Credit Rating Agencies - Term Paper Example

? Did Credit Rating Agencies Do Good Work The agencies bear the greatest responsibility of the financial crisisthat last from 2007 to 2009 and the policy makers, agencies itself and the market participants acknowledge the CRAs. The fact remains that the CRAs will not be able to satisfy the policy makers in removing the flaws in the rating methods. From the research, the CRAs were not able to improve the corporate governance. The research will try and point out on the role and benefit of credit rating agencies which are private companies with one aim of assess the rate the issue of debt to individual, company and even the government. The research will analyze the roles and benefit of CRAs in the last financial crisis of 2007 – 2009. The research will provide evidence of the financial crisis on the credibility and accountability of credit rating agencies. The credit crunch will be explained and also the contribution of credit rating agencies to the financial crisis. The benefit of credit rating agencies to investors is also discussed in the paper. The research methodology and design and reporting and analysis will be dealt with by the research paper. The role of credit rating agencies during and before the financial crisis will also be discussed in the paper. The implication of the financial crisis in the economy of Qatar will be discussed a bit to establish the impact of it is on the people. Contents Abstract 1 Contents 2 Introduction-What Is Credit Rating? 3 Research Objectives 4 Literature Review 4 Role of Credit Rating Agencies During and Before Financial Crisis 6 Credit Ratings Assignment Process 7 Research Methodology and Design 8 Reporting and Presentation of the Project 9 Credit Rating Agencies as Coercive Regulators 10 How CRAs Impact On Financial Market Participants 10 Relation between Credit Rating and Agency Problem 11 Implications of Financial Crisis on Qatar’s Economy 12 Conclusion 12 References 13 Introduction-What Is Credit Rating? Crediting rating is a common statement that refers to opinion concerning a debt instrument and its issuer company. It gives an investor a clear indication on whether the debt instrument is safe or risky. It also tells the investor the capability of the issuer company to pay interest and the principal amount in time. However, credit rating is simply an opinion rather than a recommendation and thus does not require an investor to buy or sell an instrument. Currently, global rating is undertaken by several credit rating agencies with the general ones are Standard and Poor’s (S&P), Moody’s Corporation both of whom are based in the USA and Fitch Rating Firm. The above named rating agencies hold the majority of the credit rating share. However, there are more than 100 minor credit rating agencies in the market offering quality credit rating in national markets and industries (Benmelech 2009). Credit rating is usually done by experts who examine various factors and provide the rating is expressed in either alphabetical or alphanumeric symbols. AAA is the highest possible rating as per the S&P agency. High quality credit investment grades are grades AAA and AA whereas grades A and BBB offer medium credit quality investment grades. However, grades BB, B, CCC, CC and, C means that the issuer has a low credit quality and maybe there is no existence of investment credit quality. Grade D is the lowest possible credit rating, and this means that there is no way that the creditor will recover his interest plus the principal amount. According to this credit rating, those companies with AAA, AA, A and, BBB grades presents less risk and thus most investors will be attracted to invest in them since they have assurance that there will be a gain in their market share. Credit Rating Agencies (CRAs) plays a bigger role in today’s financial markets in Qatar. The rating is normally followed closely by the investors, issuers, borrowers and government’s financial institutions. Research Objectives The research objectives are to establish the following; How the credit rating agencies work. The importance of creditworthiness of corporation, individual and the government What is the roles of CRAs before and after the financial crisis To establish the impact of the financial crisis on the economy Literature Review Global financial crisis is believed to have started in July 2007 as a result of the credit crunch. This resulted to US investors losing confidence in the value of subprime mortgages and thus leading to a liquidity crisis. US Federal Bank responded by injecting huge amount of funds into capital markets globally, a move which crashed and turned these stock market volatile. Due to globalization, the financial crisis was reflected in markets worldwide. Governments tried as much as possible to reduce the impacts of this crisis on their banks and other lending institutions. various factors has contribute the liquidity crunch and subsequent crisis (Sy 2003). These factors include; commodity bubbles, panic between investors to withdraw their money from banks, rising real estate prices and, liquidity problems in Equity funds among others. Commodity bubble was caused by a sharp rise in prices of various basic commodities and a collapse in housing. Oil prices in Qatar and other GCC countries rose significantly reaching 149 US dollars per a barrel in 2008. This was the highest possible ever recorded, and it greatly resulted to respective increase in prices of other related services and products. Another major cause of the financial crisis was the widespread panic among global investors which resulted in them withdrawing larger amounts of funds from banks. This move led to imbalance in lending structure