Credit rating agencies' role in capital markets and investor protection

Credit Ratings

The company which is responsible for assigning the issuers of particular kind of debt obligations and debt instruments the credit ratings is known as a credit rating agency (CRA). There are a few cases in which the ratings are given to the underlying debt servicers. It is the special purpose entities, non-profit organizations, companies, national governments and the state and local governments who, in majority of the cases get the securities issued. The credit worthiness (i.e., the ability to pay the loan back) as well as the rate of interest which is applied to a specific security being issued is taken into consideration while assigning a credit rating to an issuer. After the financial crisis which took place in 2007/2009 the value of this kind of ratings was questioned to a great extent. A report was submitted by the Securities and Exchange Commission to the congress in 2003 which contained details of the plans to have an investigation conducted into the credit rating agencies' anti-competitive practices as well as the issues regarding the conflicts of interest (Partnoy, 2006).

Investors, broker-dealers, issuers, governments and investment banks make use of the credit ratings. The range of investment alternatives is increased by the credit rating agencies for the investors and they are provided with easy-to-use measurements of relative credit risk as well as more independence. All this usually lowers the costs for the lenders and borrowers and increases the efficiency of the market and in turn the overall supply of the risk capital present in the economy gets increased which results in stronger growth. The capital markets also get opened to various types of borrower who otherwise might get shut out completely; these can be startup companies, universities, small governments and hospitals (Partnoy, 2006).

Credit rating is relied upon by the issuers as something that can verify the worth of their credit in an independent manner as well as the resultant value of the instruments which is issued by them. In majority of the cases there should at least be one rating for an important bond issuance and this rating should preferably be from a respected CRA in order for the issuance to be successful. It has been shown by the studies done by Bond Market Association that a debt issuance with at least 3 ratings is now being preferred by a lot of the institutional investors (Partnoy, 2006).

The credit ratings are also used by the issuers in particular structured finance transactions. For example, if a company which has quite high credit ratings and it wants to obtain a research project which is very risky then it could create an entity which is separate in the legal terms and has particular assets owned by it and doing the research work. All of the research risks will then be assumed by this "special purpose entity" and in order to finance the research it will issue own debt securities. The credit rating of the SPE will probably be quite low and a high rate of return will have to be paid by the issuer on the issued bonds. Although, the overall credit rating of the parent company will not be lowered by this risk as, the SPE is going to be an individual entity. Another way through which borrowing can be done on better terms by a company that has low credit rating by forming an SPE and transferring its important assets to this newly formed subsidiary and issue debt securities which are secure. In this way in case that the venture doesn't work the lenders will have the option of the assets that will be owned by the SPE. This will also help in lowering the interest rate which the SPE, as a part of the debt offering has to pay (Partnoy, 2006).

It is possible for the same issuer to have various credit ratings for various bonds. It is the structure of the bond that is responsible for this difference such as; the way that the bond was secured, the extent of its subordination to other debt etc. The "credit rating advisory services" are offered by a lot of large CRAs. The basic function of these services is that they give instructions to the issuers on how they can structure the SPEs and bond offerings so that they can achieve specified credit rating for a particular debt tranche. A probable conflict of interest is created by this since it might be felt by the CRA that it has to give the specified rating to the issuer as the advice regarding the structuring of offering was followed by the issuer. This conflict is avoided by some of the CRAs in such a way that they decline to rate the debt offerings that their advisory services had been sought for (Partnoy, 2006).

History of the Rating Market

Taking into consideration the recent events it is beneficial to take into account the credit rating agencies' history as well as the role that was played by them in the financial markets. Credit ratings have been made use of in order to differentiate between debt creditworthiness grades since the beginning of the last century. However, it was in the beginning of 1975 that explicit references were started being made by SEC to the credit ratings in its rules. Originally the term "NRSRO" was adopted by the Commission in 1975. The sole purpose of using this term at that time was to determine the capital charges on various grades of the debt securities under the Commission's net capital rule for broker-dealers. However, this concept of NRSRO was incorporated into various SEC rules and regulations which also included the rules that were issued under the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company Act of 1940. This concept of NRSRO was started to be used by Congress in its legislation along with many other regulatory bodies such as banking regulators both abroad and at home (Frost, 2006).

