined rating grades shall be added to the current letter-based system.
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End automatic reliance on ratings: To reduce reliance by lenders and investors on credit ratings to make decisions, all references to "external ratings" in EU law will be checked to see whether they trigger automatic reactions to ratings (e.g. when a lower grade is given by a rating agency to a country, particular investors have to sell the bonds they hold from that country). All such references are to be deleted by 2020, subject to appropriate alternatives to credit risk assessment being identified and implemented.
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Conflicts of interest: To prevent conflicts between the interest of the rating agency (wanting to earn money from ratings) and the interest of the client (wanting to have a high rating), there shall be limits on cross-shareholdings. Where an investor simultaneously holds shares in more than one credit rating agency, these shares must not exceed 5% and must be disclosed to the public. Furthermore, agencies must not hold a stake of more than 10% in any entity that they rate.
- Civil liability: Where a rating agency has committed, intentionally or with gross negligence, any infringements with a damaging impact on a credit rating, an investor or issuer may sue the agency. In the case of issuing shares, however, the issuer will have to first establish that the infringement was not caused by misleading and inaccurate information supplied by the share issuer to the credit rating agency.
The Cypriot Council Presidency as well as Commissioner Barnier welcomed the result of the legislative process. This is not a big surprise as the compromise draft legislation seems not very different from the Commission’s initial proposal.
Before releasing the draft new legislation, the Commission itself had taken out any really strong and potentially controversial proposals. More progressive proposals that had been suggested are, for example, the creation of a public agency, long-term prohibitions of take-overs by the three largest rating agencies, or prohibitions to rate an issuer and its issued papers at the same time. Strong liability clauses to sanction wrong doing by rating agencies, as they were part of the US Dodd-Frank-Act (even though later on cancelled) also have not been part of the Commission’s proposal for a draft directive.
Some of the final compromise elements seem to be pretty weak, particularly the 2020 timeline for reducing the overreliance on ratings and the necessity to find alternatives. The Green Group in the EP also criticised that the compromise did not totally prevent the crossholding of shares in rated entities. Anyway, in the last year it became more and more evident that the former power of rating agencies is on the decline and that investors do not take ratings that seriously anymore. However, particularly the binding use of ratings will remain an important issue, for western countries, but also increasingly for emerging and developing countries. |
