What is a Rating Agency?

Definition of a financial rating agency

The role of a financial rating agency is to assess the solvency of private and public companies, local authorities and even States. In English, we speak of “rating”. On the stock market, these agencies make it rain and shine. They have a strong impact on the financial markets.

The agencies give an opinion on the viability of a company or a State to repay its debts. In other words, they assess the risk of default for creditors. The rating assigned by the rating agencies determines the quality of the borrower’s signature.

The assessment is based solely on financial criteria through ratios ( liquidity ratio, intermediate management balances for example), the study of the balance sheet or the income statement . The valuation of a company is done on demand. Indeed, it is the company that pays to be evaluated.

Impact of financial rating

The quality of the signature, its “grade”, has a strong impact on the financing conditions of the company or the State. The better the rating, the lower the cost of borrowing. This is valid both for financing through the financial markets (the stock exchange) but also for bank loans.

The state rating serves as a benchmark for all companies in the country. A company cannot have a lower financing cost than the State to which it is attached. The government borrowing rate serves as a market benchmark, this is called the risk-free rate (the current crisis has shown us that there is no such thing as a risk-free asset, including a government bond, but that is the name commonly used). Even for a company rated, maximum rating, the cost of borrowing will be higher than that of the State. A risk premium is added for each company, which depends on its rating. The better its rating, the lower the premium. Thus, companies classified in the “Speculative” family will have a significant risk premium and borrowing rates sometimes exceeding 10% on the market.

However, the rating of a loan can change over time. Thus, in the event of a rise in the rating, the stock price will rise and borrowing rates will fall. The opposite effect will occur if the rating is downgraded.
In general, a good rating from a rating agency on a company will have the effect of attracting investors. Insurance companies can only have assets in the portfolio. However, are becoming a scarce commodity with the crisis and over time, as the debt crisis worsens, it is questionable whether an asset will maintain this maximum rating.

Rating agencies criticized

The main criticisms against rating agencies are due to their very functioning. Indeed, it is the companies that pay to be assessed which creates a conflict of interest. On the one hand, there is the client, who necessarily wants to have the best possible rating, and on the other, there is the rating agency which above all does not want to lose its client. We can therefore ask ourselves whether companies are valued at their fair value, whether they are not overestimated in terms of their repayment capacity.

Some people also argue that the agencies did not see the economic crisis coming and therefore they are inefficient. We can indeed doubt the analytical capacity of these agencies. The latest financial crisis has also revived criticism of the role of rating agencies in speculation.

Alternatives to the current financial rating system

Three alternatives have currently been put forward to deal with criticism of financial rating agencies:

– “The investor pays” : For many years, it was investors who paid to obtain an entity’s rating. . Some would like this system to come back on the agenda in order to avoid conflicts of interest between the client and the agency. However, this system receives criticism whether or not the information is released to the public. Indeed, the investor who has paid to obtain a note will not necessarily wish to share this information. You should know that on average, a request for evaluation by a rating agency costs around Rs. 70,000.

Creation of a public rating agency : The problem is that you would need a global rating agency, otherwise disparities could appear between the assessment methods of different agencies. There would then be no viable comparison between different countries or geographical areas which is a major problem for investors. In addition, a public agency involves administrative red tape that could considerably slow down the rating process.

– Use of an intermediary : A third party could intervene between the rating agency and the client. This third party would be a market authority which would exercise control over the agencies. He would be responsible for choosing an agency to meet the different demands of clients. The rating would always be the responsibility of the customer. Any conflict of interest would thus be avoided. The problem is that this type of method is opposed by rating agencies who wish to maintain their independence but also their clients who pay to receive a good rating.

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