Why Do We Need Credit Rating Agencies

AG912 International Financial Markets and Banking

Assignment 2

Name: SHREYANS JAIN                                                                

Student number: 201768529

Part A

Part A – task [1]

A credit rating agency is an entity which assesses the ability and willingness of the issuer company for timely payment of interest and principal on a debt instrument. Each rating symbol is an alphanumeric representation of the probability of degree of repayment risk associated with debt instruments. Rating is denoted by a simple alphanumeric symbol, for e.g. AA+, A-, etc.

Rating only provides an additional input to the investor and the investor is required to make his own independent and objective analysis before arriving at an investment decision.

According to Partnoy, the essence of the reputational capital view is that credit rating agencies fill an important need arising from the information asymmetry between issuers and investors. Credit rating agencies are reputational intermediaries that bridge the information gap, not unlike restaurant or movie reviewers, except that they use letters (such as AAA) instead of stars or tomatoes. (Partnoy.2017).

According to Benmelech, Credit rating agencies are of central importance in credit markets and credit ratings play a key role in corporate financial policies. However, the influence of credit rating agencies is not confined only to corporate bond but also rate government such as sovereign ratings-municipal bonds and structured finance products. In world’s financial markets the rating agencies have been described as “superpowers” because they provide useful information to participants in credit markets and potential investors on the bonds that they rate, and thus are highly significant as they produce information that would be otherwise inexistent. (Benmelech,2017).

According to benmelech, the usefulness of credit rating agencies according to benmelech is that Credit rating agencies are of central importance in credit markets and credit ratings play a key role in corporate financial policies. However, the influence of credit rating agencies is not confined only to corporate bonds. For example, on September 24, 2007, the U.S. Securities and Exchange Commission granted the registration of S&P as a nationally recognized statistical rating organization (“NRSRO”) under the U.S. Credit Rating Agency Reform Act of 2006. The registration applies to five classes of credit ratings for which an NRSRO may be registered under the Act. Those are:

1. financial institutions, brokers, or dealers;  
2. insurance companies;  
3. corporate issuers;  
4. issuers of asset-backed securities;  
5. issuers of government securities, municipal securities, or securities issued by a foreign government.  

He also evaluated the quantitative content of rating decisions made by S&P and assess its development over time. His results suggest that S&P rating decisions moved from being quantitative to being qualitative and then being highly quantitative again in the last few years, and can be predicted using firm characteristics with a high degree of accuracy. In addition to analysing the quantitative content of credit ratings over time, he also analyses the evolution of credit rating standards and find that conservatism in credit ratings exists and continues through 2015. The results suggested that rating standards were kept more lenient during the global financial crisis, and it is possible that ratings were artificially held up to avoid even further downgrades.

According to Partnoy, Scholars and regulators generally agree that credit rating agency failures were at the centre of the recent financial crisis. Congress responded to these failures with reforms in the 2010 Dodd-Frank Act. He demonstrates that those reforms have failed. Instead, regulators have thwarted Congress’s intent at every turn. As a result, the major credit rating agencies continue to be hugely profitable, yet generate little or no informational value. The fundamental problems that led to the financial crisis—overreliance on credit ratings, a lack of oversight and accountability, and primitive methodologies—remain as significant as they were before the financial crisis. He also addresses each of these problems and proposes several solutions.

First, although Congress attempted to remove credit rating agency “regulatory licenses,” the references to ratings in various statutes and rules, regulatory reliance on ratings remains pervasive. He showed that regulated institutions continue to rely mechanistically on ratings and demonstrates that regulations continue to reference ratings, notwithstanding the Congressional mandate to remove references. He suggests several paths to reduce reliance.

Second, although Congress authorized new oversight measures, including an Office of Credit Ratings (OCR), that oversight has been ineffective. Annual investigations have uncovered numerous failures, many in the same mortgage-related areas that precipitated the financial crisis, but regulators have imposed minimal discipline on violators. Moreover, because regulators refuse to identify particular rating agencies in OCR reports, wrongdoers do not suffer reputational costs. He proposes reforms to the OCR that would enhance its independence and sharpen the impact of its investigations.

Third, although Congress authorized new accountability measures, particularly removing rating agencies’ exemptions from liability under section 11 of the Securities Act of 1933 and Regulation FD, the Securities and Exchange Commission has gutted both of those provisions. The SEC performed an end-run around Dodd-Frank’s explicit requirements, reversing the express will of Congress. Litigation has not been effective as an accountability measure, either, in part because rating agencies continue to assert the dubious argument that ratings are protected speech. He argues that the SEC should reverse course and implement Congress’s intent, including encouraging private litigation.