Influence of CRAs to Raise Funds in Global Financial Markets - Essay Example

Table of Contents Particulars 1.0 Introduction 2 2.0 Understanding CRA’s 3 3.0 Influence of CRA’s to Raise Funds in Global Financial Markets 3 4.0 Accountability of CRA’s 7 5.0 Major Issues and Their Solutions 8 6.0 Conclusion 9 10.0 References 10 1.0 Introduction This report has been drafted with a prime objective to provide readers with a complete understanding of the influence of Credit Rating Agencies (CRA’s) on the ability of businesses and governments to raise finance in the global financial markets. The report has been prepared in a comprehensive and synchronised manner so as to ensure maximum learning to the readers. The report initially focuses on the role of Credit Rating Agencies and their impact in the past to raise finance in the global market along recent regulatory changes in the landscape. The report also looks to highlights how credit rating agencies enhances accountability to raise further funds in the global financial market scenario and how they regulate the financial markets along with a brief discussion on the current problems of CRA and recommended solutions to the same. The major portion of the report looks to completely focus on the topic of how credit rating agencies act as an important regulator to raise finance in the global financial markets. Finally a conclusion is provided to ensure that the report covers all theoretical and practical understanding of the entire topic under study. 2.0 Understanding CRA’s Credit Rating Agencies (CRA’s) in simple can be understood as agencies which are specialists in providing complete information in context to creditworthiness of bonds. Creditworthiness is the likelihood that the issuer might make a default on the principal or the associated interest due on its bonds. Credit Rating Agencies are thus commercial firms who on a constant basis assess the ability of various firms, companies, institutions and government to service their associated debts. Credit Rating Agencies do this task by specifically assigning credit ratings in the form of a letter-graded scale which symbolizes the agencies opinion as of a specific date on the creditworthiness of a particular firm, company, security or its obligations (Mora, 2005). However, it is of prime importance to understand that the ratings provided by the agencies are not an absolute predictor in context to a debtor making a default in its payment or obligations the same is however subjective in nature with regard to the creditworthiness of the firm. The three major functions on which a CRA looks to work upon are Providing all necessary information and various assessments for investors. Enabling the issuers to assess capital markets and raise funds from the same and Helping the regulators to regulate the global financial market in a better and comprehensive manner. 3.0 Influence of CRA’s to Raise Funds in Global Financial Markets Credit Rating Agencies play an important role in influencing the ability of businesses and governments to raise funds or finance in the global financial markets. The criteria based on which CRA’s evaluate the creditworthiness are in effect apply to the rules in the global financial markets. A high quality rating by an a quality rating agency allows for unproblematic access to most liquid capital markets whereas a low rating provided by a credit rating agency assigns a junk bond status and in turn might exclude a bond from the most liquid markets making it difficult for the issuer to sell his bonds and raise funds on a global financial market scenario. The ratings provided by the credit rating agencies also has a direct impact on the cost of borrowing as it will be lowest for the holder or the issuer of the highest ranking which is generally categorised as AAA or AA+ and will further increase the rating signals higher credit risks (Sy, 2004). The greatest influence of CRA is that large investors need to rely extensively on the ratings provided by the CRA’s for screening in-transparent capital markets. Thus they act as de-facto regulators in the global financial market. Furthermore Credit Rating Agencies have acquired a monopolistic position in the global capital market which helps businesses and government to raise finance in the global financial markets. For access to the capital and financial markets borrowers rely on the service offered by credit rating agencies (Michael, 2002). Credit rating agency have a direct impact on investors and their buying or investing decision as only after a credit rating agency has rated a large number of firms and institutions in a unique comparable fashion does their rating become attractive for investors to invest on the bonds issued by the issuer and help them to raise considerable finance from the global financial markets. Credit Rating Agencies play an important role in enabling businesses, corporations and government in raising finance in the global financial market. As instead of opting for debt or taking a loan from a bank these entities sometimes and particularly in modern financial market borrow money directly from the investors by issuing bonds or notes (Smith and Walter, 2001). Investors on account of the ratings provided which resembles the credit risk of the issuer purchases these debt securities expecting to receive principal plus interests either when the bond matures or as of a specific periodic payment date being scheduled by the issuer of such bonds who are mostly businesses and governments. Businesses and financial institutions including government to some extent specially those who are involved in credit sensitive transactions may also use credit agencies to analyze the counterparty risks which is a potential risk that a party to the bond may not fulfil the associated obligations and the