Credit rating agencies – Credibility at stake
Credit rating agencies (CRAs) are considered the gatekeepers to the financial markets. They are an integral part of the capital markets, providing assessment of default and loss probabilities on a variety of fixed-income instruments worldwide. While their processes are unique, their ratings reflect their reviews and analyses of everything from sovereign debt and public finance debt issues to traditional corporate bonds, asset-backed securities, and a host of structured instruments. Nerina Visser, Board Member of the South African Society of the Chartered Financial Analyst Institute (CFA) says, despite being around since the 1860s, these agencies have come under increasing attack in the past few years by investors, regulators, and the business community. In her opinion she discusses the regulations and the credibility of CRAs.
In recent decades, regulators, legislators, and self-regulatory organisations have come to rely upon credit ratings for a variety of reasons beyond their traditional use as a means of determining the likelihood that a debt issuer would be able to meet its obligations. More recently, these ratings have come to be seen as indicators of risk for a variety of purposes, including financial institution capital ratios and credit default swaps, among others.
Quite recently ratings agency Fitch has warned government that unless power supply problems are addressed, the country could face a downgrade. This after it had decided to keep its rating unchanged at BBB – two notches above junk status.
The reputational crisis of CRAs is on-going and poses the question of whether these agencies are playing a credible role in the financial space. This uncertainty came after the banking collapse in 2008 where CRAs were criticised for failing to rate certain financial products correctly which contributed to the collapse.
Even before the financial crisis, CRAs were already coming under close scrutiny. Public authorities were acutely aware of the pivotal and deepening role played by rating agencies in the financial system and had observed several apparent failings.
At the forefront have been questions around the independence and consistency of CRAs, lack of regulation of CRAs themselves, ownership structures of these independent, privately-owned companies, and the requirement that entities have to pay CRAs to be rated, to name but a few.
Some of the issues of independence and objectivity have been addressed through a series of self-imposed changes within the CRA industry, and CRAs are making a concerted effort to communicate more effectively with the users of their ratings. This is a clear acknowledgement of the impact that they have on the broader investment industry.
Although each CRA uses its own rating scale consistently, that does not mean that there is consistency between the ratings of different entities (e.g. sovereign ratings vs. corporate bonds vs. financial instruments) nor is there necessarily consistency between different ratings agencies. For many years, the credit ratings of agencies were rarely questioned, despite apparent inconsistency in ratings.
However, there are no standard formulas to establish an institution’s credit rating; instead, CRAs simply use their best judgement based on their own analysis. Unfortunately, they often end up making inconsistent judgements, as indicated by the variation in ratings between different CRAs.
The manner in which CRAs operate and convey their opinions can affect the way that investors and others perceive the independence, quality, and purpose of their ratings. CRAs, therefore, should take steps to ensure that their processes do not undermine the perceived independence of their opinions. They also should ensure that they are clear about the types of instruments they are rating and the risks they are considering.
In their defence, rating agencies have stressed that they are merely providers of opinions on the probability of defaulting, not market performance, and that their ratings should never be used as the sole reason for an investment decision. Unfortunately both regulators and the broader investment industry have increasingly placed undue reliance on the outcome of the ratings process, and not focussed enough on the detail of the process itself. Terminology such as “investment grade” and “junk status” are interpreted superficially, to the point of replacing internal credit assessments. This has resulted in some unfair criticism being levelled at CRAs in an attempt to shift blame.
Although scrutiny pertaining to CRAs credibility, independence and consistency is a good thing, the investment industry should not neglect its own responsibility to due diligence and applying care and skill in the investment decision making process, for example, by building up its own credit assessment process.
