The Top 3 Credit Rating Agencies: How They Work and Why They Matter

Credit rating agencies play a crucial role in financial markets by providing independent assessments of the creditworthiness of various entities The “Big Three” firms of Moody’s, Standard & Poor’s (S&P), and Fitch dominate the global credit rating industry with a collective market share of over 90% This article will examine the history, function, and impact of the three major credit rating agencies.

A Brief History of Credit Rating Agencies

The origin of credit rating agencies can be traced back to the 19th century In 1841, Lewis Tappan founded the Mercantile Agency, which published credit ratings and credit histories of American businesses. This was one of the first organized credit reporting services.

John Moody published an analysis of railroad bonds in the early 1900s. This made Moody’s the first modern credit rating agency. The Standard Statistics Bureau was created in 1906 and changed its name to Standard Fitch Publishing Company was formed in 1913. Over the years, these companies have grown through mergers and purchases to become the Big Three rating agencies we know today.

There used to be some smaller companies that competed with the Big Three, but now there is only one big company that does all the credit ratings. Even though new competitors have come up in recent years, they are still the biggest in the world.

The Role and Function of Credit Rating Agencies

Credit rating agencies assess the creditworthiness of bond issuers and debt instruments. Their credit ratings serve as indicators of the likelihood that a particular entity will be able to repay its financial obligations.

The major services provided by rating agencies include:

• Corporate credit ratings: Assessment of non-financial companies’ ability to meet debt and financial obligations.

• Sovereign credit ratings: Analysis of national governments’ ability to honor debt commitments.

• Structured finance ratings: Evaluation of securities backed by pools of assets like mortgages.

• Credit scoring models: Development of statistical models to predict creditworthiness of individuals or small businesses.

Credit ratings are shown by letters that give a quick picture of how creditworthy someone is. As an example, S Ratings can have modifiers like ” ” or “-” to show different levels of quality within a category.

Rating agencies collect a lot of financial information about the companies they rate. Their credit analysis incorporates both quantitative factors (e. g. financial ratios) and qualitative factors (e. g. management expertise). The focus is assessing the risk of default.

The “Big Three” Credit Rating Agencies

While there are a few smaller competitors, Moody’s, S&P, and Fitch dominate with a collective global market share over 90%.

Moody’s

• Founded in 1909, headquartered in New York
• Employs over 11,000 people worldwide
• Known for its extensive research coverage and conservative ratings
• Rated over $59 trillion in securities globally as of 2020

Standard & Poor’s (S&P)

• Originated from 1860s mercantile credit ratings publications
• Became one of the Big Three through acquisitions and mergers
• Employs over 25,000 people in 30 countries
• Rated over $43 trillion in securities outstanding globally as of 2020

Fitch Ratings

• Formed in 1913 through merger of several credit rating pioneers
• Dual headquarters in New York and London
• Employs around 3,500 analysts worldwide
• Rated over $31 trillion in securities outstanding globally as of 2020

This oligopoly exists because credit ratings have been deeply embedded in financial regulation. Ratings from the Big Three receive official recognition from governments and central banks.

The Impact and Criticism of Credit Rating Agencies

Credit ratings directly impact the borrowing costs and access to capital for bond issuers. Higher ratings allow entities to raise money more cheaply. Lower credit ratings can increase financing costs significantly.

Governments incorporate ratings into financial regulations regarding capital reserves and permissible investments for banks, insurers, and institutional investors. Central banks may use ratings to determine eligible collateral for lending. Ratings affect trillions of dollars in fixed income investments.

However, credit rating agencies have also faced criticism, especially after the 2008 global financial crisis. Some key concerns raised include:

• Conflicts of interest: The “issuer pays” business model creates inherent conflicts of interest, as agencies are paid by the entities they rate.

• Ratings volatility: Sudden massive downgrades during crises can destabilize markets. Gradual ratings actions may be more appropriate.

• Lack of transparency: The qualitative factors considered in ratings are not always fully disclosed. The extent of due diligence has also been questioned.

• Over-reliance on the Big Three: Given their dominance, many feel markets are too dependent on just three rating providers.

Proposals for reform include reducing regulatory reliance on ratings, increased competition, enhanced transparency, and exploration of alternative compensation models for rating agencies.

The Importance of Credit Ratings for Investors

Despite valid criticisms, credit rating agencies look poised to continue playing a key role. Their ratings offer investors critical independent analysis of credit risks. Ratings help quantify probabilities of default rather than just guesswork.

Key reasons why credit ratings still matter for investment decisions:

• Ratings reflect extensive credit research and experience that most investors lack.
• They provide a common frame of reference for comparing bonds from different issuers.
• Ratings offer useful warning signals of deteriorating creditworthiness.
• Regulations still refer to ratings in many contexts like bank capital requirements.

While ratings should not be the sole factor in decisions, they remain valuable inputs into the investment process.

Moody’s, S&P, and Fitch dominate the global credit rating industry due to their long track records and regulatory recognition. Despite recent criticisms, credit rating agencies continue providing financial markets with independent assessments of credit risks. While not perfect, their ratings offer investors important signals about the probability of default on bonds and loans. Used judiciously, ratings can contribute to prudent investment decisions.