Updated Feb 01, 2022

What is a credit rating agency?

What is a credit rating agency?

One of the most essential functions in the financial markets is that of credit rating agencies. We will discuss what credit rating agencies are, how they operate, some of the different agencies, and who controls them in this article.

 

 

What are credit rating agencies?

 

Individual companies, stocks, government, corporate, or municipal bonds, mortgage-backed securities, credit default swaps, and collateralized debt obligations can all be assigned a credit risk rating by credit rating agencies. The likelihood of a borrower defaulting on their loan repayment obligations is measured by credit risk.

 

The rating provided to one of these securities can be used to determine whether the security is a good investment or a risky gamble. Investment-grade securities have a higher rating, whereas speculative securities have a lower rating.

 

This means that a market participant may want to buy investment-grade assets outright or go long on them, but they may also want to speculate on the price movements of securities with a higher implied rate of credit risk using financial derivatives like CFDs or spread bets.

 

CFDs, also known as spread bets, allow you to go long and speculate on the underlying's price rising, or short and speculate on the price decreasing. This makes them popular financial solutions for market players who want to invest in securities with a higher risk of default.

 

 

What is the working of a credit rating agency?

 

Credit rating agencies assess a company, person, or entity and issue ratings to them. Companies, state governments, non-profit organizations, countries, securities, local government bodies, and special purpose entities can all be rated by these authorities.

Financial statements, type of debt, lending and borrowing history, payback capabilities, historical credit repayment behavior, and other criteria are all taken into account when determining a rating. Each of these elements plays a part in calculating the final result, the credit score.

 

The credit rating agency does not decide on whether or not an entity should be granted credit; rather, it gives the report and extra information to help the lender analyze the situation and make an informed choice.

 

 

Credit Ratings' Importance

 

A credit rating is an accurately analyzed assessment of a borrower's creditworthiness. As a result, the scorecard has an impact on how much corporations or governments pay to borrow money. In other words, a downgrade lowers the bond's value and hikes interest rates. As a result, the general investor sentiment toward the Borrower Company or Country is influenced.

 

If a company's fortunes are perceived to have declined and its rating is dropped, investors may demand higher returns to lend to it, deeming it a riskier bet. Similarly, if a country's economic and political policies appear doomed, global credit agencies reduce its ratings, affecting the flow of investment into that country. On a macro level, these changes have an impact on a country's economic policy.

 

For countries and financial institutions issuing bonds, an endorsement from a credit rating agency makes life easier. It shows investors if a company has a track record and how likely it is to repay their money.

 

 

Credit scores’ Importance

 

A credit score is vital for borrowers, whether they are individuals or corporations because credit rating organizations objectively evaluate the borrower's financial situation to determine whether they are trustworthy with a new line of credit. Lenders use the credit reports provided by these agencies to determine whether or not to approve or reject loan applications.

 

A bad credit score can make it difficult to obtain a loan in any part of the country. Even if they are approved for a loan, the terms may be restrictive and the interest rate expensive. A good credit score, on the other hand, can lead to a speedy loan approval as well as other benefits such as an overdraft, cheaper interest rates, and a lower margin, among other things.

 

 

What Is the Difference Between a Credit Score and a Credit Rating?

 

These two names are frequently used interchangeably; however, they are not synonymous. The following are the distinctions between the two:

 

A credit rating is a measure of a company's or a business's creditworthiness. However, it is not commonly utilized by people like us. It provides insight into the company's capabilities. These ratings are commonly expressed by alphabetical symbols and are based on corporate financial instruments. The lower the rating, the less likely it is that you will default on your payments.

 

A credit score, on the other hand, is a number produced by a credit agency and assigned to individuals based on their credit report. This number might range from 300 to 900. When it comes to getting a loan or a credit card, your credit report is crucial.

 

 

Who regulates credit rating agencies?

 

Following the financial crisis of 2008, credit rating firms were subjected to more stringent regulations. The introduction of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in 2010, was particularly important in the United States.

 

The legislation established measures aimed at preventing any bank from becoming too big to fail, as well as examining Fed bank bailouts and monitoring high-risk derivatives. It also established several new institutions charged with overseeing the US and worldwide financial systems, in the hopes of preventing a repeat of the 2008 financial catastrophe.

 

Depending on the geographical area, several organizations control credit rating agencies. Credit rating agencies situated in the United States, for example, are regulated by the Securities and Exchange Commission (SEC).

 

Credit rating agencies are regulated by the European Securities and Markets Authority (ESMA) in Europe; once the UK leaves the EU, this duty will be taken over by the Financial Conduct Authority (FAC). ESMA's regulatory mission is to maintain "credit rating activities' integrity, responsibility, good governance, and independence to ensure quality ratings and high levels of investor trust."

 

 

Process of Credit Rating

 

Credit rating is generally done at the request of borrowers or issuer corporations in India. The borrower or issuing company asks the credit rating agency to give the proposed instrument a rating. The majority of credit rating companies use the following procedure:

 

Agreement

The rating agency and the issuer company have reached an agreement. It contains information about the terms and circumstances for completing the rating.

 

The formation of an analytical team

The duty is assigned to a team of experts by the rating agency. The team is usually made up of two analysts with extensive understanding of the appropriate business area and is in charge of rating.

 

Information gathering

The analytical team gathers the necessary data from the client company and investigates the financial position, cash flows, nature and basis of competition, market share, operating efficiency arrangements, cost structure, selling and distribution records, power (electricity), and labor situation, among other things.

 

Meeting with government authorities

The analytical team visits and engages with the client's executives to gather explanations and gain a better grasp of the client's business.

 

Discussion about findings

After the analytical team has finished studying the facts and analyzing them, the topic is presented to an internal committee (made up of experienced analysts) for a rating opinion.

Meeting of the rating committee

The internal committee's conclusions are forwarded to the "rating committee," which is made up of a few directors and has the final authority for assigning ratings.

 

Decisions communication

The rating committee's decision is notified to the asking company.

 

Information to the public

The rating is made public through reports and the press by the rating business.

 

Revision of the rating

The rating agency should monitor the assigned rating once the issuer company has accepted it. Throughout the instrument's life, the rating agency keeps track of all ratings.

 

 

Who regulate credit rating agencies in India?

 

The Securities Exchange Board of India (SEBI) is the country's stock exchange. In India, it is recognized as the credit rating agencies' regulator. It was founded by an Act of Parliament in 1992 to protect the interests of securities investors, promote the development of the securities market, and regulate it.

 

Credit rating agencies summed up

• Credit rating agencies evaluate the credit risk of corporations, stocks, government, corporate, and municipal bonds, mortgage-backed securities, and collateralized debt obligations.
• The Big Three are Moody's, Standard & Poor's, and Fitch Ratings, which are the three primary credit rating agencies.
• Standard and Poor's and Fitch Ratings utilize the same rating scale and modifiers, although Moody's uses slightly different modifiers to indicate equivalent data.
• Many people believe credit rating companies contributed to the financial crisis of 2008 by mistakenly assigning low-risk ratings to high-risk mortgages and loans.
• Following the crash, credit rating firms were subjected to increased scrutiny, with the agency in charge of oversight varying by geographic location.