Credit rating Agencies – CRAs – are part of the infrastructure of the financial system. However, their role and presence in the financial markets might have remained subtle and latent until the 2008 global financial crisis. Many commentators of the 2008 crisis cited the drop in mortgage value of previously highly rated residential mortgage-backed securities (RMBS) as the reason for the failure of Lehman Brothers – an American investment bank – which marked the beginning of the US financial markets crisis that had a contagion effect on the leading economies of the world. CRAs make creditworthiness judgments of private and public borrowers/issuers of fixed-income securities, but an interrogation of their business model proves that CRAs could have elements of conflict-of-interest.
The Role of CRAs
CRAs play a critical role in contemporary capital markets. According to the International Organization of Securities Commission – IOSCO – the fundamental role of a CRA is to assess the credit risk of corporate and government borrowers and issuers of fixed-income securities by analyzing relevant information available regarding the issuer or borrower, its market, and its economic circumstances (p. 3).
In their daily conduct and operations, CRAs collect information about an issuer of security which they analyze and then make public in the place where the issuer will trade the security for buyers/investors to use. The CRAs’ analysis helps them arrive at a conclusion about the borrower within the capital markets spectrum. The conclusion the CRA arrives at is their opinion regarding an issuer’s likelihood or ability to meet their contractual as well as financial obligations to the investors. The conclusion is not a recommendation to the issuer to sell or to the investor to buy, and it neither addresses market volatility nor liquidity risk.
Nonetheless, the CRA’s rating on security makes it more marketable than security traded without a rating (Amadou, 2009). Therefore, the summative description of a CRA is a service provider that specializes in the issuance of credit ratings on professional grounds (European Commission, 2013). Excellent examples of CRAs operating today include Moody’s, Standard and Poor’s (S&P), and Flitch (European Commission, 2013; Allen, 2014; White, 2019; Tichy, 2011). Ostensibly, CRAs play a central role in the investment decisions of financial market participants.
The biggest consumers of CRAs’ ratings are investment decision-makers. According to Amadou (2009), the first group of rating users comprises buy-side firms such as insurance companies. These firms use the ratings to comply with internal by-laws, and for compliance with specific regulatory demands. The second group of users of CRA ratings is that of sell-side firms such as investment banks.
The sell-side firms use ratings in addition to their internal credit analysis to manage risks and to trade. The sell-side companies additionally play the role of dealers in credit ratings-dependent markets. Broker-dealers will also acquire ratings for their borrowed short-term and long-term debts. Financial contracts also have rating triggers which make ratings quintessential in private contracts. Rating triggers are contractual provisions that terminate credit availability or accelerate credit obligations in the event of specified rating actions, with the result that a rating downgrade could lead to an escalating liquidity crisis for issuers subject to rating triggers (Amadou, 2009, p. 9).
If such consumers of creditworthiness ratings did not exist, CRAs would have no one to consume their services.
Other than coming up with ratings, CRAs secondarily perform other roles in the financial markets. According to Elkhoury (2008), CRAs help in the management of private as well as sovereign credit risk, especially upon the revision of their roles by the Basel Committee on Banking Supervision (BCBS). Additionally, CRAs solve the problem of informational asymmetry between the investors and securities issuers about the creditworthiness of the issuers (Elkhoury, 2008; Rafailov, 2011).
Other than making security more marketable, ratings also make security more tradable because there is an inverse relationship between a rating and the interest rate of a debt (Elkhoury, 2008). Also, the rating level determines the eligibility of debt because the higher the grade rating is, the lower the default risk implying a high probability of debt repayment (Rafailov, 2011; Fabozzi & Jones, 2019). Such are the less salient, but equally ubiquitous ways CRAs affect the global financial markets.
CRAs and Conflicts of Interest
With the 2008 global financial crisis came many questions about CRAs key among them being whether conflicts of interests affect the CRAs’ professionalism. However, to be able to address this concern comprehensively, it is essential to understand the CRAs’ business model. According to Allen (2014), White (2019), and Rafailov (2011), CRAs operate on an “issuers pay” business model.
As White (2019) posits, the CRAs primarily draw their revenues from fees that the issuers of securities pay to obtain ratings. This is to say that the borrower who wants investors to have faith in them pays the CRA, and when called upon provides the information the CRA needs to analyze before issuing a rating.
With the knowledge of CRAs’ business model and mode of operations, it is possible that CRAs could have conflicts of interest. According to Anand (2016), the CRA gives a rating on the creditworthiness of a borrower for which the borrower pays, and in an attempt to keep a long-term working relationship with the borrower, the CRA is likely to give a rating that pleases the borrower even if it jeopardizes the investor’s solvency. Fabozzi and Jones (2019) agree with Anand (2016) on the fact that the CRAs business model predisposes them to potential conflicts of interest and this fact makes the objectivity of the CRAs’ ratings questionable.
There is a likelihood that the CRA will dupe the investor to safeguard their interest with the issuer. For instance, in 2001 only four days before Enron filed for bankruptcy, CRAs had rated it (BBB-) irrespective of the fact that the CRAs had information about Enron’s problems months in advance (Rafailov, 2011). Tichy (2011) describes CRAs as all-powerful, mysterious, ignorant, corrupt, and dubious because they have previously threatened to downgrade a country’s – Greece’s – rating to influence policy. It is also alarming that a non-governmental entity should make creditworthiness judgments about the government’s debt obligations (White, 2019), and such an entity’s interests remain non-conflicted.
Conclusively, CRAs rates the creditworthiness of a borrower and consequently sheds light on the investors’ solvency prospects. The rating that a CRA gives shows how likely a borrower is to meet their contractual and financial obligations to the investors. However, from the assessment of CRAs issuer-pays business model, CRAs could probably have conflicts of interest. There is no guarantee of objectivity in a situation where the party that needs a rating for approval pays the party that does the rating.
Allen, J. 2014. ‘Credit Rating Agencies Again Playing a Vital Role in the Marketplace?’. CFA Institute. Web.
Amadou, N. 2009. The systemic regulation of credit rating agencies and rated markets. IMF Working Paper No. WP/09/129, pp. 1-36. Web.
Anand. 2016. Systemic risk, institutional design, and the regulation of financial markets. 1st edn, Oxford University Press, Oxford, UK.
Elkhoury, M 2008, Credit rating agencies and their potential impact on developing countries. United Nations Conference on Trade and Development Discussion Papers no. 186, pp. 1-27. Web.
European Commission. 2013. New rules on credit rating agencies (CRAs) enter into force – frequently asked questions. Web.
Fabozzi, F & Jones, F. 2019. Foundations of global financial markets and institutions, 5th edn, The MIT Press, Cambridge, MA and London, England.
International Organization of Securities Commissions. 2008. The role of credit rating agencies in structured finance markets. International Organization of Securities Commissions – IOSCO, Madrid, pp.1-17. Web.
Rafailov, D. 2011. ‘The failures of credit rating agencies during the global financial crisis – causes and possible solutions’. Economic Alternatives, vol. 1, no. 1, pp. 34-45. Web.
Tichy, G. 2011. ‘Credit rating agencies: part of the solution or part of the problem?’. Intereconomics, vol. 46, no. 5, pp. 232-262. Web.
White, L. 2019. ‘The credit rating agencies and their role in the financial system’. forthcoming in E. Brousseau, (ed.), Oxford handbook on institutions, international economic governance, and market regulation, 1st edn, Oxford University Press, Oxford, UK: pp.1-33. Web.