Even though the concept of NRSRO was used by SEC for the regulatory purposes before the Rating Agency Act was enacted but still no legislation has given statutory regulatory authority to the Commission over the credit rating agencies. Prior to the enactment of Rating Agency Act the credit rating agencies were identified as NRSROs by the Commission staff, this was done through the no-action letter process. According to this process the documents and information which was submitted by the credit rating agency was reviewed by the staff in order to determine if the broad market acceptance has been achieved by the agency for its ratings. If the staff decides that the agency has been able to achieve the acceptance then, a letter is issued by the staff which states that enforcement actions aren't recommended against the broker-dealers who made use of the agency's credit ratings for the sake of complying with the net capital rule of the Commission (Frost, 2006).

With this process 11 firms were previously identified by the SEC staff as NRSRO. However, a consolidation of many NRSROs took place with the help of which 5 of the credit rating agencies which had been acknowledged under the no-action letter process were able to stay in business at the time of enactment of Rating Agency Act. These agencies were: A.M. Best Company, Inc.; Fitch, Inc.; DBRS Limited; Moody's Investors Service, Inc.; the Standard & Poor's Division of the McGraw Hill Companies, Inc. between the passage of the Rating Agency Act and its enactment there were two more NRSROs identified. These were; Rating and Investment Information, Inc.; and Japan Credit Rating Agency, Ltd. (Frost, 2006).

The Credit Rating Agency Reform Act of 2006

The no-action letter was replaced by the rating Agency Act with a program of the Commission for the credit rating agencies which elect to get registered as NRSROs. According to the Rating Agency Act an agency which is seeking to be registered as an NRSRO has to apply in the Commission for the registration, make some of its information in the application public so that its credibility could be evaluated easily and procedures could be implemented in order to manage the handling of conflict of interest and nonpublic information. According to the statutory mandate the implementing rules of the Commission require that an NRSRO's conflicts of interest should be disclosed and particular conflict of interest should be proscribed. The important Rating Agency Act's provisions as well as the new Commission rules have been mentioned below briefly (Flandreau, 2009).

Accuracy and Responsiveness

Rating has proved to be very useful in various constituents of capital market. There are different benefits that can be achieved by makinguse of rated instruments for various classes of people.

1) Investors: By recognizing the risk safeguards are rated againstbankruptcy. It tells us about the risk which is present in aninvestment. The credibility of the issuing company can be evaluated.Information regarding the instrument quality is given by the ratingsymbols in a rather simpler manner which can be apprehended by a layinvestor and it can further help him in reaching a decision regarding theinvestment without getting help from a broker. The institutions aswell as individuals can draw up their own policies regarding creditrisk and evaluate the risk premium which is offered by market oncredit ratings' basis (Dittrich, 2007).

2) Issuers of Debt Instruments: A company which has highly ratedinstruments has higher chances of getting wider access to capital andthat too at a cost of borrowing which is relatively low. Best timingand pricing of issues is facilitated by rating and it also givesfinancing flexibility. Rating can be used as a marketing tool by thecompanies that have rated instruments in order to make a better imageof the company in customers', creditors' and lenders' eyes. Companies areencouraged by ratings to give more disclosures regarding theirmanagement patterns, accounting systems and financial reporting. Theinvestors who need mandated rating from renowned rating agencies tomake investments can also do so with the help of these ratings (Dittrich, 2007).

3) Financial Intermediaries: When it comes to decisions concerninginvestment and lending the financial intermediaries such as investmentadvisors, merchant bankers and banks find rating to be quite useful (Bolton et al., 2008).

4) Business Counter-parties: The business Counter parties find creditratings to be very helpful in the establishment of businessrelationships especially when it comes to opening letters of credit, getting into the collaborating agreements and awarding contracts etc.(Bolton et al., 2008).

5) Regulators: With some help from credit ratings, the entry barriersand eligibility criteria for new securities, promoting the efficiencydebt securities market, monitoring the financial soundness of firmscan be determined by the regulators. The transparency of financialsystem is increased by this which leads to a sound development of themarket (Bolton et al., 2008).

