Role of Credit Rating Agencies in Determining Attractiveness of Companies and Countries

How Credit Ratings Agencies Do their Job

When companies and countries need to borrow money from the market, there needs to be an agency that determines their creditworthiness or their ability to repay and be a source of good investment. Even for individuals when they apply for a loan, the banks and financial institutions assess their ability to repay and their soundness.

For instance, when you apply for a home or an automobile loan or for a credit card, the bank has internal processes that determine whether you should be given the loan. Similarly, when companies and countries borrow, there are credit rating agencies that assign ratings to them to signal to the market about their creditworthiness.

The difference between individuals, companies, and countries as far as rating agencies are concerned is the scale of borrowing and the depth of analysis. Whereas countries are rated on a whole host of parameters, companies are rated according to the assets they hold, the cash flow both future and current, and individuals according to their credit history.

The point to note is that more often than not, lenders need independent agencies that assess the creditworthiness of the parties and this is where credit rating agencies come into the picture.

Accolades and Brickbats for Credit Ratings Agencies

Of course, credit rating agencies have been the target of investors in recent times as they have been blamed for not assessing the risk and return of certain securities and loans as was the case during the subprime crisis when the agencies gave good ratings to the mortgages and the financial instruments built on top of them.

Indeed, many credit rating agencies like Moody’s, S&P, or Standard and Poor’s were the matter of investigation by the regulators because they were perceived as being hand in glove with the banks. This is the reason why credit ratings agencies need to be independent and autonomous.

Moreover, credit rating agencies have a lot of power as their negative ratings can mar the chances of companies and countries being unable to borrow at cheaper rates.

In other words, when the rating of a company or a country is lowered, it loses access to market borrowings at cheaper rates and has to pay a premium to secure funds. This premium is the result of the increased risk that lenders take for lower rated companies and countries.

Proprietary Algorithms and Parameters for Rating

There are various parameters on which credit ratings agencies assess the creditworthiness. For countries, the bonds are rated according to the prevailing economic, political, and social situation as well as on previous financial history and future projections of growth. Each of these variables is assigned a weighting and the cumulative average is arrived at according to their importance. To arrive at the consolidated credit rating, the agencies have both objective and subjective means of analysis.

The parameters described above are the objective ones and the group or the assessors’ taking the decision has a subjective parameter wherein they can use their judgment and decide accordingly.

Further, companies are rated according to the growth projections and the cash flow situation as well as assets and outstanding liabilities.

The point to note here is that the credit ratings agencies have proprietary algorithms and software that they have developed which they use to rate the financial instruments. Apart from this, there is something called the counterparty risk which each financial instrument bears and this is an important factor in determining the rating.

Closing Thoughts

Finally, credit ratings agencies are known to make errors of judgments as discussed earlier. However, they are also known for getting it right as evidenced during the debt ceiling debate in the United States in 2011 when the sovereign rating was lowered because the lawmakers in Congress and the Senate failed to arrive at a deal till the eleventh hour. Hence, the key take away from this article is that credit rating is an art as well as a science and hence, one must understand the entire process rather than touching upon it superficially.

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