company may lose funds or finance (Rousseau, 2005). A credit rating agency of counterparty risk thus may help businesses analyze their credit exposure to financial institutions who had agreed to assume certain financial obligations and further evaluate the viability of the potential partnerships and other associated business relationships. In recent years the credit rating agencies have become increasingly more important in the management of financial market risk and help business and governments to raise finance in the global financial markets. Ever since the Great Depression the CRA’s benchmarks or ratings is also extensively used in the regulation of global financial markets. Banks or certain other investors for example are only allowed to hold lower risk securities which are rated as “Investment Grade”. Furthermore in context to the market benchmark for analyzing credit risk, regulations on a constant basis keep in touch with the changing credit risks in the market. Furthermore these ratings are viable on an international basis making it easier for governments or businesses to raise funds in the international or global scenario (Reisen, 2002). Since the CRA judgement ratings define a globally uniform benchmark, they make up a crucial reference for international regulatory standards as well. Thus, the increasing importance and dominance along with prominence of credit risk agencies for risk management in the market place and in regulations make them an important element in copying with the risk of globally interconnected financial markets which helps many businesses and governments to raise finance in the global financial markets. Credit Ratings provides an additional source of certification to the various debts instruments offered by the issuer i.e. the businesses and governments to raise finance in the global financial markets which not just help them to attract a large number of investors but also forewarns them of the risk involved in the underlying transactions (Lehmann, 2004). It helps in encouraging financial discipline among the various corporate competing against each other and ensures better financial planning with easier means to raise finance then looking towards bank loans. Interest rates are made competitive via ratings which allow companies to make a choice and compare their situation with others to make a better financial decision. In a nutshell having a good rating makes it a lot easier and simpler for businesses to raise finance in the global financial markets (Vanessa, 2008). One of the major source used by businesses to raise finance is through IPO, credit rating in an indirect manner can also have an impact in reducing the degree of IPO Pricing. Uncertainty in information or information asymmetry can lead to IPO under-pricing which can to a considerable extent be reduced by rating system and thereby ensure a reduction in IPO pricing and an overall increase in raising of funds by businesses and governments as credit ratings can to a considerable extent reduce the extent of price revision during the book building period and can further reduce the price volatility in the aftermarket of the IPO enabling to attract more investors towards the businesses and ensuring a better and synchronised manner to raise more finance in the global financial markets. Credit Ratings in their role as information gatherers and processors also helps businesses and governments to reduce their capital cost by certifying its correct value in the financial market which helps in eliminating or reducing the information asymmetries between the purchaser and the issuer. It makes a clear correlation between the two significant variables which help in raising funds in the financial market which are the ratings grade and the bond spreads as lower is the rating higher is the spread. Further there are other indirect benefits which help business and governments to raise finance in the global finance market as it helps in fostering the selling of Foreign Direct Investments and promote a vibrant local capital market and greater transparency in all its dealings. Unlike the most important role played by Credit Rating Agencies and their ratings is to foster the development and smooth functioning of both capital and financial market on a global basis and help both companies and governments to grow and raise finance on a continuous basis. 4.0 Accountability of CRA’s Looking upon the benefits which a credit rating agency provides to businesses and governments in raising finance in the global financial market it is important to understand the accountability of credit rating agencies in order to make a better understanding of the entire topic study. Looking at the Principal-agent framework, it is important to understand that credit rating agencies are solution to such problems as they enhances the accountability of borrower and makes it more transparent for borrower to enter into fair dealings which are supported and believed to be true by the investor making it easier for borrower to raise more finance through its bonds in the financial market. A credit relationship is a classical example to understand the situation in a better manner where a lender needs to accurately estimate that the borrower shall wisely use his investments to generate higher returns with lower risk takings. Yet on the other hand the borrower has no incentive to make a disclosure of his negative information in context to his creditworthiness to the aforesaid lender as doing such shall accelerate its cost of borrowing (Liu and Ferri, 2001). This information asymmetry is solved to a great extent by Credit Rating Agencies who makes a clear signal of the creditworthiness to the lender for better transparency and also allows borrower to raise finance easily as a better credit rating ensures investor to largely apply on the bonds of the issuer and take higher returns which on the other side allows the issuer to raise finance easily which on a direct note further enhances the accountability of the borrower. For which Credit Rating Agencies seems to primarily enhance the accountability. 