Introduction
Credit rating agencies are companies specializing in the assignment of credit ratings for debt obligation issuers and other related instruments of debt. Credit rating, therefore, seeks to gauge the worth of the credit of a security issuer; in other words, the ability of the issuer to pay back a credit facility or loan (Namaki 2). The issuer can be any entity that deals with securities, e.g. NGO, state, local and national governments, and special purpose entities like banks and other financial institutions.
Credit ratings are the major factor in the interest rates applied on securities being issued to investors. Also, ratings act as a guide to investors looking for entities worth investing in. In essence, rating agencies help in providing an independent opinion about the credit worthiness of issuers. It is known that market participants greatly rely on credit ratings for investment decisions. Rating, therefore, affects the quality of credit issuers to a high extent. For example, an upgrade or downgrade can easily lead to a drastic change in the cost of capital for borrowing because it sways investors’ perceptions of the quality of a borrowing firm or a client (Namaki 2).
The credibility that the rating agencies have in the recent past comes under scrutiny, especially in the backdrop of the global financial crisis. This is because some firms like Lehman Brothers were rated as investment worth, effectively misleading many investors to put their money into the company that was going collapse. Despite the dent in trust, credit rating still plays a crucial role in the financial industry, and no investors should ignore them during the decision-making process. Credit ratings, therefore, remain important components in financial decision-making, while downgrades can have far-reaching effects on the industry.
To better understand the effect of downgrades, it is important to focus the discussion on the uses of credit ratings.
Uses of credit ratings
Issuers, investment banks, investors, broker-dealers, and governments rely on credit ratings for financial decision-making. Investors, in particular, find credit ratings useful because they increase their investment alternatives through easily understandable measurements, which due to increased efficiency, lower the costs associated with borrowing and lending. In return, there is likely to be increased capital injection to the economy through easy access to credit by small governments, start-up businesses, and educational institutions, thereby fueling stronger growth of the economy (Brooks and Faff 18).
Bond issuers also rely on credit ratings to independently verify their credit worth and the effectiveness of the evaluation instruments they use. Governments also depend on the credit ratings for regulation of the finance industry and for running structured financial transactions.
Effects of a credit rating downgrade
In August 2011, S&P downgraded the US credit rating due to the situation of the country’s growing deficit and near default on its debt obligations. Currently, the Eurozone is embroiled in a currency crisis whose effects are likely to result in a possible collapse of various European economies, such as Greek, Spanish and Italian ones. So far nine countries in the Eurozone have had their credit ratings downgraded thanks to the Euro crisis.
These agencies assess the riskiness involved in lending to large institutions and governments, and downgrading reflects a lack of confidence in the institutions and governments to repay their debts within the stipulated time. It is important to note that credit rating downgrades institutions because banks have a ripple effect reverberating across the economy up to the individual consumer. Experts contend that credit downgrades have a lasting and relatively more severe impact on banks in the long term.
High-interest rates
A rating downgrade of banks and other institutions means that they are riskier borrowers. Riskier borrowers pay higher interest rates because creditors perceive them as unworthy of credit; hence they access it at high-interest rates. In situations involving government, treasury bills markets determine the level of interest that the short-term loans attract. A credit downgrade will spur a yield increase from bonds. Such as a situation that will force the government “to spend more to borrow the same amount of money” (Mui par. 3).
Because most consumer loans have a close link with government-related securities, customers accessing credit facilities from a financial institution will in return pay high-interest rates (Mui par. 3). According to Brooks and Faff, this may stimulate mortgage defaults among homeowners because a great number of people finance their home loans with two or more loans (12). These loans require people to service them every month by paying interest on them. Varying interest rates will, therefore, have a long-lasting effect on these consumers.
Besides governments, banks will also access loans at higher interest rates, a cost that they are likely to pass on to the consumer. High-interest rates will discourage people from borrowing, effectively starving small businesses, education institutions, and individual borrowers because the general economy needs credit. According to Amaral, credit flow is the lifeblood of the economy (par. 1). Lack of it will negatively impact the economy since most entities and individuals that need it will have to ground operations and lay off workers, thereby raising the rate of unemployment. Additionally, lack of credit from banks will discourage consumers from spending and encourage savings which in the long run will bring more negative effects on the economy.
Low investment
Many investors rely on the credit ratings from agencies to make investment decisions. A credit downgrade on banks and other institutions will effectively label them as less suitable for investment. When investors buy a company’s shares, they own part of the firm and invest in the company which needs capital that can sustain its operations. A low credit rating discourages potential investors to deal with the entity starving for much-needed capital. In the case of governments, potential buyers are shunned away denying governments crucial funds needed to implement fiscal and monetary policies.
Besides being shunned by potential investors, people may lose faith in downgraded banks which may lead to a panic withdrawal, and in the worst case, it is likely to be a scenario collapse of a financial institution.
Conclusion
There is a suggestion that credit ratings have not been accurate when presenting the financial health of financial institutions. As said earlier, credit downgrades affect the perception of the institutions by the customers. Perceptions influence the financial behavior of customers that in return impact variables, such as consumer spending. Additionally, credit downgrading affects the flow of credit in the economy which weighs down on investments and overall economic growth. Despite their importance, there is a need for reform in the credit rating industry to ensure rating capture to create a true picture of debtors.
Works Cited
Amaral, Pedro 2011, Credit Flows to Businesses during the Great Recession. Web.
Brooks, Robert, & Faff, Robert, 2004, The national market impact of sovereign rating changes. Web.
Mui, Ylan Q. “Five ways the downgrade in U.S. credit rating affects you”. The Washington Post 2011. Washingtonpost. Web.
Namaki, Sel n.d, The Rise and Fall of the credit Industry. Web.