Credit risk: what we know, what we don’t know and what we should know

By Mei Lin KER

With the deregulation of the financial markets, companies have progressed from traditional method of bank borrowing to the issuance of corporate bonds to seek capital from the general public. As a potential lender, how will you assess which company is a safer haven to park your money? Is there a way to allow you to gauge the default risk of each company so that you can make an informed choice? One of the solutions lies in credit rating agencies. The use of ratings is pervasive in today’s society. From movies to restaurants to even car safety, ratings are compiled to provide consumers a quick assessment and comparison of the desirability of the product or service. In the financial industry, credit risk ratings for corporate and sovereign debt instruments are provided by credit rating agencies (CRAs) with the current industry leaders being Moody’s, Standard & Poor’s (S&P), and Fitch.

The probe by the US Congress Committee uncovered the credit rating agencies as one of the main culprits fuelling the GFC calamity. Their failure in providing correct ratings to certain complex financial products led to the severity of the financial meltdown. Under Basel II, banks utilising the standardised approach to determine their regulatory capital are required to use external credit assessments to determine the weightings for calculation of the total risk-weighted assets. Elevated to the status of “nationally recognised statistical rating organisations” (NRSROs), Moody’s, S&P and Fitch provide such external credit statistics. Though more rating agencies have been added to the list as the years passed, the Big Three maintain their dominant positions, collectively representing 95% of the market. What do we actually know about such agencies to trust their competency in providing accurate and unbiased ratings? Let’s explore further.

What we know is that credit rating agencies hold a relatively pivotal role in debt issuers’ ability to secure public funds. Debt instruments to be issued must be independently assessed by rating agencies from which interest rates will be determined. Assigned to both corporate and sovereign debt instruments, credit ratings provide an indication of the issuers’ ability to repay their debt obligations. The ratings are commonly expressed in letters with “AAA” being the highest rating. AAA-rated instruments are the cream of the crop, deemed as having the lowest probability of payment default. The ratings affect investors’ confidence and thus the ease of securing funds. Consequentially, higher interest rates are allotted to lower-rating instruments to compensate for the extra risk undertaken. Credit ratings help to bridge the information gap between lenders and borrowers so that market efficiency can be achieved and provide a common language for investors to assess and compare the credit risks across debt instruments. Taking into account both macroeconomic and microeconomic factors, the agencies periodically conduct rating reviews to reflect the latest future outlook the companies and governments are subjected to. Besides the Big Three, there are also credit rating agencies that focus on providing geographical and industrial-based ratings.

Truly, what we don’t know is the potential biasness of the credit ratings provided by each rating agency. There exists a conflict of interest in achieving corporate profitability and providing accurate, unbiased ratings. CRAs are not public utilities, but are for-profit companies. Paid by the very companies they are rating, it makes obvious business sense for the agencies to rate the issuers favourably to sustain an ongoing business with them. In fact, one of the contributory causes of GFC was the blatant awarding of “AAA” ratings to mortgage-backed securities simply to secure more businesses. Coupled with the oligopolistic nature of the industry with the regulatory authority dictating the agencies to use, an anti-competition environment develops and presents the perfect platform for potential customer blackmailing, making it hard to determine the fairness of the credit ratings conferred.

Hannover Re, a German insurance company, can lay testament to this. It was approached by Moody’s who offered to provide a free risk assessment in the hope that the company will enlist Moody’s for subsequent rating services. However, it failed to get back to Moody’s after that who subsequently downgraded its status to junk. Panicked investors dumped its shares and Hannover Re lost US$175 million in just an afternoon. Clearly, CRAs seem to wield the control on companies’ ability to gain access to capital, and they know it. This power imbalance, together with competitive pressures and financial rewards, can steer CRAs into using underhanded methods to secure new businesses. Skewing the ratings is one example and a colossally destructive one as it can lead to erroneous assessment and decision making by investors who utilise the bogus ratings.

Ultimately, what we should know is that a credit rating is merely the rating agency’s opinion of the credit worthiness of a counterparty at a point in time. It is thus a subjective inference of credit risk. It certainly does not mean a recommendation to buy, sell or hold a certain bond. A triple-A rating also does not mean a risk-free investment; it only means the agency reckons that it has the least probability of payment default; not that it will not default at all. Thus investors should be wary of the subjectivity of the ratings and not be overly reliant on them as one of the critical determinants of their final decision. In fact, investors need to be aware of falling into the potential common pitfall caused by the phenomenon – illusion of knowledge. First put forth by American behavioural psychologist Stuart Oskamp, it is a situation in which the more information people have, the greater their confidence level but the less accurate their judgment will be. Often, over-optimism and overc-onfidence ensue from those conferred top ratings with investors viewing them as a stamp of approval and recognition that borrowed cash will be repaid on time and in full.

Indeed, the speed with which the market responds to a downward rating adjustment as exemplified in the Hannover Re’s case seems to indicate that the market views the ratings very seriously. Perhaps this is due to investors’ complacency to rely on rating agencies which are “officially recognised”, thus lending blind faith to both their credibility and the credit ratings they have churned out. Or it may be the sheer complexity of the instruments to be evaluated that makes adopting the readily available ratings an easier and cheaper way to determine the credit risk. Unquestioned reliance on the ratings and lapses to carry out own risk analyses at regular intervals will be the perfect recipe for financial disaster as manifested by the GFC. However, the recent downgrade of the Eurozone countries seems to create no major impact to the countries concerned. Hopefully this is a sign that the market is becoming wiser in not reacting immediately to such rating downgrades.

In the aftermath of the GFC, credit risk is undeniably a serious business not to be taken lightly. Especially with the continued use of NRSROS under Basel III, we should plod on with extra care. Despite the U.S. government’s efforts to instill more third-party controls of the rating agencies to rein in any unbridled reward pursuits, investors should still adopt a cautious stance towards the use of such ratings, particularly if the risk implications are immense. For now, we should at least attempt to compare the credit ratings provided by a few CRAs and understand their rating rationale in addition to our own risk analyses to gain a more balanced insight for better decision making. The famed American historian Daniel Boorstin couldn’t put it any better – “The greatest enemy of knowledge is not ignorance, it is the illusion of knowledge”. Thus any third-party information including the use of credit ratings should be taken with a pinch of salt and not let the barrage of so-called expert information cloud and detract from your own risk analyses and common sense.

Mei Lin Ker is a Master of Applied Finance student at Queensland University of Technology.

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