Credit Rating
A credit rating is an assessment of the creditworthiness of a borrower, expressed as a grade that indicates the likelihood of default. Credit ratings are issued by rating agencies and are used by investors, regulators, and issuers to assess and to price credit risk.
Purpose
The purpose of a credit rating is to summarise information about the ability and willingness of a borrower to meet its obligations. Ratings reduce the cost of information for investors, who would otherwise have to assess each borrower themselves, and they facilitate the pricing and the trading of debt.
Ratings are used in regulation, where they determine the capital that banks and other institutions must hold against their exposures. They are used in investment mandates, where they define the universe of eligible securities. They are used in contracts, where they can trigger covenants or collateral requirements.
Scale and Methodology
Ratings are expressed on a scale that ranges from the highest quality to default. The scale typically uses letters and modifiers, with a distinction between investment grade, which denotes lower risk, and speculative grade, which denotes higher risk. Ratings apply to issuers and to individual obligations.
The methodology of rating agencies combines quantitative analysis of financial statements and of market data with qualitative assessment of management, strategy, and the operating environment. Agencies assess the capacity to service debt, the volatility of cash flows, and the resilience of the borrower to adverse conditions.
Ratings are forward-looking and are reviewed periodically. Agencies may place a rating on watch, indicating that a change is under consideration, and they may change a rating in response to developments.
Role in Markets
Credit ratings influence the cost of borrowing, since investors demand higher yields from lower-rated borrowers. They influence the allocation of capital, since many investors are restricted to investment-grade securities. They influence the behaviour of issuers, who may manage their finances to preserve a rating.
Ratings also influence the dynamics of credit markets. Downgrades can trigger sales by investors whose mandates require them to hold only investment-grade securities, and they can raise the cost of funding for the affected borrower. This can create feedback between ratings and market conditions.
Criticism and Reform
Credit ratings have been criticised for their role in the financial crisis, when securities that were rated highly subsequently defaulted. Critics argued that the ratings were based on flawed models, that they were subject to conflicts of interest, and that they were relied on excessively by regulators and investors.
Reforms have sought to reduce reliance on ratings in regulation, to increase transparency about methodology, and to strengthen the independence of agencies. The debate about the role of ratings in the financial system continues, and it reflects broader questions about the governance of credit and about the limits of quantitative assessment.
The Rating Process
The rating process begins with the collection of information about the issuer or the obligation. Analysts examine financial statements, projections, the competitive position of the issuer, the quality of management, and the legal and regulatory environment. They meet with management and assess the strategy and the risks of the business.
The analysis is distilled into a rating that reflects the assessed likelihood of default and the expected recovery in the event of default. The rating is reviewed by a committee, which provides a check on the judgement of the lead analyst and ensures consistency across obligors.
Ratings are monitored after they are assigned. Agencies issue outlooks and place ratings on watch to signal that a change is under consideration. The monitoring process is continuous, and ratings may change in response to developments in the issuer's circumstances or in the environment.
Structured Finance
The rating of structured finance securities, which are backed by pools of assets, differs from the rating of corporate or sovereign obligations. The analysis focuses on the characteristics of the underlying assets, on the structure of the transaction, and on the credit enhancement that protects investors.
The complexity of structured finance created challenges for the rating agencies. The models used to assess these securities relied on assumptions about the correlation of defaults and about the behaviour of house prices and other variables, and these assumptions proved to be unreliable during the financial crisis. The resulting downgrades were large and rapid, and they contributed to the disruption of markets.
The experience led to reforms in the rating of structured finance, including changes to the methodologies and to the disclosure of assumptions. It also prompted a broader reconsideration of the role of ratings in the financial system and of the reliance placed on them.
Rating Agencies and Competition
The credit rating industry is concentrated, with a small number of agencies dominating the market. The dominance of the largest agencies reflects the advantages of reputation and of regulatory recognition, which create barriers to entry for new agencies.
This concentration has raised concerns about competition and about the incentives of the agencies. The issuer-pays model, in which the issuer of a security pays for its rating, has been criticised for creating conflicts of interest, since the agency may be reluctant to assign a low rating for fear of losing business.
Reforms have sought to address these concerns, through measures to increase transparency, to strengthen internal controls, and to reduce regulatory reliance on ratings. The effectiveness of these measures remains debated, and the concentration of the industry persists.
Alternative Approaches
The limitations of credit ratings have encouraged the development of alternative approaches to assessing credit risk. Market-based measures, such as credit default swap spreads and bond yields, provide continuous and timely information about the market's assessment of creditworthiness.
Internal models, used by large banks to assess their own credit risk, provide another alternative. These models allow banks to tailor their assessments to their portfolios and to their own information, and they are subject to supervisory approval. The use of internal models has grown, particularly since the post-crisis reforms to bank capital regulation.
These alternatives complement rather than replace ratings. Each approach has strengths and weaknesses, and the combination of information from different sources provides a more robust assessment of credit risk than any single measure.
Summary
Credit ratings are a central institution of credit markets, providing assessments of creditworthiness that are used by investors, regulators, and issuers. Their analysis requires attention to methodology, to conflicts of interest, and to the reliance placed on them, and their limitations have prompted the development of alternative approaches.