Credit quality and independent rating agencies 269
ratings must be subject to internal stress tests. Moreover, internal and external audi-
tors should audit the quality of ratings, and adequacy of their use.
While banks rate their loans clients, correspondent banks, and trading partners,
they are themselves rated by the independent rating agencies in terms of their corpor-
ate governance and finances. Globalization means this is becoming increasingly
important. As far as credit risk is concerned, the best advice to companies is to get a
grip on its fundamentals and to get moving in doing something constructive about it.
Credit risk is everyone’s concern. Poor credit rating will not cease to exist because it
is ignored.
12.2 Independent credit rating agencies
Independent credit rating agencies first saw the light of day as statistical organiza-
tions in the late 19th century. In the United States they are regulated by the
Securities & Exchange Commission (SEC). Their size varies significantly, and it
takes years to develop a credit-rating franchise. It is not that easy to get a SEC des-
ignation to operate a nationally recognized statistical rating organization
(NRSRO, a term coined in 1975) in the United States; it is also fairly difficult to
develop the necessary skills, particularly so if the rating agency wants to develop
global dimensions.
Since the beginning, the objective of rating by independent agencies has been to
provide an unbiased opinion on creditworthiness. This is not an advice, or a recom-
mendation. Fundamentally, rating agencies aim to inform; it is not part of their mis-
sion to protect anybody.
Up to a point, the protection of investors is the job of bank supervisors, by means
of assuring credit institutions under their authority are financially sound.
By contrast, the parties responsible for malfeasance are the attorney-general,
police, and judiciary – and there has been plenty of criminal action in the early
years of the 21st century.
The growing role of rating agencies is easily explained by the fact that in a glob-
alized market economy there is always the possibility of financial and industrial
companies going bankrupt – but at the same time investors should know of their
credit status. Creditworthiness is a crucial variable in nearly all business decisions.
If the supervisory authorities have a policy of too much tight reign to avoid bank-
ruptcies, this will kill entrepreneurial activity. In this case, prevailing laws and regu-
lations will be counterproductive. In the banking industry, in particular, regulators
can only set a minimum capital standard.
2
They cannot and they should not target
100% security. Legislators and regulators must define what kind of security they
want. The regulators mission is to:
Provide conditions for orderly market behavior
Create market transparency, and
Avoid systemic risk, which will tear apart the financial fabric.
270 The Management of Bond Investments and Trading of Debt
Notice that as far as debt instruments are concerned, the regulators don’t aim at
stockholder protection beyond that of guaranteeing an orderly market. Taking care
of individual investors is not part of their charter. Information on credit status is the
mission of independent rating agencies which, as we saw, address the default proba-
bility of bonds and issuers, including banks, funds, other companies and sovereigns;
and also securitizations and structured financial transactions.
The role of regulators, rating agencies, and financial analysts versus investors
is shown concisely in Figure 12.1. While, as we will see in section 12.6, there
are general principles for credit rating, every sector of the economy also has its
own criteria which impact on the default probability of companies operating in
it. Other things being equal, shareholders and bondholders who know the prob-
ability of default assigned by rating agencies have better protection than those
who don’t.
For instance, in the insurance industry the credit risk of the insurer is judged by
its solvency – that is, the company’s ability to pay the claims arising from policies it
has underwritten. The insurer’s rating corresponds to bond rating, but the predom-
inant factor is that of criteria proper to the insurance industry, distinguishing
between regulatory capital and economic capital: The capital demanded by regula-
tors typically stands at 4–5% of assets in life insurance, and 15% of revenue in non-
life insurance.
To calculate economic capital an insurance company has to set its risk tolerance,
which impacts on the economic activity it undertakes. It also has to account for the
so-called rating agency factor, which gives a perception of the insurer’s creditworthi-
ness from the outside. This is also a function of risk tolerance.
Banking and insurance are classical examples of creditworthiness. There are other
industry sectors which are novel in the credit rating business. A case in point is the
REGULATORS
SYSTEMIC RISK LOANS DEPOSITS
SECURITIES
ANALYSTS
INDEPENDENT RATING AGENCIES
BONDHOLDERS
SHAREHOLDERS
INVESTORS AND OTHER STAKEHOLDERS*
Figure 12.1 The role of regulators, rating agencies, and analysts vs. the
investors (*for instance, in insurance, the policyholders)

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