Introduction
Credit rating agencies are normally mandated to provide independent opinions concerning the credit quality of issuers. However, investment decisions that are made by users in the market (by relying on credit rating) cause the credit rating agencies to affect credit rating of issuers.
Rating downgrade can lead to increased cost of capital for the borrowing entity as it gives a bad impression to the investors about the credit quality of the borrowing firm. In practice, credit rating agencies have a challenge in terms of setting credit rating that best describe the credit quality of a certain issuer while taking into consideration the effect of these ratings on the quality of the issuer.
Standard and Poor’s, Moody and Fitch ratings are the three commonly known credit rating agencies. They have been under serious scrutiny in the past and this was after the global financial crisis.
These agencies have recently put their focus on the United States and European sovereign debt. This lead to the S & P’s unprecedented downgrade of the United States long held triple. This rating subsequently caused global sell-off and market volatility.
United States and Europe have put some measures to regulate the three major rating agencies. This includes the formation of Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted by the United States.
It holds rating agencies accountable as well as safeguards investors and businesses’ interests. On the other hand, European Union formed the European Securities and Market Authority as an independent authority. This body regulates the credit rating agencies’ activities.
Fitch has downgraded the credit ratings of major banks in the United States and Europe. As a result, it induced fear concerning the impact to the world economy. This downgrade has increased concerns of a new credit model as the global banking system continues to deal with huge levels of debt.
The rating agencies lowered the ratings for Barclays Bank, Bank of America, Deutsche Bank, and Morgan Stanley as well as downgraded their long-term issuer-default rating.
The Role of Credit Rating Agencies
These bodies have a major role to play in the business society. They provide information about the risks that may be encountered in the event of debts. Global investors benefit the most from this. The securities involved may be government bonds and preferred stock.
Others include collaterals, corporate bonds and certificates of deposit. The riskiness of investing in the mentioned securities is normally determined. This may be where a debt issuer such as a corporation, bank or local government fails to pay interest on debt at the right time.
Credit rating agencies give their opinion by use of a letter grade. The highest and safest is ‘AAA’. A double ‘AA’ grade represents a lower grade. A single letter ‘A’ represents much lower grades. The general market and investors may be greatly influenced by the ratings.
Industry Structure
Credit raters have been mostly criticized based on the issuer-pays model. This system is used by S & P, Moody’s and Fitch. This involves bond’s issuer paying the rating agencies for the first rating and ratings of security. These ratings may be provided free of charge.
The general public and investors may access it freely. The rating agencies used this mode. This was after a long time of using the subscriber-pay model. This made companies that invest in bonds to pay for the ratings.
There have been issues facing the issuer-pay mode. This has made those using subscriber-pays to search for a better choice. Some subscriber-pays entities are against the main credit rating agencies. This is because of the fact that they are monopolistic and have caused the ratings to be biased. The companies against them include the Egan-Jones Rating Company.
Impact on the Eurozone Crisis
The European Union (EU) has commented on the issue. It has accused the three major rating agencies for being biased when providing rates in the region. This is despite the financial crisis in the area. The rating agencies are still being blamed by various EU officials for increasing the European sovereign debt crisis.
This has spread through Greece, Portugal and Ireland. This begun when S&P’s decided to downgrade Greece’s debt to a lower status. As a result, it changed the investors’ confidence and increased the country’s debt problems (Bolton, Freixas, and Shapiro 20).
Eurozone crisis heightened when Moody’s downgraded Portuguese debt to junk status in mid 2011. It stated that the country might require a way out. This came just a month after the European Union and International Monetary Firm officials had agreed on the first rescue plan. A few days later, Ireland was also downgraded to junk status. This led to a panic in European and global markets.
European Union agreed to create a fiscal union as well as improve liquidity in the financial sector using European Central Bank but the crisis persisted. This led to the increase in borrowing costs, which raised fears over European Union Bank’s liquidity. These issues became worse when S&P downgraded nine Eurozone states.
Consequences of downgrade
A downgrade of euro zone’s ‘triple A’ nations could have a serious implication. It may affect the ability of Europe’s bailout fund and European financial stability facility to help the struggling countries. Some critics say that the downgrade further push away investors in the market despite recent positive signs over Europe’s debt crisis.
