What is the real power of credit rating agencies?

Origin and methods of rating agencies

The history of credit rating agencies dates back to the early 20th century, with the establishment of the first agencies such as Moody's in 1909. Originally, these agencies provided investors with information about the quality of bonds and stocks. Over the decades, their role has significantly expanded, and they have become indispensable players in global financial markets.

Over time, rating methodologies have become more sophisticated, incorporating various financial and economic criteria to assess creditworthiness. The 1970s marked a turning point with the introduction of municipal bond ratings and increased recognition of the importance of ratings in investment decisions.

Today, credit rating agencies use complex methodologies to evaluate the creditworthiness of entities. These methodologies include financial analysis, economic outlooks, governance, and other relevant factors. Financial analysts at the agencies scrutinize financial statements, management reports, market conditions, and sector risks to assign their well-known ratings.

Transparency in rating methodologies is crucial for maintaining investors' confidence. Agencies often publish detailed reports explaining the criteria and reasons for the ratings assigned, thus allowing investors to understand the basis of their evaluations.

These ratings have become essential for investors as they provide an accurate assessment of the creditworthiness of issuers. They assist investors in making informed decisions, evaluating risks, and comparing investment opportunities. Investors, therefore, use ratings to diversify their portfolios, allocate assets, and manage risks.

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The 3 main rating agencies set the tone for financial trends

The three main global rating agencies are American companies: Moody's, Standard & Poor's (S&P), and Fitch Ratings. This brings up a fundamental question about their independence, as they dominate the market and are responsible for most of the credit ratings worldwide.

Moody's
Founded in 1909, Moody's is a rating agency that assesses the solvency of bond and debt issuers. It is known for its detailed analyses and financial reports.

Standard & Poor's
S&P, founded in 1860, is one of the oldest rating agencies. It provides a wide range of rating services covering the public and private sectors.

Fitch Ratings
Fitch Ratings, established in 1913, stands out for its rigorous analytical approach and ratings covering a vast range of financial instruments.

Each one uses its own rating criteria. However, some approaches are common:

- Financial analysis: reviews of financial statements, financial ratios, and performance trends.
- Economic environment: analysis of macroeconomic conditions and economic forecasts impacting the entity being analyzed.
- Governance: assessment of management and corporate governance quality.
- Sectoral risk: analysis of risks specific to the industry or business sector.

Ratings are also variably assigned depending on financial instruments and the entity. The main types of ratings include:

- Credit ratings: the assessment of borrowers' solvency, whether it is a state or a company,
- Bond ratings: this involves rating specific bond issues.
- Sovereign ratings: The assessment of governments' capacity to repay their debt. This type of rating is particularly used when the media talks about the potential downgrade of France's rating.

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How do Fitch, Standard & Poor's and Moody's assign their ratings

To evaluate borrowing states and countries, agencies use sovereign ratings. This assessment gauges their creditworthiness, that is, their ability to repay state loans. It takes into account economic performance, political stability, fiscal and monetary policies, and foreign exchange reserves.

Sovereign ratings directly influence the interest rates of state loans and the risk perception by international investors. A high rating indicates a low probability of default, thus attracting more investments. Conversely, the more a rating deteriorates, the less investors have confidence: to lend, interest rates must therefore be higher.

Agencies also assess companies through corporate ratings. Again, the rating reflects the entity's purported ability to honor its financial obligations. Ratings are based on the analysis of financial performance, cash flows, debt structure, and competitive position. As with states, investors use corporate ratings to evaluate the risk associated with investing in company stocks or bonds. A high rating can reduce the borrowing cost for the company and improve its access to capital markets.

Financial ratings assess the creditworthiness of financial institutions such as banks, insurance companies, and investment funds. They consider capital ratios, asset quality, risk management, and liquidity. These are important for the stability of the financial system. They influence the interest rates of interbank loans and the confidence of depositors and investors.

Finally, the growing impact of Environmental, Social, and Governance (ESG) ratings should be noted. As their name suggests, they assess the environmental, social, and governance performance of companies and institutions. These criteria are becoming increasingly important for investors who seek to integrate sustainability considerations into their investment decisions. With a growing financial impact, these ESG ratings also influence companies by encouraging them to improve their sustainability practices.

Notation can evolve and be modified

The ratings assigned to various entities are not final. On the contrary, they evolve with economic conditions. Rating agencies, therefore, regularly revise ratings to reflect changes in the financial or economic situation of the entities. Revisions may be triggered by specific events, changes in financial performance, or modifications in market conditions.

Transparency in the revision process is essential to maintain investor confidence. Agencies often publish reports explaining the reasons for rating revisions and the future outlooks of the rated entities.

