The Relevance of Rating Agencies

Jan 20, 2012

- By Asad Dossani, Author, The Lucrative Derivative Report

Asad Dossani
The purpose of rating agencies is to provide an independent assessment of the credit risk of debt instruments and issuers of debt securities. They rate everything from company debt, sovereign debt, asset backed securities, etc. A major issue in the financial markets today is sovereign debt ratings. Various European countries have had their credit ratings lowered, and the US lost its AAA rating in August last year.

Naturally, the actions of rating agencies have resulted in heavy criticism from the various governments involved. This is especially the case in the Eurozone, where rating agencies have come under heavy fire due to their actions destabilizing markets and making the debt crisis worse. ---------------------------------------- Have an enriching Saturday! ----------------------------------------

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Some of the criticism is justified in the sense that rating agency actions can have a significant impact on the markets, and in the case of the Eurozone, it can be destabilizing. However, this does not mean that they are wrong. Countries get their credit ratings lowered whenever they have debt problems, and rating agencies are simply exposing the facts about countries with risky debt.

The real problem lies not with what rating agencies are doing. They are entitled to their opinion, just as any other financial institution or individual investor. The problem is the importance that we place on the opinion of rating agencies. The financial markets are heavily influenced by the opinions of rating agencies.

For example, when financial institutions require securities as collateral, they will usually specify a minimum rating for the collateral. The regulations that govern the investments of many institutions (e.g. pension funds) will often specify what rating a debt instrument needs to have for it to be a valid investment.

The rules of the financial system are based on the assumption that what the rating agency says is a fact. This is wrong. What the rating agency says is an opinion, not a fact. If Equitymaster or any research institution says that a particular stock is undervalued, this is an opinion or a view, and not a fact.

There is no such thing as a fact when it comes to the performance of future investments. When we talk about the performance or riskiness of investments, we can only express opinions and views. Investors and institutions can have different and opposing views on the same investment.

The same logic must be applied to credit ratings and debt instruments. A credit rating agency puts forward an opinion regarding the default risk of a debt instrument. As investors, we can agree or disagree with the rating, and base our actions on our own views.

Governments should learn to do the same. They should stop putting so much emphasis on what the rating agency says, and focus on the task at hand, which is to improve their financial situation. They should realize that a credit rating is simply the opinion of a particular organization, and treat it as such.

is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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4 Responses to "The Relevance of Rating Agencies"

Hasit Hemani

Jan 22, 2012

The Rating Agencies are doing a yeoman's job for general as well as professional people, very useful and appropriate. As long as they are doing their task with honesty and integrity their verdict will be noticed and valued. That is why even President Obama got incensed when US credit was downgraded. One more interesting function they can undertake is giving different Govt.s and large Corporations's management, efficiency ratings. Are they working on the optimum level of competency and proficiency required or functioning below standard ? It will give them a real jerk when their competency level will be made public.

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Rockson Rodrigues

Jan 22, 2012

What Assad says is right, that the ratings agency views an opinion and may not be a fact.
However one must remember that as per internal policies of most Banks, countries and banks are provided credit limits based on the ratings provided by the Rating Agencies and therefore it becomes difficult to discard their opinion, even though one may not agree with their views.
Does this call for a revamp of the existing system in the banking industry?

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Rajendran

Jan 22, 2012

Exactly!

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Piyush Singh

Jan 20, 2012

Granted, the attention given to the Ratings are overwhelming. One, however, must not forget that the role of Rating agencies is to impart transparency in the use of financial instruments - & they have, so far, played that role with proficiency, thereby, earning some credential. We know that rating, although, are views - but a employed from research-based analysis - this adds much to their perceived credence.

The malady arises from the fact that the rating domain has been primarily regulated (or maneuvered) by only 3 agencies; & that there influence has an American resonance. The fact that the markets gives a unjustifiably good ear to these agencies, the idea of Sovereign credit rating becomes unnecessarily radical. I opine that the RA's should be mitigated from doing any Sovereign Debt rating.

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