All you need to know about credit rating

Origins of credit rating

The first credit rating agency was set up in New York in 1841 to rate the ability of merchants to pay their financial obligations. This was taken over by Robert Dun, who published the first rating guide in 1859.

The second agency was established by John Bradstreet in 1849 – which merged with the first agency to form Dun & Bradstreet in 1933. In 1900 and 1916, John Moody established Moody’s Investors Service and Poor’s Publishing Company respectively. Standard Statistics Company and Fitch Publishing Company were set up in 1922 and 1924 respectively.

Poor’s and Standard merged together in 1941 to form Standard and Poor’s. Since 1970, a number of credit rating agencies have been set up all over the world – including in countries like Malaysia, Thailand, Korea, Australia, Pakistan, Philippines and India.

The origin of credit rating agencies shows that they developed as information businesses, closing the knowledge gap between borrowers and investors, and publishing information about creditworthiness of borrowing entities – which assisted investors in making credit decisions. Essentially, credit rating agencies developed as a response to asymmetric information.

Meaning of credit rating

Credit ratings are opinions about credit risk. Standard & Poor’s ratings express the agency’s opinion about the ability and willingness of an issuer – such as a corporation, state or municipal authority – to meet its financial obligations in full and on time.

Credit ratings also provide opinions on credit quality of a debt instrument issued by a corporate entity or municipal authority bond, and the relative likelihood that the issue may default.

A rating once issued by an agency does not remain valid for the entire life of the debt instrument. Whenever the risk characteristics of the instrument changes, the rating must be reviewed: upgraded or downgraded.

Credit rating is widely recognised to be among the most critical methods for assessing creditworthiness. It plays a key role in financial markets by closing the informative asymmetry between lenders and investors on one side and issuers on the other – about the creditworthiness of corporate entities (corporate risk) or countries (sovereign risk).

Credit rating agencies

Credit ratings are issued by Credit Rating Agencies (CRAs). CRAs specialise in analysing and evaluating the creditworthiness of corporate and sovereign issuers of debt instruments.

In the current financial architecture, CRAs (External Credit Assessment Institutions) have an expanded role to play as per the Basel Committee on Banking Supervision (BCBS)’s capital standards for banks under Basel II and III to assist in computing banks’ regulatory capital for credit risk.

The rating agencies fall into two categories: recognised and non-recognised. The former is recognised by regulatory and supervisory agencies such as Securities and Exchange Commissions and central banks in each country for regulatory and supervisory purposes.

In the United States, as at 2016, nine CRAs – of which the best known are Moody’s and Standard and Poor’s (S&P) and Fitch Ratings – are recognised by the Security and Exchange Commission (SEC). The majority of CRAs such as the Economist Intelligence Unit (EIU), Institutional Investor (II), and Euromoney are non-recognised.

Importance of credit rating

Credit ratings establish a link between risk and return, and as such provide a yardstick against which to measure the risk inherent in a rated debt instrument. Investors use credit ratings to assess the risk level and compare offered rate of return with expected rate of return to optimise risk-return trade-off; hence the need for credit rating in a financial system. Thus, credit rating:

(a) Assists investors to make sound investment decisions.

(b) Assists debt instruments issuers to price issues fairly, correctly and appropriately.

(c) Assists regulatory agencies such as the Bank of Ghana and Securities and Exchange Commission to determine eligibility criteria for debt instruments. For example, SEC requirement for mandatory credit rating of commercial papers.

(d) Serves as a marketing tool for highly rated corporate entities, as it creates confidence in existing and potential clients, business partners, investors and the public.

In an efficient capital market, returns on investments match associated risks. Debt instruments with higher ratings offer lower rates of return, and those with lower ratings offer higher rates of return. Thus, the availability of unbiased credit rating directly assists in forming an efficient market.

A corporate entity whose debt instrument has been rated and published will follow rational and sound financial and business practices, as the rating agency keeps a close watch on the entity’s performance and will not hesitate to lower the ratings if circumstances so warrant.

In general, credit rating is expected to improve efficiency and quality consciousness of the capital market, as it establishes a meaningful relationship between quality of debt and yield from such debt.

What credit rating does not constitute

Credit rating is not a recommendation for purchasing, selling or holding of debt instruments. Decisions to invest in debt instruments must be based on (i) expected rate of return; (ii) risks associated with the investment; and (iii) risk profile of the investor. Of these three issues, credit rating provides information on only one of them; namely, credit risk associated with the investment.

Credit rating agencies do not conduct a comprehensive audit on operations of debt instrument-issuing entities. Though the rating agency does make a complete study of information made available and tries to gather data on various aspects of the entity, it cannot certify that all the information provided is true and fair.

Credit rating does not create a fiduciary relationship between the rating agency and users of the ratings.

Role of credit rating in the capital market

Credit rating reduces information asymmetry between debt instrument issuers and investors by providing information on the rated debt instrument and the entities.

Credit rating assists in solving an important principal-agent problem by capping the amount of risk the agent can take on behalf of the principal.

Credit rating assists in solving the collective action problem of dispersed debt investors by monitoring performance of rated debt instrument and entities, with downgrades serving as a signal to take action.

Credit rating effectively reduces the burden on investors to research the creditworthiness of debt instruments or issuers.

(e) Credit rating assists portfolio managers in making investment decisions and lenders in credit decisions.