The actual influence and conflicts of interest arising from the economic model of agencies

Credit ratings can have a significant impact on financial markets. They influence borrowing costs, interest rates, and investment decisions of financial institutions and individual investors. Thus, investors often react sensitively to rating changes. A downgrade can lead to a rise in borrowing costs and a drop in asset prices, while an upgrade can have the inverse effect. But this is not always the case. If they send a strong signal, it is not always followed by a market reaction.

Credit rating agencies face several criticisms, notably for their lack of transparency, conflicts of interest, and their role in financial crises. Critics also highlight the market's concentration among a few large agencies, thereby limiting competition and diversity of opinions. In response, they have undertaken various reforms aimed at improving transparency, accountability, and minimizing conflicts of interest. They have also diversified their methodologies and increased their communication efforts with stakeholders.

One of the criticisms is a potential conflict of interest. Credit rating agencies are indeed private businesses that finance themselves by charging either investors or debt issuers.

Moody's, Fitch and S&P primarily use the « issuer-pays » model to finance their operations. This means that debt or securities issuers (such as companies, governments, and financial institutions) pay the rating agencies to assess their solvency and assign a rating.

This model is based on 3 main pillars:

1. Credit Evaluations:
- Debt Issuers: Companies, governments, and other issuers pay the agencies for ratings on their bonds and other debt instruments. These ratings are essential to access financial markets and obtain favorable financing terms.

- Structured Products: They also assess complex financial products like asset-backed securities (ABS) and mortgage-backed securities (MBS). The issuers of these products pay for these rating services.

2. Analysis and Research
- Publications and Reports: The agencies generate revenue by selling analytical reports, economic forecasts, and other publications to investors, financial institutions, and regulators.
- Data and Analyses: The sale of financial data and market analyses constitutes a significant part of the revenues. These services are particularly valuable to investors who use this information to make informed decisions.

3. Consulting and Training Services
- Consulting: The agencies offer risk management and financial strategy consulting services to companies and institutions.
- Training: They may also offer training programs and seminars for finance professionals, generating additional revenue.

The « issuer-pays » model poses challenges, especially in terms of conflicts of interest. To mitigate them, agencies implement certain measures. The first is a strict separation of commercial teams and analysts to ensure that rating decisions are not influenced by commercial considerations.

Next, they strive to publish detailed methodologies on rating criteria to ensure the transparency of their evaluations. On the other hand, agencies are subject to strict regulations by bodies such as the Securities and Exchange Commission (SEC) in the United States and the European Securities and Markets Authority (ESMA) in Europe. These regulators oversee rating practices to ensure the integrity and independence of evaluations. At the international level, efforts are being made to harmonize rating agency regulations. The International Organization of Securities Commissions (IOSCO) and other bodies collaborate to establish global standards for regulation and oversight.

Finally, agencies are constantly looking to diversify to reduce dependence on the « issuer-pays » model. This includes expansion into the following areas:

- ESG Ratings: The assessment of environmental, social, and governance (ESG) performance is a growing field, meeting an increased demand from investors for sustainability information.
- Data Technology and Analysis: Agencies now tend to invest in advanced technology tools such as artificial intelligence (AI) and big data analysis to provide more sophisticated and accurate rating and analysis services.

Alternative solutions to rating agencies?

Traditional rating agencies differentiate themselves from other rating systems by their methodological approach and expertise. Alternative systems, such as peer-review rating platforms and social network-based ratings, offer different perspectives but often lack the rigor and institutional recognition of established rating agencies.

Alternative rating systems offer a greater diversity of opinions and increased transparency, but they can suffer from bias and unreliability. However, they remain important channels of information, the ideal for investors always being to diversify their sources in order to make enlightened decisions.

Benefits to ratings... and limitations

Credit ratings offer several advantages, including the standardization of creditworthiness assessments, facilitating cross-border investments, and improving market transparency. However, they also have limitations, such as the risk of market overreaction, overreliance on ratings, and potential conflicts of interest.

To improve ratings, agencies need to continue innovating, diversifying their information sources, and strengthening their methodologies. Adopting advanced technologies and collaborating with regulators and stakeholders can also contribute to enhancing the reliability and relevance of ratings.

Looking forward, rating agencies face several challenges, including the need to adapt their methodologies to emerging risks, increase their transparency, and maintain their independence. They also need to seize opportunities offered by advanced technologies and new market trends. To meet these challenges, they must invest in research and development, collaborate with stakeholders, and adopt a proactive approach to anticipate market changes.

Technology is indeed transforming the ratings sector by introducing advanced data analysis tools, predictive modeling, and artificial intelligence. Ultimately, it will improve the accuracy, speed, and relevance of ratings.