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Company that assigns credit ratings

A credit rating agency (CRA, also called a ratings service) is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by making timely principal and interest payments and the likelihood of default. An agency may rate the creditworthiness of issuers of debt obligations, of debt instruments, and in some cases, of the servicers of the underlying debt, but not of individual consumers. Other forms of a rating agency include environmental, social and corporate governance (ESG) rating agencies and the Chinese Social Credit System. The debt instruments rated by CRAs include government bonds, corporate bonds, CDs, municipal bonds, preferred stock, and collateralized securities, such as mortgage backed securities and collateralized debt obligations. The issuers of the obligations or securities may be companies, special purpose entities, state or local governments, non profit organizations, or sovereign nations. Rating downgrades during the European sovereign debt crisis of 2010–12 were blamed by EU officials for accelerating the crisis. Mercantile credit agencies—the precursors of today's rating agencies—were established in the wake of the financial crisis of 1837. These agencies rated the ability of merchants to pay their debts and consolidated these ratings in published guides. The first such agency was established in 1841 by Lewis Tappan in New York City. It was subsequently acquired by Robert Dun, who published its first ratings guide in 1859. Another early agency, John Bradstreet, formed in 1849 and published a ratings guide in 1857. Companies were founded to provide investors with financial information on the growing railroad industry, including Henry Varnum Poor's publishing company, which produced a publication compiling financial data about the railroad and canal industries. Following the 1907 financial crisis, demand rose for such independent market information, in particular for independent analyses of bond creditworthiness. His ratings became the first to be published widely in an accessible format, and his company was the first to charge subscription fees to investors. In the next few years, antecedents of the "Big Three" credit rating agencies were established. Poor's Publishing Company began issuing ratings in 1916, Standard Statistics Company in 1922, As the market grew beyond that of traditional investment banking institutions, new investors again called for increased transparency, leading to the passage of new, mandatory disclosure laws for issuers, and the creation of the Securities and Exchange Commission (SEC). International "sovereign bond" rating shrivelled during the Great Depression to a handful of the most creditworthy countries, after a number of defaults of bonds issued by governments such as Germany's. and the increased complexity of the financial markets. The rating agencies added levels of gradation to their rating systems. In 1973, Fitch added plus and minus symbols to its existing letter rating system. The following year, Standard and Poor's did the same, and Moody's began using numbers for the same purpose in 1982. For example, the commission changed its minimum capital requirements for broker dealers, allowing smaller reserves for higher rated bonds; the rating would be done by "nationally recognized statistical ratings organizations" (NRSROs). This referred to the "Big Three", but in time ten agencies (later six, due to consolidation) were identified by the SEC as NRSROs. Rating agencies also grew in size and profitability as the number of issuers accessing the debt markets grew exponentially, both in the United States and abroad. By 2009 the worldwide bond market (total debt outstanding) reached an estimated $82.2 trillion, in 2009 dollars.

Defenders of credit rating agencies complain of the market's lack of appreciation. Argues Robert Clow, "When a company or sovereign nation pays its debt on time, the market barely takes momentary notice but let a country or corporation unexpectedly miss a payment or threaten default, and bondholders, lawyers and even regulators are quick to rush the field to protest the credit analyst's lapse." Others say that bonds assigned a low credit rating by rating agencies have been shown to default more frequently than bonds that receive a high credit rating, suggesting that ratings still serve as a useful indicator of credit risk. A number of explanations of the rating agencies' inaccurate ratings and forecasts have been offered, especially in the wake of the subprime crisis: For instance, a 2008 report by the Financial Stability Forum singled out methodological shortcomings—especially inadequate historical data—as a contributing cause in the underestimating of the risk in structured finance products by the CRAs before the subprime mortgage crisis. The ratings process relies on subjective judgments. This means that governments, for example, that are being rated can often inform and influence credit rating analysts during the review process
The rating agencies' interest in pleasing the issuers of securities, who are their paying customers and benefit from high ratings, creates a conflict with their interest in providing accurate ratings of securities for investors buying the securities. Issuers of securities benefit from higher ratings in that many of their customers—retail banks, pension funds, money market funds, insurance companies—are prohibited by law or otherwise restrained from buying securities below a certain rating. Agency analysts may be underpaid relative to similar positions at investment banks and Wall Street firms, resulting in a migration of credit rating analysts and the analysts' inside knowledge of rating procedures to higher paying jobs at the banks and firms that issue the securities being rated, and thereby facilitating the manipulation of ratings by issuers. The functional use of ratings as regulatory mechanisms may inflate their reputation for accuracy.

