Introduction
Credit ratings are assessments of the creditworthiness of a particular debt issuer or entity, intended to provide investors and other stakeholders with an indication of the debt issuer’s ability to meet its obligations. Credit ratings are assigned by independent credit rating agencies, which are companies that are authorised, registered and monitored in jurisdictions where there is an existing regulatory framework for credit rating agencies.
How Credit Ratings Work
Credit ratings provide an assessment of the creditworthiness of a debt issuer. It is important to note that credit ratings are not investment recommendations - they are only one of the factors used to inform investment decisions. It is up to an individual investor to weigh the risks and potential rewards associated with an investment and make informed decisions based on the individual’s own objectives and risk tolerance levels.
Credit rating agencies use a specific methodology to assess creditworthiness of an entity. This methodology is based on the entity’s ability to meet its financial commitments and to repay its debt in accordance with the original terms of the borrowing. Factors such as the entity’s current financial strength, business operations, management and business strategy are evaluated in order to accurately assess the ability of the entity to meet its current and future obligations.
The primary purpose of credit ratings is to provide investors with an indication of debt issuers’ ability to meet their financial obligations. Credit ratings also provide information about relative creditworthiness of entities within the same sector or industry.
Classification of Credit Ratings
Credit ratings are assigned to entities on a scale or in categories, with the most creditworthy entities receiving the highest ratings and those with the weakest financial standing receiving the lowest ratings. For example, credit ratings can be assigned with a numeric rating (e.g. ‘AAA’ or ‘A+’) or with a letter-based rating (e.g. ‘excellent’, ‘good’ or ‘poor’).
The two primary credit rating agencies in the United States, Standard & Poors and Moodys Investor Services, both use letter-based ratings. Letter-based ratings are typically offered in a range that varies somewhat between agencies, but typically span from ‘A’ (excellent) to ‘C’ (poor).
Brief History of Credit Rating Agencies
Rating agencies first appeared in the late 19th century as investors sought to identify which companies and securities offered the highest returns and the least risk. The first credit rating agency was Standard Statistics Company, which was founded in 1898.
In the early 20th century, ratings became much more common as new markets for securities developed in the US, UK and Europe. Rating agencies grew in number and influence, and by 1920, a few of the major rating agencies established international offices.
In 1936, the US Securities and Exchange Commission (SEC) began to require rating agencies to register with it in order to rate securities sold to the public.
Recent Reforms
In recent years, there has been a growing interest in reforming and strengthening the regulatory framework governing credit rating agencies, as the recent and ongoing financial crisis has highlighted the potential impact of inaccurate ratings on financial markets.
In 2010, the US passed the Dodd-Frank Act, a broad financial reform bill that included provisions relating to credit rating agencies. Among other things, the Dodd-Frank Act requires rating agencies to refamiliarise themselves with the guidelines and procedures laid out in the SEC’s Rule 17g-5, which requires enhanced public disclosures and more detailed analysis of credit ratings.
In Europe, the Markets in Financial Instruments Directive (MiFID) of 2007 coupled with the Credit Rating Agency Regulation of 2009 created the European Securitisation Regulatory Framework. This framework introduced additional standards and regulations for credit rating agencies operating in Europe, focusing primarily on improving disclosure and increasing accountability.
Conclusion
Credit ratings play an important role in financial markets as they indicate the likelihood of an issuer’s ability to meet its obligations. Credit ratings provide investors with an independent assessment of creditworthiness and help to inform investment decisions. Rating agencies are regulated and subject to rules and standards established by governmental and other regulatory bodies, and have recently been subject to significant reform in the wake of the recent financial crisis.
