The Risk Rating Agencies: their origin, their evaluation procedures and their competitive differences
By: Ximena Peinado Fabregat
Just as a grade is given to an exam or to a student’s academic performance, countries, financial institutions and companies are also assigned a classification depending on their ability and willingness to pay the debt issuer.
These companies allow their users to be fully up-to-date in making investment decisions, thus generally saving time and money. For companies, having a good rating is vital to be able to find new investors who want to give a part of their capital to the development of the organization.
The classification of securities had its origin at the end of the 19th century in the United States when a credit information system was created and used by investors and financial institutions in the country. At the beginning of the 20th century, with the development of the railway industry and the bonds that financed it, rating companies were created to study the quality of these instruments.
Outside the United States, Canada was the first foreign country to create ‘Canadian Bond Rating Services’ in Montreal in 1972. Then Japan with ‘Nikoi Kensai Shimbum’ in 1979; and in Europe it was consolidated with ‘Renta 4 S.A’. in Spain. In Latin America, the first securities rating agency was authorized in Chile in 1988 and it was the Humphrey’s Risk Rating Agency Ltda.
However, the United States Securities and Exchange Commission (the government agency dedicated to protecting investors) only recognizes 9 rating agencies in the world: A.M. Best Rating Services Inc, DBRS Inc, Egan-Jones Ratings Company, Fitch Ratings Inc, HR Ratings de México S.A. de C.V., Japan Credit Rating Agency Ltd, Kroll Bond Rating Agency Inc, Moody’s Investors Service Inc and Standard & Poor’s Global Ratings.
Of these nine, the best known are Fitch Ratings, Moody’s and S&P.
We will mention Standard & Poor ‘s first for being the oldest. It was founded in 1860 by Henry Poor, who made a record of all the financing of the railroads and canals in the United States as a kind of guide for interested investors. The “Standard” part was added to the name when Poor joined the Bureau of Standard Statistics (which examined the finances of companies that were not related to the railroad industry) in the 1940s.
Moodys was established in 1909 by John Moody, who published an analysis of railway finance, rating the value of its stocks and bonds.
Third, Fitch Ratings was founded by John Fitch in 1913. Each of these rating agencies has its own procedures and ratings.
Rating System, which factors are relevant to it?
Fortunately, global credit agencies have recently started to publish their rating criteria to justify rating changes that countries or companies have.
The analysis of each company or country is decided by a committee of between five and eight people, according to S&P. The rating agencies base their evaluation on a variety of financial and commercial attributes that could influence repayment, some of which may depend on the issuer of the bond (that is, who gives the loan).
The reasons for rating adjustments vary and can be broadly related to general changes in the economy or business environment, or more narrowly focused on circumstances that affect a specific industry, entity or individual debt issue.
The process of obtaining a credit rating on a particular issue generally begins with a request from the company that has expressed interest in obtaining a rating prior to the issuance of a bond; then a series of meetings are scheduled between the company and the rating agency to acquire the necessary information to be able to give it a fair rating.
In general, a company’s growth potential, its capital requirements, the degree of competition in its market and industrial environment, its productive diversification, and ownership structure are included as business risks. Subjective judgments often play an important role in this part of the rating process. The ability of a company to meet its debt can be clearly seen by rating agencies from its income statements, balance sheets and indicative financial performance indices.
The second most important financial indicator is whether a company has spread too much: this can be measured through the measure of its debt leverage.
The third most important financial indicator measures the profitability and efficiency of the company.
Finally, other financial risks are also considered, such as whether the company can withstand economic cycles and financial flexibility in a stress scenario. However, these stress tests are not based on actual forecasts of the future performance of the company. Rather, they are generally based on the company’s past performance as revealed by its 3-5 year financial statements.
Something that can also influence the rating is the country where they are located and whether areas that belong to the OECD are located, since country risks (represented by sovereign risks) are closely related to company-level risks. It is understood that, to some extent, such a close relationship between company ratings and sovereign ratings is justifiable.
Despite having a strict procedure, rating agencies have been the subject of much criticism over the years. Well-known independent media such as “The Conversation” have expressed the opinion that many share: rating agencies can be more damaging than contributors to the economic system. Like any argument, it has its reason behind it.
But you can only know that reason if you follow our networks and continue reading the new series of Rating agencies that Pr1me Capital has for you.
Source: Academia, BBC, Moody’s analytics, ‘How do Global Credit Rating Agencies Rate Firms from Developing Countries?’ by Li-Gang Liu and Giovanni Ferri