Credit Rating Agencies: Downgraded but Not Out
Credit rating agencies are said to have the power to shape corporate fortunes and humble nations. In fact, agencies tell us less about credit quality and more about capital access, according to research by Lynnette Purda, Queen's School of Business Associate Professor and RBC Fellow of Finance
To the growing list of loathed professionals, right up there with politicians, lawyers, and journalists, it may be time to add credit rating executives.
Since the turmoil in world financial and capital markets first began in 2007, credit rating agencies such as Standard & Poor’s and Moody’s have been slagged for their outsized power to shape corporate fortunes and humble provinces and nations. The controversy came to a boil in August 2011, when Standard & Poor’s downgraded its credit rating of the U.S. federal government, the first time the U.S. was given a rating below AAA.
Do they deserve the bad rep? While she’s not ready to join their fan club, Queen's School of Business Associate Professor of Finance Lynnette Purda says credit rating agencies play a necessary role in capital markets and that there is not yet a better alternative.
“If you think they’re so bad, then don’t use them,” she said during a research presentation at Goodes Hall in March 2012. “If they have any merit, they will survive. If they don’t, they won’t. As long as we don’t have an alternative that is convenient for investment managers and funds to communicate how they want portfolios structured, then we’re stuck with ratings.”
Credit rating ecosystem
A credit rating is simply an opinion on the general creditworthiness of an obliger, or the creditworthiness of an obliger with respect to a particular debt security. A company or government pays an agency for a credit rating, which is then made publicly available for free. Other market players, sensing that credit rating agencies have access to inside corporate knowledge, feed off this information. Equity analysts adjust their targets, institutional investors boost their investments, and auditors charge lower fees for firms that are well rated.
Purda, who has 10 years of research in the area, told the School of Business gathering that credit rating agencies are considered “both useless and powerful at the same time.” They are criticized for being inaccurate, not measuring what the market expects, and being too slow and needing adjustment. Having issuers pay to secure their own rating can also be seen as a possible conflict of interest.
Some criticism may be fair comment, other less so. In terms of timeliness, she said, it is true that market indicators lead credit ratings, but that is by design: agencies aim to provide a stable rating over a business cycle.
Despite the criticism, investment managers give power to credit agencies, Purda said, “by referencing ratings in investment guidelines, even removing an investment if it falls below a certain credit agency level.”
There is no denying that credit rating agencies powerfully influence the supply and demand of debt. For lenders, they affect the ability to lend due to formal investment guidelines that rely on ratings. For borrowers, they are a key to accessing different sources of debt. “Uninformed lenders such as foreign banks and nonbank institutions are more likely to be part of a lending syndicate if the loan is rated,” she said.
Opening the credit doors
Purda suggested the stamp of approval offered by credit rating agencies, rather than their actual ratings, is the most significant takeaway. “We spend a lot of time thinking about what these agencies tell us about credit quality but what’s more important is what agencies tell us about capital access. The fact that we rely so heavily as potential lenders on ratings says who has access to capital and who doesn’t have access to capital.”
In recent years, there has been growing debate about whether or not to regulate credit rating agencies. Purda pointed out that there are two philosophical approaches. In Canada and Europe, the view is that credit agencies should be registered, with rules governing conflict of interest and certification. In the U.S., the prevailing thought is to remove reference to credit ratings from regulations and let the market prevail. There would only be a role for credit rating agencies if they provide information deemed important.
“I would advocate for that [U.S.] approach,” Purda said. “I would rather see not only informal regulation but also, within investment guidelines, that we try and find something else.”
— Alan Morantz