Credit rating agencies

Abstract

Credit Rating Agencies (CRAs) have been measuring the credit risk of debt for slightly over 100 years. The industry is characterised by artificial and natural barriers to entry and an issuer-pays system. The agencies’ ratings performed poorly for structured finance products and have been criticised for being an important factor in the financial crisis of 2007–2009. The critique focuses on poor modelling techniques and conflicts of interest.Credit rating agencies (CRAs) measure the credit risk of debt for all types of investors. Their measurement of credit risk includes default probabilities and they rate both corporate and public debt. In recent years they have also expanded dramatically into structured finance investments. In general, the CRAs use hard public information that is available to all investors, and hard private and soft private information that is provided by the issuer.CRAs serve an economic purpose: they reduce asymmetric information about issuers that investors face when making investments, thus enhancing market liquidity. They also decrease wasteful duplication of research and information production. Reputation is critical in maintaining their incentives to produce quality ratings: short-term gains from inflating an investment’s quality can be smaller than long-term losses from jaded investors.KeywordsConflicts of interestCorporate bondsCredit ratingsFitchInvestment gradeMoodysSecurities and Exchange Commission (SEC)Standard & Poor’sStructured financeJEL ClassificationsD82G14G24G28