Prologue:
“There are two superpowers in the world today in my opinion. There’s United
States and there’s Moody’s Bond Rating Service. United States can destroy you
by dropping bombs, and Moody’s can destroy you by downgrading your bonds. And
believe me; it’s not clear sometimes who’s more powerful” (Jim Lehrer, quoted
in Scalet and Kelly, 2012, p. 479).
Introduction
Ratings are emerging as powerful metrics
for measuring the status or performance of organisations. They range from
product ratings, service ratings and credit ratings among others (Lynn, 2013).
The aim of these ratings is to provide an objective indication of how the
organisations perform in the relevant organisational dimensions. The ratings
help independent observers to understand how the products or organisations in
question compare to competitors and to objectively determined measures of
excellence (Ryan, 2012). Credit ratings provide an indication of the
organisation’s financial health where the complex assets and liabilities of the
organisations are gauged on a predetermined scale.
In some cases, the history and commitment
of the organisation or government to meet its debt obligations is factored in
with debt default almost always leading to a downgrade of the credit rating.
The highest rating is AAA which is an indicator that the organisation is very
healthy and capable of sustaining a debt (Stopler, 2009). The impact of credit
ratings is that they indicate to investors where to invest and the level of
risk to allocate to such investments. The reliance of investors on credit
ratings is believed to be part of the things that caused the 2008 global
recession (Scalet and Kelly, 2012). It is in line with the wide acknowledgement
of the influence of CRAs that different regulatory bodies have embarked on the
process of streamlining activities of the rating agencies to ensure that market
abuse does not occur.
The influence of CRAs
The influence of CRAs can best be
described by Jim Lehrer’s statement which was quoted as follows: “There are two
superpowers in the world today in my opinion. There’s United States and there’s
Moody’s Bond Rating Service. United States can destroy you by dropping bombs,
and Moody’s can destroy you by downgrading your bonds. And believe me; it’s not
clear sometimes who’s more powerful” (Scalet and Kelly, 2012, p. 479). A good
rating makes it easy for organisations and governments to raise finances while
a poor rating discourages the same. This impact can best be understood by
understanding the psychology and interests of the investors.
The investors seek information about
organisations and governments that they seek to invest in. The sources can
either be official or independent. In general, it is believed that official
sources will seek to present a view that best serves their need to raise
finances (Hartarska and Nadolnyak, 2008). This means that weaknesses and
vulnerabilities are likely to be either ignored or covered up in official
communications. This drives the demand for independent sources that can
objectively evaluate the status of the organisations and advise on the
riskiness of the securities. CRAs fill this gap and have emerged as major
influencers of investment decisions around the world (Standard & Poor’s,
2014).
The general ratings are as follows:
Source: Tichy, 2011
One of the main concerns for investors is
whether the investments will attain the desired rates of return (Tian, Zhu and
Liu, 2012). No investor does their investments for charity or in anticipation
that the funds could be lost. It may be true that there are risk-averse
investors who may aim at investing in organisations that bear a higher risk but
are willing to pay a higher return. However, there is evidence that the ease
with which finances can be raised depends on the credit rating given. For
instance, the downgrading of the credit rating for countries such as Greece and
Spain adversely affected the economy of the two countries making it almost
impossible to raise finances from the global markets (Eijffinger, 2012).
The investors tend to be very sensitive
to market sentiments where the general mood across investors is detected and
factored in when making investment decisions (Sofya, 2013). Even though
investors try to exercise due diligence, there’s a general acknowledgement that
they may not have sufficient information to comprehensively gauge the stability
of the organisations or governments and therefore the level of risk on the
investments to be made into such bodies. For instance, ACCION is a rating
agency in the US which gauges rating after assessing the performance of the
organisations in CAMEL (Capital, Assets, Management, Earnings, and Liabilities)
hence providing a rate that reflects on most crucial dimensions of the
organisations (Hartarska and Nadolnyak, 2008). PlaNet Ratings on the other hand
evaluates governance and decision making processes, risk analysis and control,
funding, efficiency and liability, the loan portfolio, and information
management tools (Hartarska and Nadolnyak, 2008). M-CRIL rates drop out rates
in addition to the factors mentioned above. These are pieces of information
that the investors may be unable to have at their disposal hence the need to
base their judgement on the evaluation of credit rating agencies.
