By prof. dr. ir. Herbert A. Rijken
In corporate capital markets, Standard & Poor’s and Moody’s tend to fulfil the certification needs of investors, not the need for accurate point-in-time credit risk information. To support this certification need, Standard & Poor’s and Moody’s stabilize their ratings to a great extent. Research reveals that rating stabilization fully offsets the information advantage that agencies naturally have compared to publicly available information. The demand for a benchmark (reference point) in credit markets might explain why the major credit rating agencies still have a dominant position in the rating industry.
MOTIVATIONS FOR RATING STABILITY
The majority of investors believe that corporate issuer credit ratings are accurate measures of the issuer’s creditworthiness. However, investors are less satisfied about their timeliness. Several surveys conducted in the US reveal that most investors believe that rating agencies are too slow in adjusting their ratings to changes in creditworthiness. At the same time, investors prefer some degree of rating stability so as to avoid having to frequently rebalance their portfolios, even when this is justified by the underlying credit risk fundamentals. In addition, from a supervisory perspective, rating stability is desirable to prevent procyclicality effects. A prompt and full response to changes in actual creditworthiness could deepen a financial crisis. Another motivation for rating stability relates to the reputation of agencies. More timely rating adjustments will increase rating reversals within a short period of time. This might give investors the impression that rating agencies are providing inaccurate ratings, even if more timely and volatile ratings reflect the dynamics of current creditworthiness better. It is better to be late and right than fast and wrong. A factor that is not often mentioned, but potentially an important motivation for rating stability, is that of keeping the agencies’ organizational costs related to rating adjustments under control.
RATING STABILITY AND ACCURACY
Agencies aim to balance rating stability and rating timeliness using a through-the-cycle methodology. The first aspect of the through-the-cycle rating methodology is captured in its name. By filtering out the temporary component of default risk, only the permanent, long-term and structural component is measured. The second – less well-known – aspect of the through-the-cycle methodology is the enhancement of rating stability by a prudent migration policy. Only substantial changes in the permanent component of default risk lead to rating migrations and, if triggered, ratings are only partially adjusted to the actual level in the permanent component of default risk. Although not officially disclosed by agencies, Moody’s provided some insight into this in January 2002, stating that its migration policy was to be reconsidered: ‘Under consideration are more aggressive ratings changes – such as downgrading a rating by several notches immediately in reaction to adverse news rather than slowly reducing the rating over a period of time – as well as shortening the rating review cycle to a period of weeks from the current period of months’.
IMPACT OF THROUGH-THE-CYCLE METHODOLOGY ON RATING QUALITY
Precisely how rating agencies put their through-the-cycle methodology into practice is not clear. Treacy and Carey (2000) describe the through-the-cycle rating methodology as a rating assessment in a worst-case scenario, at the bottom of a presumed credit quality cycle. Altman and Rijken (2004) have quantified the parameters of the migration policy. This enables them to quantify the negative impact of the through-the-cycle methodology on the accurateness of agency ratings. The conclusion is that the agency ratings’ prediction performance is much worse than a simple credit scoring model utilizing a few financial ratios with accounting and stock price information. Recent research (2014) reveals that Outlooks and Watchlists (additional credit risk in formation provided by rating agencies) only partially close the information gap between agency ratings and equivalent ratings based on a simple credit scoring model.
Due to legal and contractual restrictions, most institutional investors are only allowed to invest in companies rated by an agency with an NRSRO status (National Recognized Statistical Rating Organization). In order to have access to the capital market, companies are forced to use ratings from NRSRO agencies. Even though the legal basis of the NRSRO status is only found in the US (SEC), having an NRSRO rating is a necessary condition for large international companies to have sufficient access to the international capital market. As long as agency ratings are used as portfolio eligibility standards set by regulators, fund trustees and boards of directors, agency ratings will serve as the reference point, even if the quality of their information is not superior and competitive sources of more accurate credit risk information are available.
A widely accepted (reference) rating scale strongly supports pricing and transaction efficiency in credit markets. The pricing of debt securities seems to be strongly linked with the level of the agency ratings and less correlated with the dynamics of the underlying credit risk fundamentals. Rating adjustments appear to trigger strong price responses in security markets, although rating adjustments primarily reflect changes in credit risk fundamentals 6-9 months earlier.
New regulation – both in the US and EU – is not focused on the certification function of agency ratings, but intends to improve the quality of the information provided by agency ratings through more strict supervision of the agencies’ internal rating assignment process and by allowing more competition in the rating industry. Not surprisingly, the new regulation does not seem to have altered the dominant position of Standard & Poor’s and Moody’s in the rating industry. For example, to allow for more competition in the rating industry, the US Congress approved the Credit Rating Agency Reform Act in September 2006. This act introduces a new system of voluntary registration, so any rating agency that can show a good track record – subject to objective criteria – can obtain an NRSRO designation. As a result, more agencies have gained NRSRO status, but the dominant position of Standard & Poor’s and Moody’s remains unaffected.
Presumably, only a restricted number of major rating agencies will survive in free-market conditions when the certification need is the most important economic function of agency ratings. Portfolio eligibility standards have to be widely accepted, so investors prefer a restricted number of rating agencies that limits conflicting rating opinions and safeguards the consistency in the rating scale. So far, investors, authorities and regulators have used the agency ratings as the benchmark for credit markets; and a benchmark needs to be stable.
For further inquiries about the research project, please contact Prof. dr. ir. Herbert A. Rijken, firstname.lastname@example.org.
Altman E.I. and H.A. Rijken. 2004. How Rating Agencies Achieve Rating Stability. Journal of Banking & Finance 28(11): 2679-2714.
Fons, J.S., R. Cantor and C. Mahoney. 2002. Understanding Moody’s Corporate Bond Ratings and Rating Process. Special Comment, Moody’s Investor Services (May).
Rijken, H.A. 2014. Added value of Outlook and Watchlist information. working paper.
Treacy W.F. and M. Carey. 2000. Credit Rating Systems at Large US banks. Journal of Banking & Finance 24(1-2): 167-201.