How Credit Rating Agencies Work

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The role of providing credit related rating services is an important part of the debt securities scheme, it assists investors and others to gauge the quality of debt instruments.

The ratings provided not only focus on informing about the instruments but also on the ratings of issuers to ensure decisions made by investors are born out of a comprehensive understanding. The agency services work with different types of organizations including governments, non-governmental organizations (NGOs) and also broker dealers among others.

Credit rating agencies are renowned for their involvement in structured financial transactions, which entail a number of loans exhibiting varying characteristics. And the firms that play a part in structured finance activities regularly make inquiries with the rating agencies, in a bid to structure individual tranches for them to attain favorable ratings.

Issuers depend on credit ratings as a standard measure of their own credit standings, and the benefits filter down to debt instruments they offer by reflecting on their value. This is partcularly true considering the effect of a rating as regards bond issues, investors could devalue or shun away from an un-rated issue. A bond issue with a good rating from a reputable credit rating agency enjoys a favorable response through higher prices and greater subscription levels.

On another level, companies often resort to registering new entities with the singular intention of diverting the debt burden of a potentially risky project to it, through deployment of its very own assets as security.

This is normally done by companies with high credit ratings and want to avoid denting these ratings with a particularly dicey project, hence the strategic creation of what is referred to as a ‘special purpose entity’.

However, credit rating firms have also been castigated for taking time to down grade companies on their list in cases where changes in financial status occur, a company that goes bankrupt today is alleged to only be updated a week later.

Additionally, agencies are often labeled as oligopolists, thanks to the preposterous market entry requirements, plus the rating domain is one that thrives on some degree of uniformity. Hence, some ratings can only be taken seriously if a number of agencies concur on a particular classification.

And to mantain good practices regulators such as those in the banking sector issue directives pertaining to the use of approved credit rating agencies by the bankers. In the United States, banks must use ratings from the Nationally Recognized Statistical Rating Organizations (NRSROs).

 

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