Gianlorenzo Zeccolella
The current financial situation reserves an exceptional role for credit rating agencies, which may actively influence and, eventually, undermine the financial market stability.
Both in the European Union and in the United States, the number of credit rating agencies is very circumscribed. There are just a few companies that operate in this business with no competition. Moody’s, Standard & Poor’s and Fitch Group, the so-called “Big Three”, hold around 92% of market share[1]. Their role is to assign a credit rating, an essential indicator to gauge both countries’ and companies’ soundness. Ratings contribute to determining the possibility to access new national and international capital resources.
Ratings as measures of creditworthiness
Several international companies, before issuing a bond, ask the rating agencies to assess the financial instruments and assign a rating (often obliged by legislation), which consequently authorizes the allocation on the market. Moreover, not all the investors assess on their own the credit quality of companies and countries, before investing. Many of them directly rely on the evaluation provided by credit rating agencies.
The higher is the credit quality, the higher will be the rating. Together with the lower cost of capital, a high rating guarantees more accessibility to external debt[2]. The scale goes from AAA the best grade, to D, meaning Default (the scale is slightly different for Moody’s. See the table below). Companies rated at BBB- or higher are in the investment-grade area, while the ones with ratings below the BBB- threshold are in the speculative-grade zone (also defined “junk” or non-investment).
| Moody’s | Standard & Poor’s | Fitch | Description |
|---|---|---|---|
| Aaa | AAA | AAA | Investment Grade |
| Aa1 | AA+ | AA+ | |
| Aa2 | AA | AA | |
| Aa3 | AA- | AA- | |
| A1 | A+ | A+ | |
| A2 | A | A | |
| A3 | A- | A- | |
| Baa1 | BBB+ | BBB+ | |
| Baa2 | BBB | BBB | |
| Baa3 | BBB- | BBB- | |
| Ba1 | BB+ | BB+ | Speculative Grade |
| Ba2 | BB | BB | |
| Ba3 | BB- | BB- | |
| B1 | B+ | B+ | |
| B2 | B | B | |
| B3 | B- | B- | |
| Caa | CCC+ | CCC | |
| Ca | CCC | ||
| C | CCC- | ||
| / | D | CC | |
| / | C | ||
| / | D |
Ratings as risk indicators
The other side that can be captured using ratings is the risk involved in an investment. It is straightforward to understand that a debt issuer – generally a State or a company – with a high credit quality and a high rating will be a safer investment than another with a speculative grade rating.
Institutional investors, such as pension funds, mutual funds and banks have different restrictions on the amount of risk they can (and they are willing to) bear.
This is partially due to regulation. Savers are investing their money in a pension fund to ensure the possibility to live respectably after retirement, without any interest in being exposed to speculative assets. Also, the investment strategy matters. Indeed, every portfolio is built pursuing certain objectives. In finance, expressed in terms of expected returns and risk. Investors, choosing to use their money to buy financial instruments instead of consuming, should receive an appropriate remuneration, proportional to the level of risk they are bearing. However, most of them would not accept the risk of losing a big portion of their capital chasing unrealistic high returns. For this reason, most of the investors will not be willing to invest a great share of their money in low rating government or corporate bonds.
The importance of credit ratings for States
When a State is downgraded the impact on its cost of borrowing can be very significant, especially if its previous ratings were already low. Going from the lowest scores of investment grade to speculative grades can cause the exclusion from the main government bond indexes and, thus, from the portfolios of many institutional investors. This generates not only a dramatic increase of the cost of borrowing money on the markets but it can seriously reduce the capacity for that issuer to finance additional spending with debt. Today, according to Moody’s and Fitch, Italy is just one notch above the junk area and the covid crisis risks to compromising its creditworthiness.
| Country | S&P’s | Moody’s | Fitch | 10 years government bond yield |
|---|---|---|---|---|
| Italy | BBB | Baa3 | BBB- | 0.49% |
| Germany | AAA | Aaa | AAA | -0.52% |
| France | AA | Aa2 | AA | -0.32% |
| Spain | A | Baa1 | A- | 0.04% |
| Portugal | BBB | Baa3 | BBB | -0.03% |
| United States | AA+ | Aaa | AAA | 1.12% |
| United Kingdom | AA | Aa3 | AA- | 0.29% |
| Japan | A+ | A1 | A | 0.04% |
| Switzerland | AAA | Aaa | AAA | -0.50% |
| Russia | BBB- | Baa3 | BBB | 5.88% |
| Canada | AAA | Aaa | AA+ | 0.82% |
| Australia | AAA | Aaa | AAA | 1.10% |
| New Zealand | AA | Aaa | AA | 1.07% |
| Brazil | BB- | Ba2 | BB- | 7.37% |
| South Korea | AA | Aa2 | AA- | 1.72% |
| China | A+ | A1 | A+ | 3.22% |
| Argentina | CCC+ | Ca | CCC | 51.23% (7 years maturity ) |
| Bulgaria | BBB | Baa1 | BBB | 0.28% |
| Romania | BBB- | Baa3 | BBB- | 2.94% |
| Greece | BB- | Ba3 | BB | 0.58% |
| Sweden | AAA | Aaa | AAA | 0.06% |
Looking at the ratings and the yields on government bonds reported in the table above, it is noticeable that also other factors affect the bond yield. Indeed Italy has similar ratings to Russia, but a much lower cost of debt.