Rating and Default Risk

The use of credit ratings is preferred by many of the investors inorder to evaluate the default risk. Rating services are being offeredby the internationally renowned credit rating agencies such asStandard and Poor's, Moody's and Duff and Phelps. The rating agencies get paid by the bond issuers in order judge the worth of the issued bond so that the flow of information to the investors could be increased which would probably bring an increase in the demand for their bonds.Bond rating is determined by the rating agencies by taking many factors into consideration such as, the values of corporate bonds is evaluated by studying the bond indenture, future earning power, management and financial resources by Standard and Poor's. To be more precise the cash flow is mainly focused upon by Standard and Poor's in order to evaluate the financial viability of a firm. There are letter grades that are assigned to the categories of the bond. The highest grade bonds: these are the bonds that have negligible risk of default are rated as A (Aaa or AAA). Pluses or minuses (e.g.Aa+ A-)are assigned by the rating agencies whenever it's appropriate in order to show where the significant rating categories stand (Tasche, 2006).

Explanation of flaws and Excessive Power

When it comes to credit rating there are a lot of limitations. Firstly, there occurs a change in the credit ratings when it is felt by the agencies that a lot of change has taken place. It is physically not possible for the rating agencies to monitor all the firms that are present in the market on a constant basis. In case of events that may impact the asset quality of an issuer in a bad way, it might have an impact on the opinions that the rating agencies have regarding that issuer. Secondly, discrete categories are imposed on the default risk with the use of credit ratings whereas, in real the default risk is actually a uninterrupted phenomenon. It was recognized by Moody in 1982 that with the addition of numbers in the letter system the number rating category can be increased from 9-10-19. However, there still is this limitation that exists. Thirdly, due to the constraints of cost and time it is not possible for the credit ratings to seize all of the issue and issuers' characteristics (Tasche, 2006).

The cost of borrowing can be reduced by the borrowing company if it is able to get higher rating for its anticipated issue. Therefore, the pressure to get good ratings is very high and if a company finds out that it will be getting a low quality rating from the hired agency it an approach another one and use the best rating from amongst the two as it is not necessary for the firms to disclose all of their ratings. According to the rating practice in India it is not necessary for a corporate entity to agree to the first rating that is given to the debt issue and it also has the option of not using that agency again to get rated. In this sort of scenario, the rating agency is not allowed to reveal the assessments in front of anyone and the corporate entity has the freedom to go to some other agency as well. However, if ones the corporate entity has agreed with its first rating then, it can't get out of it (Tasche, 2006).

It is important for the rating agencies to ensure that the rating decisions being made by them are not determined by the profitability and volume and in the hopes of ensuring a promising impact on the share price. It should also be mentioned here that the rating agencies should be judged on their performance overall and not just by one or two defaults (Tasche, 2006).

The financial meltdown: Cause and effect

After the corporation agrees with the initial rating, the rating agency has to evaluate the debt issue subsequent to its maturity and release the rating as a component of the surveillance system. It has been seen that rating agencies haven't been able to asses a disaster in making and keep giving investment grade rating to various companies, which default after a certain amount of time. It is often stated that CRB scam wouldn't have occurred, had it been a competitive credit rating agency, warning would have been issued to the company. When disaster struck then, these rating agencies became careful and started downgrading ratings for some companies (Tasche, 2006).

For example, ICRA, CARE and CRISIL downgraded at least 35, 50 and 140 companies in 1997. The rating was changed by CRISIL, CARE and ICRA by 36%, 64% and 40% by at least three or four notches (Tasche, 2006).

Performance assessment

Conflict of interest

The Rating Agency Act allows NRSRO to reveal its conflicts of interest which are probable in its case of shaping its credit ratings and for maintaining, establish and enforce policies and procedures designed moderately, while considering the nature of business deeply for tackling and managing conflicts of interests. The Rating Agency Act gave the commission the authority to forbid or reveal fully the conflicts of interests aligned with respect to credit ratings by NRSRO. The commission has highlighted rules which bar the NRSRO from harboring some conflicts of interests in case, it hasn't worked in conjunction with requirements of Rating Agency Act for managing and disclosing them.

The conflicts seen in this category are receiving of compensation from the underwriter / issuer to grade securities issued or backed by the company. The commission's rule forbids NRSRO from harboring many other conflicts in various situations. Some of the most conflicts are taking compensation for assessing credit rating, where a customer paid for the credit rating given by NRSRO with maximum total revenue at the end of the financial year which exceeded or equaled 10% of NRSRO's gross revenue (Blochwitz et al., 2003). .

