It’s big news when a country or major company’s credit rating is downgraded. But much less is said about why and how credit rating agencies operate. What are these agencies? And why do we need them?
What are credit rating agencies?
A credit rating agency is a private company whose purpose is to assess the ability of borrowers, either governments or private enterprises, to repay their debt. To do this, these agencies issue credit ratings based on the borrower’s solvency.
Since 2011, these independent companies have had to obtain certification from the European Securities and Markets Authority (ESMA) in order to operate in Europe. ESMA performs regular inspections to ensure that the rating agencies are following European regulations and the authority can issue sanctions for any infractions.
Who finances credit rating agencies?
Credit rating agencies collect a fee either from the entity seeking to receive a rating (business or government) or from the entity seeking to use and analyze the rating (the financial analysis department of a bank, financial institution, etc.).
How are credit ratings established and used?
To evaluate the solvency of borrowers, rating agencies issue credit ratings corresponding to the credit risk represented by the borrower, or in other words, the risk that the borrower will default on the loan. Credit ratings place this risk on a scale ranging from low risk (investment category) to high risk (speculative category).
Though there is no standard scale, credit ratings are typically expressed by letters corresponding to the potential risk, with the highest rating represented by AAA and the lowest rating by C or D, according to the agency. In addition to the letter grade, a credit rating might also consist of a “forecast” that describes how a particular rating may change in the future. For example, a credit rating with a negative outlook may indicate a future downgrade.
Each rating agency uses its own method to calculate its ratings. These methods take into account quantitative (financial data), qualitative (business strategy for a company or political stability for a country) and contextual criteria (changes in industry for a company or public finances for a country).
The final rating represents the credit agency’s evaluation of a borrower’s credit risk at a given time. It does not constitute investment advice.
What role do credit ratings play?
Along with other criteria, investors take credit ratings into account to help manage their portfolios. A rating downgrade indicates a greater risk for the lender. Depending on the sensitivity of the market, investors may require a higher return to protect against this risk, which in turn raises financing costs for the borrower.
Many investors give credit ratings a lot of consideration in their investment decisions. This has enabled credit rating agencies to play a central role in financial markets – a role that some economists see as excessive.
Banks are also evaluated by credit rating agencies. BNP Paribas regularly receives high credit ratings. In May 2015, Moody’s confirmed BNP Paribas’ rating of A1, while Fitch Rating confirmed BNP Paribas’ rating of A+, as did Standard & Poor’s in July 2015.