of banks and subsequently led to global collapse of financial markets. The situation was further aggravated by the capitalist systemic crisis caused by investors’ ambitions to achieve quick and substantial returns by investing on financial instruments instead of the real economy. This was in line with the perception that financial instruments were more profitable than investing on tools (Benmelech 2009). The decline of asset values for commodities was a result of liquidity problems experienced by Hedge funds and Equity funds. These problems were detrimental to insurance and pension funds which were hit by falling in prices of their assets, and it raised a speculation on whether the affected banks were still able to fulfill their obligations. Lack of clear pricing risk is also believed to have contributed to the financial crisis in early 2008; the potential investors were not getting the clear provisions on the compensations they are likely to benefit as a result of taking extra risks. Other factors like predatory lending and deregulation have been hindering capital markets and lending institutions since 1980s. Despite numerous monetary controls being in place, constant deregulations weaken these systems. Unfair business practices by lenders allow borrowers to enter into unsecured loans which are the root causes of fraud. Role of Credit Rating Agencies During and Before Financial Crisis Most of the global markets are characterized by informational difference between buyers and sellers. Financial markets commonly experienced informational asymmetries and lenders need to know the true Characteristics of borrowers, and this is why the credit rating agencies are very important, without which them the transfer markets will perform poorly. The international financial markets have grown tremendously courtesy of Credit rating agencies since the information and risks are readily available to investors who can make informed investment decisions. As a result of financial crisis, a comprehensive analysis done by Financial Stability Forum was released in April 2008. Credibility of the rating agencies was exposed by the financial crisis experienced in 2007. The role of credit rating agency is beyond the elimination of information asymmetry. The quality of the product is developed through the quality assurance of the credit rating agency to its investors (Mesa 2005). The CRAs has operated as a watchdog to investors. Importance of Credit Rating Agency on the Investor They Help In Investment Decision The CRAs give the investors ideas concerning the credibility of the issuer company and the risk associated to a particular instrument. Therefore, the investors can make the decision on whether to invest on the companies or not. The higher the rating from CRAs the more investors is willing to invest in these instruments and the lower the rating the less the investor is willing to invest. Benefits of Rating Reviews The agency always reviews the rating given to a particular instrument and therefore the investor will make the decision on whether to keep the instrument or sell it. For example if the instrument is downgraded the investor will decide to sell and keep the instrument if it is upgraded. Assurance of Safety The assurance to the investor is brought up when there’s high rating about the safety of the instrument and the risk associated in the instrument. Companies which get a high rating for their instruments will always strive to maintain healthy financial discipline. This benefit of CRAs will protect them from being bankruptcy and so the safety to the investor. Easy Understandability of Investment Proposal The credit rating agencies gives rating symbols to the instrument that can the investors understand easily. It also helps the investor to understand more on the investment proposal of the issuer company. Choice of Instruments The Credit rating makes the investor to choose from the alternative available particulars of instrument. The choice will depend on the safety or risk of the instrument. Saves Investor's Time and Effort The Credit rating agency enables the investor save time and analyzes the financial strength of an issuer company. The rating will be done by professional rating agency, and this will boost the investment decision of the investor. The investor need to waste time and effort to collect the financial information on the credit standing of the issuer company. Credit Ratings Assignment Process In this section the process of carrying out the assignment of credit rating to various companies in accordance with the regulation of 1060/2009 of European parliament and the guideline on credit rating agencies. This assignment process goes hand in hand with the company estimates and the probability that the company may be defaulters. The process is activated after the completion of the quality control on the information collected on the update process and will entails the following steps Through the assessment of the financial accounts, the derogatory data, the execution of statistical algorithm and the commercial characteristics of the company The economic unit of the company from the analyst will also be done on the qualitatively. The final credit rating of the company under review is assigned the rating by either the analyst in consultation with the head analyst who supervises and approves the rating or the rating committee. Research Methodology and Design Scientific research will be conducted to determine whether credit rating agencies has done a good work. This is because the technique applies a logical approach in order to obtain the relevant information, and it can be used in a wide range of issues in conducting the research. The credit rating agencies