The SEC has certain rules, one of them involves handling the nonpublic information by NRSRO and forbid malpractices, unfair, coercive and abusive for that matter by NRSRO- this includes threatening to modify or modifying the credit ratings or not following the systematic procedures / methods outlined for determining the credit ratings, encompassing the obligor as well as the affiliate of an obligor, buys the credit rating and other services / products of NRSRO and personnel related to NRSRO (Blochwitz et al., 2003).

Records, book keeping and financial reports

Apart from that disclosure requirements and provisions for conflict of interest, the commission and Rating Agency Act has implemented rules, which enables NRSRO to keep records and books as well as documents of the procedures and methodologies in question employed by NRSRO to work out credit ratings. These records and books will permit commission examiners to assess if their procedures are being followed as outlined and in conjunction with Rating Agency Act. NRSRO's are bound to keep both outgoing and ingoing communications sent / received by the NRSRO and its employees which comprises of maintaining, determining, changing and withdrawing credit rating (Hull et al., 2004).

The Rating Agency Act as well as implementing rules allows NRSRO's to answer in front of a commission in confidentiality, some monetary reports, every year which includes audited financial statements. Apart from the audited financial statements, rules also need NRSRO's to provide unaudited financial reports which helps the commission in executing its responsibilities under the act of Rating Agency Act (Hull et al., 2004).

The Rating Agency Act states that all records given in NRSRO are liable to special, periodic and cross examination by commission's representatives, when the commission thinks it necessary to do so. The interests of the investors have to be protected. This is also done to carry out the Securities Exchange Act of 1934 (Hull et al., 2004).

Forbidding the regulating rating procedures

The commission is also wary of congress's intent in this case implementing this statue. The commission's judgment must be taken heed rather than that of rating agencies (Hull et al., 2004). The Securities and Exchange Commission on September 17, 2009 voted in favor of instituting a rule for examining the credit ratings agencies.

Revealing the rating activity history: The Commission made an amendment allowing the NRSRO's to reveal their history on ratings action. These actions consist of downgrades, upgrades, affirmations and withdrawals. This makes NRSRO responsible for all the ratings done as earlier as June 26, 2007. The disclosure must be made under two years' time after the action has taken place for paid ratings and under one year for issuer paid ratings. They should be available online and easy to search manner (Flandreau, 2009).

Making sure that NRSRO's must have same information: Demands that an NRSRO- which is paid by the arranger to grade a structure finance product-to reveal other NRSRO's which are in grading such credit rating during the process. This amendment thus requires NRSRO to gain a representation from arranger that the required arranger will reveal the information to various NRSRO's looking to grade the product (Flandreau, 2009).

Recording the compliance reviews: This permits the NRSRO to deliver SEC a report explaining the compliance reviews for the financial year (Flandreau, 2009).

Furnishing information on conflict of interest: This permits the NRSRO to show NRSRO's net revenue percentage interrelated to 20 biggest consumers of credit rating services of NRSRO (Flandreau, 2009).

Additional information is given about magnitude of conflicts: This compels NRSRO to be available as public information for personnel, who paid for credit ratings. Under the devised rule, the NRSRO will publish a report on their website for every year, which shows the net revenue percent generated by NRSRO for that financial year for delivering services and products apart from credit rating services and current position of a person (top 10%, top 25%, top 50%, bottom 50% and bottom 25%) translating the net revenue generated by the NRSRO related to the person (Flandreau, 2009).

The references to NRSRO Credit Ratings in Rules and Forms will be removed: The commission decided to vote in favor of amendments which negate the references to NRSRO credit ratings in some SEC forms and rules (Flandreau, 2009).

Assessing the ratings

1: The rating agencies publish a report on credit risk assessment, which oversees the credit flow. They are analyzed for governing the framework of financial markets (Jafry et al., 2004).

2: For comprehending how this form of governance unfolds, the social and institutional perspective of the credit rating agency must be comprehended. Therefore, strong legal, political and professional influences are visible on credit risk assessment (Jafry et al., 2004).

3: The rating agencies are analyzed as a quasi-power structure, which isn't as important as the risk perspective. The methods of risks are assessed by periods of risk communication which involves risk management strategies discussed in a wide political setting. The risk perspective permits considering legitimization of the rating agencies. The usage of ratings as a standard is quite a genius way of lessening the innovation averse regulation (Jafry et al., 2004).