In Europe, Germany’s DAX fell to 6,075. This is a 1.7 percent fall. In France, CAC-40 fell to 3156, representing a 1.4 percent fall. The FTSE 100 index of leading British shares, on the other hand, fell to 5,588 indicating a 1.3 percent decline. The euro was also greatly affected as its value fell by 1.4 per cent. This indicates the lowest level since September 2010.
In the United States, the implication of a downgrade was also far reaching. The Dow Jones industrial average fell to 12,330. This represents a 1.1 percent fall. The broader standard and poor’s 500 index fell to 1,280 representing a 1.2 percent drop. Critics argued that a credit downgrade would probably increase the cost of borrowing for the federal government and the people in general.
However, the United States administration, economists, house republicans and Wall Street analyst concluded that the economic impact might be at stake. This is among the reasons why a bargain for debt reduction broke down.
Compromise between the parties could have a terrible consequence of default. In addition, even if congress decides to pay its bills, one credit rating agency, Standard & Poor’s, has already stated its intention of removing United States from its list of risk-free borrowers. Downgrade has many effects. However, some analysts say that they are not as severe in comparison to not raising the debt ceiling on time.
Standard & Poor’s, Moody and Fitch had earlier warned the United States administration about the rising federal debt and political standoff over raising debt ceilings that would put the nation’s credit rating at risk.
The potential risk of downgrading mortgage companies, following the federal government support of this institution, will lead to the increase in rates of home mortgage loans for borrowers. This also puts other states, including Maryland and Virginia, at a risk of being downgraded because of their economies that are tied to the government.
Downgrade of banks will cause a negative effect on the business and investor confidence. This is because interest rates for everyone that borrows will be raised. The value of the dollar will also be undermined. The stocks and bonds market will be struck hard. All these will worsen the already existing economic circumstance (Boot and Schmeits 90).
Some critics argue that, from the experience of other nation’s downgrades including Japan and Canada, suggest that investors will not always react by demanding higher interest rates. In their view, downgrading the banks will not cause many investors to dispose of their treasuries. However, downgrades of major banks may disrupt the economy. This is because the response of financial market may be difficult to predict.
Consequences of a downgrade to ‘AA+’ as listed by Standard & Poor’s included entities that heavily rely on the federal government. One of them is the Federal Home Banks. They support consumer credit. They do this by advancing loans to other banks. However, highly rated corporations based in United States that have ‘triple A’ rating such as Johnson and Johnson are likely to be left off the hook.
The downgrade implication might not be very easy to predict at times. However, Standard and Poor’s have highlighted how their own downgrade would affect the domestic markets. The company argued that such a downgrade would have significant effects. It may lead to the moderate increase in long-term interest rates.
This may be from as low as 0.25 percent to 0.50 percent. This is due to what it termed as ebbing market confidence. The economic growth will slow down and consequently increase caution between business and consumer.
The credit rating agency states that the first place where the impact of a downgrade will be felt is the stock markets. However, some experts think otherwise. They expect that there will be tough reactions from the United States markets. The effect on money markets as well as other institutional investors that hold highly rated debt is expected to be minimal.
Sovereign downgrade has serious implication on banks due to a number of reasons. They may heighten economic problems of the nation, which have negative effects for the banks. They also increase the cost of government debt and increase the bank debt costs. The most direct consequence of sovereign downgrade is the effect in the value of sovereign bonds. This reflects on the banks’ balance sheet.
Since they make up almost ten percent of the balance sheet, a fall in their value would weaken the balance sheet at the time when banks struggle to improve capital bases. In the long run, the psychological reaction to the downgrade might have the biggest impact.
Conclusion
The downgrade of banks by the credit rating agencies has both positive impacts as well as negative impacts to the banking system. When downgrading, the rating agencies should not only focus on the accuracy of their ratings but also on the impacts of those ratings.
This will enable the banks to know the probability of survival after it has been downgraded. It is also important to note that increased competition between credit rating agencies can lead to rating downgrades. In case of downgrades, banks in stronger countries such as France and Germany have more to lose from downgrades than those in weaker countries such as Italy.
Works Cited
Bolton, Patric, Xavier Freixas, and Joel Shapiro. The Credit Ratings Game. Columbia: Columbia Business School, 2009. Print.
Boot, Milbourn, and Anjolein Schmeits. “Rev. of Financial Studies: Credit Ratings as Coordination Mechanisms.” Journal of Accounting, Auditing and Finance 19 (2006): 81–118. Print.