The intervention of the European Central Bank (ECB) has certainly played a crucial role in maintaining low the yield on European countries’ bonds, especially for Italy. ECB implements its monetary policies through different channels. Among them it is worthwhile to mention the Open Market Operations and the Asset Purchase Programmes (APP)[3]. These allow the ECB to provide liquidity at a very low cost to financial institutions and banks of the Eurosystem, in exchange for this liquidity the banks provide a collateral, which can be for example a government bond. Through these instruments, the ECB receives government bonds of the EU countries, relieving the pressure on the countries yield rate. However, government bonds have to meet certain requirements to be eligible to be used as collaterals[4]. One of them is being at least in the investment grade area. Otherwise, in the worst scenario, the ECB would not be anymore allowed to hold and buy such government bonds. On 7 April 2020, to reduce the possible damages of a downgrade during the covid crisis, the ECB decided to adopt temporary collateral easing measures. Nowadays, all the marketable assets and issuers, which had at least the lower investment grade until 7 April 2020, remain eligible even in case of further downgrades (up to two notches lower)[5]. However, the fact that collateral eligibility for central banks’ purchasing programmes are tied to ratings show the relevance and the weight of these institutions in the financial markets.
Credit rating determinants and the main concerns
CRAs assign ratings considering various determinants of the debtor:
- Ability to pay–back the borrowed amount. It includes the principal plus the accrued interests;
- Ability to do it on time;
- Likelihood that the obligor may not pay because of default.
Once analyzed these three broad categories, analysts can attribute a rating that determines the company’s creditworthiness.
Recently, the most important credit rating agencies have acquired greater importance on the capital and financial markets, becoming a target for several critiques. The biggest and most prominent credit rating agencies, namely Standard and Poor’s, Moody’s, and Fitch currently have a massive impact on the capital and financial market. Their assessment of a company’s financial quality represents a fundamental component in determining the pricing of credit risk, which in turn denotes the cost of both internal and external resources.
However, the debated topic is whether those agencies may have some incentives to assign inflated ratings. The problem springs since agencies are not paid by investors but by the same companies that ask for the credit quality assessment (obligors). The borrower, who pays the agency, is interested in high ratings, which would guarantee stability (to keep the cost of external debt low). It is not complicated to understand that in this scenario, some interests are conflicting. The company that needs the assessments pays the agency that would probably be more motivated to give a high rating.
Structured products, such as Mortgage Backed Securities (MBS)[6], have always been more frequently placed on the market for several years, especially in the United States. Default rates were much more significant than what their intrinsic value was suggesting. Decomposing these structured products would have given assets with awful shapes but with an overall high rating. For this purpose, agencies have been blamed for assigning inflated credit ratings. All these inefficiencies played a critical role in the subprime crisis in 2008.
Furthermore, the insurmountable entry barriers are another crucial issue. The market of credit rating agencies is wholly dominated by three companies, characterizing it as an oligopolistic system. The leading firms may decide to cooperate and create a cartel that would increase the prices and discourage new entrants. Besides, CRAs may offer inflated ratings. In this case, it would be tough for regulators and supervisors to detect whether common shocks or collusive strategies drive extreme assessments.
What can be done to improve the situation?
It is fundamental to create a scheme of incentives where firms are motivated to deviate from such collusive synergies. An idea could be to establish a public rating department in the main global institutions – such as the International Monetary Fund or the Central Banks – that can assess the companies’ credit quality. Their outcome must be compared with the agencies’ results to notice possible differences. If there are large differences (unfair assessments) not driven by fundamental motivations, the regulators may refuse to grant the license to operate in the credit rating sector in the future period. This action may sound unrealistic. Indeed, even in case of weird and unfair behaviors, rejecting the permission to Moody’s, Standard & Poor’s or Fitch seems improbable due to their market power[7].
Notwithstanding, the conclusions drawn on some undesired qualities and drawbacks of ratings do not have to distract us from the importance of them. Indeed, credit ratings offer a great informational substance that, if not subjected to bias, might be very useful for investor’s decisions.
Michele Corio and Gianlorenzo Zeccolella
Sources and references
[1] https://www.moodysanalytics.com/regulatory-news/nov-29-19-esma-publishes-market-share-figures-for-credit-rating-agencies-in-eu/
[2] debt held by foreign banks
[3] https://www.ecb.europa.eu/mopo/implement/html/index.en.html
[4] https://www.ecb.europa.eu/mopo/assets/standards/marketable/html/index.en.html
[5] https://www.ecb.europa.eu/press/pr/date/2020/html/ecb.pr200422_1~95e0f62a2b.en.html
[6]Financial instrument secured by a mortgage or collection of mortgages.
[7] Stolper, A., 2009. Regulation of credit rating agencies. Journal of Banking & Finance 33, 1266–1273. https://doi.org/10.1016/j.jbankfin.2009.01.004