Question

Ratings Agencies play an important role in credit markets. Carefully establish what this role is and why it is important. Appraise and explain the factors that might undermine the usefulness of credit ratings.

Answer 1

Credit rating agencies like (Moody's, Fitch) play a very critical role in the financial markets

What is their role ?

Credit rating agencies, collect information about the financial position of a company, analyze it, and eventually transform the same, into an easy and understandable manner for the general public. These reports are supposed to give confidence to investors, about the risk and returns in a particular business.

Why are they important ?

The rating to a particular company, given by a credit rating agency is taken to be an indicator of the risk profile of the company. Higher the risk profile, lower will be the rating for the company. Investors assume that these ratings are true, and invest on the belief that the credit rating agency has done its job correctly. So in a way, the credit rating agency is the first check an investor does before investing in a particular company.

Factors that may undermine their usefullness

1) Credit rating agencies are paid by the very same companies that they rate: So basically if company XYZ with bad financials wants its credit rating to be done for "Moody's", XYZ will pay Moody's for its rating. If Moody's gives XYZ a bad rating, XYZ will never approach Moody's again. This problem is called the agency problem and is the single largest drawback of their usefulness. This is the very same factor, that was responsible for the 2008 financial crisis

2) Credit rating agencies are backward looking. They analyze a company based on their past financial performance, and do not take important growth indicators into account, which can skew their analysis

3) They do not downgrade companies and economies quickly enough and in most cases take their decisons only after the problems get out of control