has been providing important information to debtors and investors in regard to creditworthiness of corporation, agencies, individuals and even the government. This has seen most companies investing ten of dollarsso that ro received the rating from these agencies (Langohr 2008). The objectives of the paper are to shed light on the credibility of credit rating agency. In fact, most of these business organizations do not even attempt to study how the rating is done in the organization and in turn they require the rating even if the agencies do not have enough information to rate the company probably. This research will try to find how the services provided by the credit rating agencies which has become embedded in the investment and banking rules and securities across the world. The assessment can make or break a deal to the company by influencing the cost and risk of its financing (Kruck 2011). Data collection will be carried out by conducting a survey that will cover a large number of respondents. This is because the survey will help in finding out the credibility and impact of credit rating agencies. Well-structured questionnaires will then be used to collect data from the respondents. This is because the questionnaires are effective in obtaining data for both structured and unstructured nature of the questions. In designing the questionnaires, the researcher will have to identify the questions, determine the right sample size, and conduct a pilot survey on the selected area of interest. The questionnaire should also be coded to ease the process of data analysis. The questionnaires will then be distributed to the target population to be filled by the respondents. This will then be followed by collecting the questionnaires after a specified period on the information that has been collected. The data will then be analyzed statistically using scientific data analysis tools. Secondary data on the development of a new product will then be obtained from books and internet sources (Garci?a 2012). This will give more information the importance function and the credibility of these credit rating agencies. The credit rating agency will substantially underestimate the risk inherent in structured finance product that was partially due to shortcoming of the methodology. The credit rating agency was criticized because of the inadequate historic data that increase the risk of their models and the fact that the credit rating agency charge on deteriorating lending standards. Reporting and Presentation of the Project Data collected from the questionnaires will be analyzed and presented in tables, charts, and graphs. PowerPoint slides will also be made to make a presentation easier in displaying findings, discussions, and the recommendations. Discussion of the findings will also be made to explain the results of the study. The recommendations will then be given to guide the company on how to go about with the research. The project will take four months to collect data from the respondents. The risk analysis will be done by comparing the financial ratios with chosen benchmarks and the qualitative analysis that will focus on management character (Darbellay 2013). Credit Rating Agencies as Coercive Regulators In the process of rating agencies increase their importance across the world they have been always being criticized for wielding too much power and not being accountable in the process. The claim for the rating to be more accountable is a puzzle that the agencies need to address. There is a usual perspective on the credit rating agencies that they are the solution of accountability and will not pose any problem at all. In the part, the credit rating agencies has raised question not only for internal importance but also for external accountability of the corporation (Elkhoury 2008). In reputation point of view, the credit rating agency is not regulars, but they seek to influence the strategies and structure of the borrowers they rate. The CRAs are not coercive regulators in that the rating is only a market operation where borrowers finalize the contract with CRAs in order to get a rating. The role of credit rating agency is seen to be modest in that they provide neutral information on the borrower creditworthiness. The credit rating agencies have an impact on the strategy and framework of the borrowers. The borrowers find it difficult to escape the influence of the CRAs. The rating of the agencies is the best and useful information providers of in that the information will be used in analytical purpose of the borrowers How CRAs Impact On Financial Market Participants The credit rating agencies are coercive regulators and therefore their impact on the financial market should be discussed. The impact of CRAs will differ according to the players in the financial market. The borrowers are more affected than the investors and in some point the impact of these agencies will not have a choice in determining their effects. The principal of CRAs are the once that will hold the agencies accountable The credit agencies are the regulator in both side of the credit relationship and hence have an impact on both the borrowers and the investors, but their impact is rather modest. The rating should not be used to judge the investors, but the investors should a source of information on the credit risk in the investment instrument. The investor do not pay, but the company are the one paying in order to be rated by the agencies and cost are borne by the borrowers that pay in order to be rated. If the investor is downgraded the investor would have to shift their engagement to other investments (De Luca 2009). Relation between Credit Rating and Agency Problem Conflict of interest is a common