What do ratings agencies do?
Credit rating agencies are agencies that provide informed opinions on how likely a business is to honour all its debt obligations to investors[i]. Ratings agencies first analyse a business’s cash flow drivers and circumstances. A letter grade is then assigned, (typically ranging from AAA to D) which reflects the agency’s opinion on how likely the firm is to repay all its debt on time and in full. Ratings agencies can also provide credit ratings to governments (called sovereign ratings), or to some financial assets[ii].
- Effectiveness and transparency of government policy
- Macroeconomic performance (GDP, economic growth, inflation)
- Budgetary position and total outstanding debt
- Currency reserves and liquid assets
When rating businesses, considerations will include[v]:
- Existence of competition, possibility of new entrants and other industry-specific factors
- The business’s strategy and management
- The company’s cash inflows and debt repayment history
- Country risks (less relevant for firms with international coverage)
Some factors will be more important for particular agencies, but all agencies take a holistic view of the relevant economic and financial conditions before providing their final rating.
The Market for Credit Ratings
95% of the market for credit ratings is dominated by the Big Three: Moody’s, Standard and Poor’s (S&P), and Fitch[vi]. There are many smaller agencies, but few have the international reach of the Big Three. The market for credit ratings is reputation-based. Smaller ratings agencies do not have the experience, history, and reputation that the Big Three possess[vii]. Investors may not even recognise a rating provided by a little-known credit agency, so there is little incentive for companies and countries to look for ratings from agencies outside of the Big Three.
The Impact of the Big Three
For the purposes of providing a rating, credit rating agencies are given special access to information unavailable to the general public[viii]. Ratings are therefore trusted by investors because the agencies that provide them have more information about the company or country’s true financial position.
The sovereign ratings issued by the Big Three can have significant impacts on the fiscal position of any government. The risk-return relationship in finance argues that any uncertainty in future cash payments requires a higher interest rate paid to investors to compensate for the risk[ix]. When a country’s credit rating is downgraded by one of the Big Three, investors may be less willing to lend money to the government. The government must then increase the interest paid on government debt to sustain its current spending[x]. As an example, when S&P downgraded Victoria’s credit rating from AAA to AA, it was estimated that interest payments would increase by $10m each year going forward[xi].
In the USA, regulation prevents banks and other financial institutions from investing in bonds below BBB- class[xii]. Regulation increases the impact that credit rating agencies have on financial markets, because it effectively decides whether a business is financially strong enough to issue bonds. Issuing bonds might mean the difference between making it through a recession or declaring bankruptcy.
Policy Options to Improve Efficiency
The market for credit ratings is not without its criticisms. An ongoing issue is the problem of ratings shopping: when businesses only pay agencies that provide them with a favourable rating. Credit rating agencies in most places are only paid if the firm’s credit rating is made public. There is nothing stopping firms from taking their business elsewhere if they do not obtain their desired rating[xiii]. The existence of ratings shopping leads to inaccurate ratings, as agencies have incentive to scale up their ratings to maintain their market share.
The ratings industry is unique because additional competition may lead to counterproductive outcomes. Ratings shopping might be more of a problem with more agencies in the market. If the whole market was served by a single firm, the result is also unlikely to be efficient because of monopoly pricing.
One policy option worth considering is the introduction of a not-for-profit, international ratings agency run by the UN[xiv]. A publicly owned rating agency will provide ratings with fewer conflicts of interest. Although it will still be difficult for the organisation to compete with the reputation possessed by the Big Three.
Another option is to mandate upfront payment to ratings agencies for their services. There will be less of an incentive for firms to shop for ratings if there is an additional cost associated with doing so[xv].
Credit Ratings and Investment
Credit ratings are informed opinions, but each opinion is constructed with a mix of facts and predictions. Investors still need to conduct their own analysis because conflicts of interest can arise with the production of any credit rating. All the AAAs and Bs issued by ratings agencies are a simplification of a much larger picture.
Despite the inherent issues regarding competition, credit rating agencies are a critical part of the finance industry. Their opinions dictate the investments that are made by investors. Credit rating agencies help provide some certainty in the uncertain world of finance.