4: The fees should involve more subsidies granted by government to credit rating agencies due to the fact that credit and loans given by banks as well as small / medium size companies shrinked rapidly. These companies don't seek the assistance of credit rating agencies for checking their credit criteria. On the basis of the ratings assigned to small / medium sized companies by rating agencies, will assist them in booking loans and credit from banks (Jafry et al., 2004).

5: There has been widespread conflict of interest as well as entry in rating industry, which has caused a serious assessment of quality of ratings. Market discipline and self-regulation hasn't worked either. Hence, there must be a free entry check of credit rating agencies too, if viable. Moreover, the credit rating agencies should also be graded (Jafry et al., 2004).

6. However, CRAs lack transparency and do not provide clear information about their methodologies. Therefore, laws must be framed for credit rating agencies, whenever they give ratings to any company the methodology adopted by them and the procedure should be made clear. This will help in enabling viability of the ratings (Jafry et al., 2004).

7: The CRA's need to augment and clarify the information given to investors on structured products for judge the reliability of the information taken from underwriters, sponsors and issuers, which will the viability of rating methodologies and transparency of models in question. They can also pay heed to conflicts of interests and add concerns pertaining to remuneration models (Jafry et al., 2004).

8: The investment frameworks and risk management frameworks shouldn't rely on ratings, identify the shaky ground surrounding ratings and discern products with respect to their risk characteristics (Jafry et al., 2004).

9: The sponsors, underwrites and issuers must give apt and concrete information to CRA's and investors (Jafry et al., 2004).

10: The authorities should assess if the rating rules (for supervisory and regulatory) give rise to perverse incentives for investors and give way to reliance on ratings as a replacement for autonomous assessment. They should assess carefully, the intermediate insinuations of any alterations to ratings frameworks and oversee supervisory rules / regulation rules (Jafry et al., 2004).

International credit crisis and credit rating

The present economic crisis is a sequence of events related deeply which opened up a Pandora box. For instance, the Wall Street crashed and burned, the international stock markets fell head over heels, the credit markets became more active making demands such as economic relations without involving stock markets, while the worldwide governments were left with implementing bailout packages. The factors causing this financial instability are multiple and quite far reaching. The critics have in this case put the blame on rating agencies playing a pivotal role in worsening the situation. The official bodies involved in this case are namely:

Security and exchange commission

Financial stability forum

President's Working Group

International organization of securities commissions

All of these organizations did an incompetent task of evaluating the default risk of CDO and such relevant tools on which subprime mortgage backed securities are based. These tools have high ratings, which had an adverse effect on the financial markets. Subsequently, the subprime borrowers were late in their mortgage payments which brought the viability of the ratings into limelight. This led to a severe financial crisis (Tiomo, 2004).

The investors were compelled to sell off the securities at dirt cheap prices for sustaining liquidity. The subprime mortgages have a default rate, which is just a tip of the iceberg for the critics. The rating agencies have come under severe pressure for employing faulty methods and processes to rate different products. Moreover, ratings have been performed with incompetence on certain products related to subprime mortgages. For instance, CPDO (Constant Proportion Debt Obligation) was initiated back in 2006, as a tool for attaining the fixed yield targets by differing leverage as the market allows. In the case of CPDO, the source of risk and return is based on ratio of corporate credit expanse.

So, there is no relation with the subprime mortgages. In early 2008, Moody downgraded at least 21 European CPDO's. This is the half of their rated CPDO's. But moreover, at humble estimates, the CPDO downgrades show a clear coding error on behalf of Moody. In early 2008, Moody surprisingly discovered that his work had driven $7 billion worth of CPDO's at AAA level. The error was directly attributed to coding error which tarnished data integrity.

It is quite plausible that the blunders created by agency models were further boosted by CDO arrangers, who were bent on herding behavior. After the arranger developed a method, which attained a certain rating, rest of the arrangers followed up, which augmented the deficiencies the rating system previously harbored. So in case, the agency models were deficient on the whole, as deemed by the observers, then these agencies failed to predict the efficiency of subprime loans and payback capacity of the subprime borrowers. They also failed at the core level as they didn't see the error of their work in case of certain securities. This feature requires more research and analysis (Tiomo, 2004).

In conclusion

As evidenced above, the blunders committed by these agencies created a disaster for the world financial markets. The rating agencies took the heat rightfully for this incompetent work performed. The commission has proper laws and regulations overseeing business practices.