Question

Do the various regulatory uses of credit ratings make sense? Why or why not?

Answer 1

Credit rating is an assessment of the creditworthiness of a borrower in general terms or with respect to a particular debt or financial obligation. When an entity seeks to borrow money ,it would seek to get a credit rating and based on its rating, interest component on such debt issuance can be influenced. Standard & Poor’s, Moody’s and Fitch are major global players in the credit rating business.They control approximately 95% of the ratings business .These entities conduct substantial due diligence in rating the borrowers.

Credit rating changes can have a significant impact on financial markets. A prime example of this effect is the adverse market reaction to the credit rating downgrade of the U.S. federal government by Standard & Poor’s on August 5, 2011. Global equity markets plunged for weeks following the downgrade.

Although, the ratings provided by these agencies provide an indication of the credit worthiness of the borrowers but sometimes it would be detrimental to blindly follow the ratings. For instance Moody's, Standard & Poor's, and Fitch Ratings all maintained at least A ratings on AIG and Lehman Brothers up until Lehman Brothers declared bankruptcy Sept. 15; the federal government provided AIG with its first of four multibillion-dollar bailouts.

However, the regulators do encourage use of credit ratings for Initial Public Offerings (IPOs) by the issuer so that it gives an indication to the prospective investors about the financial standing of the company. But it is to be kept in mind that the credit ratings provide ratings based on their judgement and financial data shared by the entity wanting to get itself rated , so it’s to the discretion of the rating agencies and they can very well maintain that they are just giving an opinion about the credit worthiness of the entity and they cannot be held accountable for any misrepresentation by the entity and it is the responsibility of the management to provide true and fair picture of the financial statements of the entity.

Hence to summarize, use of the credit ratings to an extent do make sense as it gives an indication of the credit worthiness of the entity but blindly following the rating and not applying own due diligence can be detrimental and the consequences can be grave.