3 - The use of ratings

Summary

Issuers, investors and intermediaries

What purposes do ratings fulfil in today's financial markets? Who uses credit ratings and what do they use them for? In order to understand the role of CRAs in contemporary finance, we need to consider the different perspectives of the consumer of ratings. From the perspective of the issuer, having a rating enables the issuer to have access to capital markets in the first place. It expands “the pool of investors and available capital”, implying a diversification of funding resources. This is in contrast to the situation when an issuer borrows money from a bank to refinance itself. Resorting to capital markets to access credit means that an issuer faces a myriad of potential investors, instead of depending on only one or a limited number of financial institutions to take out a loan. This may sound more beneficial for the issuer than it actually is, however. Admittedly, the dependence on banks for funding is significantly reduced. At the same time, a new dependence is created. With the pervasiveness of rating, issuers now depend heavily on the judgement of a few credit rating agencies to gain access to capital and secure favourable funding conditions. According to S&P, the issuer uses ratings to “optimize the cost of funding”; having a rating from the Big Three allows debt issuers to refinance themselves on capital markets at a lower cost. The rating signals whether an issuer is creditworthy, reflecting a price tag of credit risk to investors. This knowledge reduces perceived uncertainty, and thus reduces the risk premium issuers have to pay on financial markets.

From the perspective of investors, ratings represent a “third- party opinion of credit quality”. CRAs regard their ratings as supplementary to the investors’ own credit analysis. Legally speaking, a rating does not exempt investors from due diligence; it is not an investment recommendation. To put it bluntly, investors are ultimately responsible for their own choices. Furthermore, ratings create comparability across asset classes, geographies and peers, helping investors to make informed decisions. This implies that different type of issuers compete for funding; a nation state competes for funding with its peers as well as with private companies.