Conversely, the complaint has been made that agencies have too much power over issuers and that downgrades can even force troubled companies into bankruptcy. The lowering of a credit score by a CRA can create a vicious cycle and a self fulfilling prophecy: not only do interest rates on securities rise, but other contracts with financial institutions may also be affected adversely, causing an increase in financing costs and an ensuing decrease in creditworthiness. Large loans to companies often contain a clause that makes the loan due in full if the company's credit rating is lowered beyond a certain point (usually from investment grade to "speculative"). The purpose of these "ratings triggers" is to ensure that the loan making bank is able to lay claim to a weak company's assets before the company declares bankruptcy and a receiver is appointed to divide up the claims against the company. The effect of such ratings triggers, however, can be devastating: under a worst case scenario, once the company's debt is downgraded by a CRA, the company's loans become due in full; if the company is incapable of paying all of these loans in full at once, it is forced into bankruptcy (a so called death spiral). These ratings triggers were instrumental in the collapse of Enron. Since that time, major agencies have put extra effort into detecting them and discouraging their use, and the US SEC requires that public companies in the United States disclose their existence.

However when it was discovered that the mortgages had been sold to buyers who could not pay them, massive numbers of securities were downgraded, the securitization "seized up" and the Great Recession ensued. Critics blamed this underestimation of the risk of the securities on the conflict between two interests the CRAs have—rating securities accurately, and serving their customers, the security issuers who need high ratings to sell to investors subject to ratings based constraints, such as pension funds and life insurance companies. the importance of structured finance to CRA profits, and pressure from issuers who began to 'shop around' for the best ratings brought the conflict to a head between 2000 and 2007. A small number of arrangers of structured finance products—primarily investment banks—drive a large amount of business to the ratings agencies, and thus have a much greater potential to exert undue influence on a rating agency than a single corporate debt issuer. A 2013 Swiss Finance Institute study of structured debt ratings from S&P, Moody's, and Fitch found that agencies provide better ratings for the structured products of issuers that provide them with more overall bilateral rating business. This effect was found to be particularly pronounced in the run up to the subprime mortgage crisis. In the wake of the global financial crisis, various legal requirements were introduced to increase the transparency of structured finance ratings. The European Union now requires credit rating agencies to use an additional symbol with ratings for structured finance instruments in order to distinguish them from other rating categories. Sovereign borrowers are the largest debt borrowers in many financial markets. Governments from emerging and developing markets may also choose to borrow from other government and international organizations, such as the World Bank and the International Monetary Fund. The rating methodologies used to assess sovereign credit ratings are broadly similar to those used for corporate credit ratings, although the borrower's willingness to repay receives extra emphasis since national governments may be eligible for debt immunity under international law, thus complicating repayment obligations. National governments may solicit credit ratings to generate investor interest and improve access to the international capital markets. However, credit rating agencies were criticized for failing to predict the 1997 Asian financial crisis and for downgrading countries in the midst of that turmoil. detailing how credit ratings are used in U. S. regulation and the policy issues this use raises. Partly as a result of this report, in June 2003, the SEC published a "concept release" called "Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws" that sought public comment on many of the issues raised in its report. Public comments on this concept release have also been published on the SEC's website. In December 2004, the International Organization of Securities Commissions (IOSCO) published a Code of Conduct for CRAs that, among other things, is designed to address the types of conflicts of interest that CRAs face. All of the major CRAs have agreed to sign on to this Code of Conduct and it has been praised by regulators ranging from the European Commission to the US SEC.