The significance of ratings is related
to the fact that organisations seek rating randomly. In a study carried out by
Hartarska and Nadolnyak (2008) on 130 microfinance institutions across 63
countries, it was found that there was no significant different in the
performance of the organisations that were rated as compared to those that were
not rated. This means that there is no common characteristic of organisations
that seek credit ratings and this makes such ratings to be perceived as not
only random but also objective and accurate. In other platforms, rating
agencies are condemned as being corrupt and often capable of colluding to
either inflate or deflate a rating to gain some predetermined end (Tichy,
2011). This condemnation may be justified considering the process through which
the ratings are given. In most cases, the rating process takes the form of a
negotiation between the agencies and the firms and it is only when a rating has
been agreed upon that the same is published officially (Baresa, Bogdan and
Ivanovic, 2012). This means that there is some level of complicity and that the
final ratings may not be as objective as required.
Credit ratings provide the guidance for
international investors. It provides a measure for the riskiness of an
organisation or government in terms of a rating that is understandable
worldwide. The influence of these ratings is well-acknowledged across the world
and it informs the condemnation of rating agencies in the financial crises in
Greece, Portugal and Spain (Tichy, 2011). The credit ratings are believed to
have frustrated the ongoing efforts by the IMF to revive the economies by
making it impossible for the countries to source for funds from the global
finance markets. The same acknowledgement is made in relation to the global
recession. Credit agencies were faulted for colluding with financial
institutions to overrate securities and organisations hence misinforming the
investors about the level of risk that was being borne in making investments
(Tichy, 2011). In the end, crisis was sparked by the organisations in question
being unable to bear the liabilities that they had absorbed.
The influence of credit rating agencies
on the decisions of investors can have a disciplining effect on organisations,
especially in the financial sector. Financial regulation sets the basic
minimums that ought to be adhered to for banks and financial institutions to
operate. However, industry best practice may not be easily generated through
such regulation. The CRAs can facilitate the development of such standards by
providing a good rating for organisations that have certain internal structures
and operations strengthened (Ryan, 2012). In recognition of the fact that good
ratings are good for them, such organisations would be bound to implement
policy recommendations that conform to the recommendations of the CRAs. The
CRAs can therefore have a profound impact on the market structure and lead to
new trends in corporate governance.
The collusion between the CRAs and the
organisations being rated can be eliminated by using unsolicited ratings where
independent bodies provide a rating. If such rating agencies are not paid by
the organisations being rated, they would not be under pressure to provide a
favourable rating.
Challenges faced in the rating
markets and remedies proposed
One of the main challenges faced in
relation to credit ratings is the rigidity of the rating agencies. They base
their ratings on a set of characteristics within the organisations and
countries. These measures are often rigid and this means that where there are
salient reforms in the economies or organisations, the same may not be
reflected in the ratings (Boylan, 2012). This means that crucial reforms are
ignored and this can be a big problem for governments especially in the
developing world. For instance, there is an argument that the evolution of the
EU into a monetary union ought to have influenced the rating for sovereign risk
of the countries within the union. There are those who argue that the riskiness
of the sovereign debt should be evaluated in context of the country specific
characteristics as well as the commitment of the EU to maintain economic
stability within the region. By ignoring this important stabilising force
within the EU, the rating agencies downgraded sovereign ratings for Italy and
Spain hence triggering a crisis that may not have occurred in the first place. The
other weakness observed among credit rating agencies is their rigidity in terms
of their willingness to alter their ratings.
In most cases where the ratings are
proven to have been inaccurate, credit rating agencies tend to be unwilling to
change the same. This has something to do with the need to show the market that
they are always accurate and therefore not prone to mistakes. In reality,
however, credit rating agencies are prone to mistakes of judgement such as
underestimation of liabilities, exaggeration of assets and other weaknesses. As
Tichy (2011) notes, the general tendency for credit ratings to provide an
optimistic valuation of organisations tends to be higher than their tendency to
be either accurate or pessimistic. Irrespective of these challenges, credit
ratings remain one of the most common tools used by investors to gauge the
riskiness of securities floated in the international market.