factor in any credit rating system as the agents takes center stage. It is established, when the agent is expected to act at the best interest of the principle. To the contrary, the agent is taken away with self-interests, which are mostly different from the principal’s best interests resulting to an agency problem. Every entity requires credit rating to be able to determine the worthiness of its corporations and organizations. They therefore hire credit rating agencies, who act as middle men between the investors and the issuers they rate as they act as agents of issuers and investors. This relationship between the credit rating agency and the investors, results to potential agency problems as the credit rating agencies are paid to provide ratings by the investors. This practice of issuers normally paying the agencies results to conflict of interests between the two parties. Some of the main characteristics of the credit rating agency are that they should be free to provide any information as long as they abide to the underlying rules and regulations. Despite being tempted to give higher ratings, they should ensure that they provide the best as the risk of losing the issuers is looming. With pressure coming from the investors who provide large sums of money for higher ratings or pile pressure to the credit rating agencies for higher ratings, they normally inflate or change their ratings in order to retain the main businesses. Implications of Financial Crisis on Qatar’s Economy The Middle East is one of the regions, which have been greatly affected with the fall of oil prices however, Qatar has been the slightest affected by this impact. This is evident in the country’s GDP growth rate that continued to expand due to the increased production in crude oil and natural gas and their continued export to other countries. The GDP for Qatar in 2008 was 17%, while in 2010, it was 16.6%. The inflation rate of the country did not also drop much due to freezing of prices in consumer goods and increase in supply of housing units. Banks and other financial institutions had monetary cover and support from different governments hence did not encounter instability. Investor projects by the Qatar Investment Authority increased increasing investor assurance in the banks. Sectors such as tourism and real estate experienced increased investments projects, which contributed to the growth of Qatar’s economy. Conclusion The credit rating agencies is a major international capital market regulator. From the agency standard, they have set major influence to the borrowers to access the capital market under certain conditions. The credit rating agencies will strengthen how the market works and are embedded in regulation, and its meant to justify the agency to acquire the reputation has real actors in the industry. And this has raised accountability challenges in the credit rating agencies where the internal and external work. Neither the financial market participant nor the public regulator can hold credit rating agencies accountable (Sy 2009). The continuous demands that exist pose a challenge to credit rating agencies and accountability of these agencies remains a challenge. The extensive principal-agent structure has been rather important for the scrutiny of credit rating agencies. First the structure allows making sense of the demands for CRA accountability. The standard view on CRAs suggests that complaints about rating downgrades are always attempts at ‘shooting the messenger’ for the bad news for which CRAs are themselves, not really responsible. Contrary to this, the extended important structure highlights how CRAs affect borrowers and even regulators. The attempt to alleviate the impact of possibly wrong judgments on the part of the agencies begins to make sense. Again, the structure shows how the problem of accountability has been in respect to credit rating agency that differs in the hierarchy of public administration which can be analyze well in the traditional structure. Actors seeking to hold CRAs accountable do so because they are affected by the adverse consequences of how credit ratings work. The main principal lack the power that the internal principals have and finally help the credit rating agency to be accountable References Benmelech, E., & Dlugosz, J. (2009). The credit rating crisis. Cambridge, Mass, National Bureau of Economic Research. De Luca, J., & Russo, P. (2009). Credit rating agency reform. New York, Nova Science Publishers. Darbellay, A. (2013). Regulating credit rating agencies. Cheltenham, Edward Elgar Pub. Ltd. https://login.proxy.bib.uottawa.ca/login?url=http://www.elgaronline.com/view/9780857939357. Elkhoury, M. (2008). Credit Rating Agencies and Their Potential Impact On Developing Countries. Geneva, Switzerland, United Nations Conference on Trade and Development. Garci?a Alcubilla, R., & Ruiz Del Pozo, J. (2012). Credit rating agencies on the watch list: analysis of European regulation. Oxford, Oxford University Press. Kruck, A. (2011). Private ratings, public regulations: credit rating agencies and global financial governance. New York, Palgrave Macmillan. Langohr, H. M., & Langohr, P. T. (2008). The rating agencies and their credit ratings what they are, how they work and why they are relevant. Chichester, England, Wiley. Http://www.books24x7.com/marc.asp?bookid=29490. Mesa Graziano, C. D. (2005). FEI survey on credit rating agencies. [New York], FERF. Sy, A. N. R. (2003). Rating the Rating Agencies: anticipating currency crises or debt crises? [Washington, D.C.], International Monetary Fund. Sy, A. N. R. (2009). The systemic regulation of credit rating agencies and rated markets. [Washington, D.C.], International Monetary Fund. Read More