Regulatory authorities and legislative bodies in the United States and other jurisdictions rely on credit rating agencies' assessments of a broad range of debt issuers, and thereby attach a regulatory function to their ratings. This regulatory role is a derivative function in that the agencies do not publish ratings for that purpose. The use of credit ratings by regulatory agencies is not a new phenomenon. The Credit Rating Agency Reform Act of 2006 created a voluntary registration system for CRAs that met a certain minimum criteria, and provided the SEC with broader oversight authority. The practice of using credit rating agency ratings for regulatory purposes has since expanded globally. The Basel III accord, a global bank capital standardization effort, relies on credit ratings to calculate minimum capital standards and minimum liquidity ratios. Against this background and in the wake of criticism of credit rating agencies following the subprime mortgage crisis, legislators in the United States and other jurisdictions have commenced to reduce rating reliance in laws and regulations. The 2010 Dodd–Frank Act removes statutory references to credit rating agencies, and calls for federal regulators to review and modify existing regulations to avoid relying on credit ratings as the sole assessment of creditworthiness.

Credit rating is a highly concentrated industry, with the "Big Three" credit rating agencies controlling approximately 95% of the ratings business. as of December 2012, S&P is the largest of the three, with 1.2 million outstanding ratings and 1,416 analysts and supervisors; Moody's has 1 million outstanding ratings and 1,252 analysts and supervisors;

The three largest agencies are not the only sources of credit information. All of the large securities firms have internal fixed income analysts who offer information about the risk and volatility of securities to their clients.—led to a drop in the share of the three by just one percent—from 98 to 97%. The reason for the concentrated market structure is disputed. One widely cited opinion is that the Big Three's historical reputation within the financial industry creates a high barrier of entry for new entrants. Following the enactment of the Credit Rating Agency Reform Act of 2006 in the US, seven additional rating agencies attained recognition from the SEC as nationally recognized statistical rating organization (NRSROs). While these other agencies remain niche players, some have gained market share following the Financial crisis of 2007–08, and in October 2012 several announced plans to join together and create a new organization called the Universal Credit Rating Group. The European Union has considered setting up a state supported EU based agency. In November 2013, credit ratings organizations from five countries (CPR of Portugal, CARE Rating of India, GCR of South Africa, MARC of Malaysia, and SR Rating of Brazil) joint ventured to launch ARC Ratings, a new global agency touted as an alternative to the "Big Three".

Credit rating agencies generate revenue from a variety of activities related to the production and distribution of credit ratings. The sources of the revenue are generally the issuer of the securities or the investor. Most agencies operate under one or a combination of business models: the subscription model and the issuer pays model. Under the subscription model, the credit rating agency does not make its ratings freely available to the market, so investors pay a subscription fee for access to ratings. This revenue provides the main source of agency income, although agencies may also provide other types of services. Under the issuer pays model, agencies charge issuers a fee for providing credit rating assessments. The subscription approach was the prevailing business model until the early 1970s, when Moody's, Fitch, and finally Standard & Poor's adopted the issuer pays model. Today, eight of the nine nationally recognized statistical rating organizations (NRSRO) use the issuer pays model, only Egan Jones maintains an investor subscription service. Smaller, regional credit rating agencies may use either model. For example, China's oldest rating agency, Chengxin Credit Management Co., uses the issuer pays model. The Universal Credit Ratings Group, formed by Beijing based Dagong Global Credit Rating, Egan Jones of the U. S. and Russia's RusRatings, uses the investor pays model, while Dagong Europe Credit Rating, the other joint venture of Dagong Global Credit Rating, uses the issuer pays model. Critics argue that the issuer pays model creates a potential conflict of interest because the agencies are paid by the organizations whose debt they rate. However, the subscription model is also seen to have disadvantages, as it restricts the ratings' availability to paying investors. In 2010 Lace Financials, a subscriber pays agency later acquired by Kroll Ratings, was fined by the SEC for violating securities rules to the benefit of its largest subscriber. A 2009 World Bank report proposed a "hybrid" approach in which issuers who pay for ratings are required to seek additional scores from subscriber based third parties. Other proposed alternatives include a "public sector" model in which national governments fund the rating costs, and an "exchange pays" model, in which stock and bond exchanges pay for the ratings. Crowd sourced, collaborative models such as Wikirating have been suggested as an alternative to both the subscription and issuer pays models, although it is a recent development as of the 2010, and not yet widely used.