In recognition of their immense power,
rating agencies could abuse it by seeking to punish policy makers for failure
to conform to policy recommendations that they make. For instance, the crisis
in Italy and Portugal is believed to have been sparked off by the rating
agencies after the EU had effectively come to the rescue of Greece (Lynn, 2013;
Scalet and Kelly, 2013). This makes them appear as rogues who do not hesitate
to abuse the immense power at their disposal. This immense power stems from the
fact that the market structure is oligopolistic in nature. In the US, the 3
dominant players are Standard & Poor, Moody’s Corporation, and Fitch
ratings (Tichy, 2011). This makes collusion easy with the ratings coming from
the main rating agencies tending to be similar or the difference being minimal.
The ratings tend to be similar for major
organisations and governments. For instance, the three leading rating agencies
for Greece and Spain are as outlined below:
Tichy, 2011
The influence of the rating agencies is
also related to the relative lack of transparency in the manner in which the
ratings are done. When looked at from a business perspective, it is this
mystery that gives the agencies an edge over players in the market (Eijffinger,
2012). Following a set guideline for rating would mean that any institution or
investor can effectively rate an organisation hence there would be a low demand
for the rating services. The agencies therefore combine their experience with
characteristics of the organisations and governments for them to give a rating
which reflects the riskiness of the bodies to the best of their knowledge
(Standard & Poor’s, 2014). Nevertheless, independent observers view this
confidential approach to operations as a problem. It gives the rating agencies
the leeway to give ratings that may be inaccurate but aimed at achieving a
certain goal.
Even though the rating agencies conduct
sovereign rating, the main source of their income is securities rating. The
source of the funds are the organisations whose risks need to be rated. There
is therefore a natural tendency for the rating agencies to be sympathetic and
inflate ratings to please their customers and guarantee future business. Boylan
(2012) describes the rating process as follows. The organisation contacts the
rating agency to rate their securities. The rating agency then examines the
securities and the organisation to produce a rating. If the organisation is not
happy with the rating, a compromise is reached by swapping certain liabilities
and the revised rating analysed (Boylan, 2012). It is only after there is an
agreement on the rating that the same is published. This makes unsolicited
ratings quite more reliable than those commissioned by the organisations in
question.
These challenges form the basis for
recommendations for regulation in the sector. Among the main propositions is
the recommendation for greater transparency to be achieved (Boylan, 2012). This
can be done through disclosure of the rating mechanisms and information used. The
other solution to the challenges is to push for market based solutions. Rating
agencies can be ranked based on their accuracy. This would make the most
accurate agencies more dependable in providing investors with guidance as to
the riskiness of securities. This would be in addition to governments demanding
the institution of certain controls within the agencies to ensure that the
rates provided are accurate (Kemper and Rao, 2013). There’s however some levels
of justified pessimism in that no amount of regulation is sufficient to eliminate
the biases that the rating agencies may have.
The influence of the rating agencies
remains high due to the fact that they considered objective while they may not
in actual sense be as objective. In the end, the rating provided is a
reflection of the personal judgement of the organisation and how some of the
elements impact their credit worthiness.
Conclusion
Credit rating agencies play an important
role in guiding investors on which securities or sovereign debts are worth the
risk. This indication is important as most investors are often unable to gather
the information that they need to gauge the riskiness of stocks. The general
market psychology is that official sources tend to highlight the positive
aspects of the organisations while seeking to cover up areas of weakness that
could discourage investment. This means that there is need for an independent
rating agency to assess the characteristics of such an organisation and inform
the market on the riskiness of the same.
The CRAs have a significant influence on
the ability of the organisations or governments to raise finances. This is
apparent in countries such as Spain and Italy whose ability to secure sovereign
debts was negatively impacted the moment they got downgraded. This immense influence
motivates the drive by governments around the world to regulate the sector and
make the approach to rating more reliable. Irrespective of the outcome of these
drives, it is sensible to conclude that the influence of CRAs on the ability of
organisations and governments to raise finances is very high.
References
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