Credit Rating Agency – What Is It? How Does It?

Definition:

A credit rating agency is a company that assesses and assigns the credit ratings of entities. The credit ratings of entities are assigned based on an evaluation of the credit risk of the entity. Credit ratings predict the ability of entities to repay debts and the risk of default by the entity.

Credit rating is an evaluation made by a rating agency regarding the qualitative and quantitative information of an entity’s debt background. Rating agencies assess the credit rating of different companies or government entities. For individual entities, consumer credit bureaus will assess their credit ratings.

When entities want to deal in debt, different institutions may require them to produce a credit rating report. The credit rating report helps these institutions assess the financial strength of the entities.

Similarly, credit ratings help these institutions evaluate whether the entity that wants to deal in debt can meet the interest and principal payment requirements of the debt. The credit ratings will differ for every specific debt issue. Similarly, the overall credit rating of an entity may also differ from its credit rating the debt issue.

Credit rating agencies give entities ratings such as AAA, AA+, Aa1, etc. The type of credit rating that entities receive depends on the rating agency that is providing the credit rating.

For example, one of the leading rating agencies Moody gives a credit rating of “Aaa” to the best credit rating entities. For Standard & Poor’s, another credit rating industry giant, the credit rating is “AAA”.

Similarly, the lowest rank for Moody’s is “Caa/Ca/C” for highest risk credit ratings and “C” for entities in default. For Standard & Poor’s, the highest risk rating is “CC/CC/C” while for entities in default, the credit rating is “D”.

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Leading Rating Agencies

Currently, there are three main credit rating agencies in the industry. These three agencies hold the majority of market share for the industry, which are Standards and Poor’s (S&P), Moody’s Investor Services and Fitch Group.

S&P and Moody’s, the top two among them, dominate about 80% of the overall market. Similarly, Fitch Group holds 15% of the market. This means as a whole these three agencies dictate 95% of the industry. These agencies are also known as the big three in the world of credit rating agencies.

Implications

Credit rating reports produced by rating agencies can have many implications. The credit ratings of an entity can be the difference between qualifying and not qualifying for dealing in a particular type of loan. For entities to obtain the loan, they must demonstrate that their credit rating meets the requirements for trading.

Similarly, the credit rating of an entity can dictate the cost of borrowing of the entity. The lower the credit rating of an entity, the higher will be the interest rates they will have to pay. This is mainly because the risks for the instrument holders increase significantly for lower credit ratings. Therefore, they will require higher rewards in return.

For companies, if they are planning to issue specific types of securities, they must rate their debt first. This is because investors make decisions regarding investing in the debt instruments of a company based on these credit ratings.

Similarly, companies issuing Exchange Traded Funds (ETFs) will need credit rating agencies to rate them before being trading them in the market.

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Criticism of Rating Agencies

Credit rating agencies have often been criticized for not identifying all the risks that have an impact on an instrument’s or entity’s creditworthiness. Because the company issuing the instruments pays the fee for the credit rating, investors think it causes a conflict of interest.

Some investors also accuse rating agencies of giving favorable ratings in exchange for compensation. That’s why some investors don’t fully rely on these credit ratings when making decisions regarding their investments.

Some investors also accuse credit rating agencies of causing financial losses due to the role these agencies play in downgrades. The downgrades by these agencies have caused negative perception in the market for certain instruments, thus, causing market participants into forced selling.

There are famous cases of the leading rating agencies downgrading the debt of some countries and forcing them into crisis. Some of these downgrades have later proved to be baseless.

Conclusion

Credit rating agencies are companies that assess and assign credit ratings of entities. A credit rating is an evaluation made by rating agencies regarding an entity’s debt background.

The type of credit rating that debt will receive depends on the rating agency assessing it. Three leading rating agencies around the world dictate 95% of the industry’s credit ratings.

Credit ratings can have implications on the qualification requirements of debts and can dictate the borrowing costs of entities. Companies may also be required to rate their debts before trading them publicly. Credit rating agencies have received many criticisms due to some of their actions.

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