5.0 Major Issues and their Solutions The paper has already highlighted how credit rating agencies influence the ability of the businesses and governments to raise finance or funds in the global financial markets. However it would be impractical to understand the topic without looking at some of the major concerns or issues and their recommended solutions that credit rating agencies impose in the global financial markets (White, 2001). Credit Rating Agencies has been long criticised for lack of competition as the financial rating industry has been largely dominated by the Standard and Poor’s and Moody’s on a global basis of which both are required to issue a rated debt instrument so they do not compete with each other. Furthermore high ratings given to low quality assets has been one of the major reason for the Financial Crisis of 2008 which can be regarded as “Rating Triggers” has always been a major concern for transparency and accountability issues of Credit Rating Agencies (Hashem, Schuermann, Bjorn-Jakob & Scott, 2006). The credit rating agencies also lack timeliness and Pro-cyclical behaviour with a greater criticism on account of its independency as there has been a considerable argument that rating agencies which provides a solicited rating may have an incentive of higher rating to attract more subscribers and earn more revenues. Thus all these issues makes it difficult for businesses and governments to maintain transparency in their debt dealings and gains lack of confidence by the buyer or investor among various securities making it difficult to raise finance or funds in the global financial markets. In order to further ensure a fair and transparent rating system so as to enable businesses and governments to gain confidence of the investors and attract more investors towards the purchase of debt securities it is important to install competition within the credit rating agencies which has already been accelerated by forming of new institutions and agencies. Furthermore, the methodology used for ratings need to be revised along with regulatory landscapes and changes to bring uniformity and considerable reforms as per the current financial global markets. Raising the accountability and responsibility of credit rating agencies can further help in boosting up the confidence of both the issuer and investor upon the transparency of the rating system. Looking at the past rating gaps, it would be of great importance to install a global regulatory framework and making it compulsory for large business organizations to ensure proper and correct rating from authorised rating agencies. 6.0 Conclusion This paper looks to highlight and critically appraise the influence of credit rating agencies on the ability of various businesses and governments to raise more funds and finance in the global financial markets. The paper throw light that it is an undisputed fact that the credit rating agencies play an important role in the global financial market to eliminate or reduce the information asymmetry between both the parties i.e. the investor and the lender on one side and on the other side about the creditworthiness of the companies or businesses (Corporate risk) and counties or government (Sovereign risk). An investment graded security by CRA’s can put a security, bond, company or country on a global radar which is meant to raise large finance in the global financial markets and help to boost a country’s or governments economy. Indeed, in case of growing economies the credit rating agencies help them to show their worthiness of money and attract a larger pool of foreign investors thereby helping to raise more finance in the global financial markets. Furthermore credit rating agencies also acts an important tool to help market regulators in promoting stability and efficiency in global securities and financial markets and make the markets more transparent and efficient in a synchronised and comprehensive manner. 7.0 References Hashem, P., Schuermann, T., & Bjorn-Jakob, T. Scott, M. (2006). Macroeconomic Dynamics and Credit Risk: A Global Perspective , Journal of Money, Credit & Banking, 38 Liu, LG. and Ferri, G. (2001). How do Global Credit Rating Agencies Rate Firms from Developing Countries?, ADB Institute Research Paper no.26 Lehmann, A. (2004). Sovereign Credit Ratings and Private Capital Flows to Low-income Countries, African Development Review 16 (2) Michael K. (2002). Credit Ratings: Methodologies, Rationale and Default Risk, Risk Books Mora, N. (2005). Sovereign Credit Ratings: Guilty Beyond Reasonable Doubt, Mimeo, American University of Beirut Reisen, H. (2002). Ratings since the Asian Crisis, United Nations University, Discussion Paper no. 2002/2. Rousseau, S. (2005). Enhancing the Accountability of Credit Rating Agencies: The Case for A Disclosure-Based Approach, CMI, University of Montreal Smith, R. and Walter, I. (2001). Rating Agencies: Is there an Agency Issue? Stern School of Business, New York University Sy, A. (2004). Rating the rating agencies: anticipating currency crises or debt crises? In: Cantor, R, (Ed.), Recent Research on Credit Ratings (special issue), Journal of Banking and Finance 28 (11) Vanessa P. (2008). Is Ignorance Bliss? Consumer Accuracy in Judgments about Credit Ratings, Journal of Consumer Affairs, 42 White, L. (2001). The Credit Rating Industry: An Industrial Organization Analysis, paper Presented at the Conference on The Role of Credit Reporting Systems in the International Economy, The World Bank, Washington D.C., 1-2 March Read More