Rating agencies and their role and power: how the 3 agencies (Moody's, S&P, Fitch) work, their impact on financial markets and related controversies

Imagine a world where you had to borrow money from someone you didn't know. Before you do, you would want to know his or her solvency and reliability. Is he or she a conscientious taxpayer? Is his income stable? This is the role of credit rating agencies in the financial world. They are like trusted experts whose opinions are listened to and whose assessments have a profound impact on the financial behaviour of countries and large corporations alike.

But who are these giants? We're mainly talking about the big three: Moody's, Standard & Poor's (S&P) and Fitch Ratings. These three agencies control more than 90% of the global ratings market and their activities affect virtually everyone, from the largest investors to ordinary investors who buy government bonds, for example.

How do credit rating agencies work?

The main task of a credit rating agency is to assess the borrower's... creditworthiness or the ability to deliver on your commitments. This is true for companies as well as for countries. They analyse in depth the borrower's financial situation, debt, income, market position and also future prospects. In the case of countries, they also look at the economic structure, political stability and government policies.

The result of the analysis is expressed as a rating, which is a simple combination of letters. The most common rating scales are similar for the three agencies:

AAA / Aaa: Highest creditworthiness, virtually zero risk of default. This is the best possible rating.
AA / Aa: Very high creditworthiness, very low risk.
A: High creditworthiness.
BBB / Baa: Good creditworthiness, but could be affected by economic conditions in the medium term. This is the lowest rating, which falls into the so-called investment-grade.
BB / Ba and lower: Belong to speculative grade (junk bonds/non-investment grade). For them, the risk of insolvency is significant.

Rating agencies are constantly monitoring the situation and their ratings are subject to change. If the economic situation deteriorates, the rating may be downgraded. Conversely, in times of stability and growth, the rating may rise. Ratings are often accompanied by an outlook: positive, stable or negative.

The impact of ratings on financial markets

Ratings have a huge impact because they are an important indicator for investors. Most large institutional investors, such as pension funds and insurance companies, are only obliged to invest in investment stage in rated bonds. This is part of their risk management policy.

Bonds yield and price: When a company or country's rating falls, for example from investment to speculative, it must offer investors a higher interest rate (return) to obtain a loan. The higher interest rate compensates for the increased risk. This means, however, that borrowing becomes more expensive. The lower the rating, the higher the interest rate is usually.
Access to capital: A rating downgrade could lead to a situation where many institutional investors are forced to sell their bonds, which in turn reduces the borrower's liquidity and makes it more difficult to raise future loans.
Economic stability: A positive rating reflects economic stability, attracting foreign investment and fostering growth. A negative rating outlook, on the other hand, can act as a preemptive warning, signalling that a country or company is facing potential problems.

Controversies and criticisms of credit rating agencies

Despite their important role, CRAs have received a lot of criticism over the years. Their main controversies relate to conflicts of interest as well as questionable decisions.

Conflict of interests: the borrower requesting the rating pays for the CRA service. This creates an obvious conflict of interest. Critics argue that agencies may be motivated to give better ratings to borrowers in order not to lose customers. This was one of the main accusations in 2008. financial crisis after many of the 'highly rated' (AAA) complex financial products proved worthless.
Slow response: Agencies have often been criticised for reacting too slowly. Ratings often fall only after the economic problems are already public and all other market participants are aware of them.
Power and monopoly: As these three agencies control the market, their assessments have a huge impact. A single agency decision can trigger a panic in the market, affecting the savings of millions of people. For example, in 2011, S&P downgraded the United States, causing a short-term market shock, even though other agencies kept their ratings high.

Of course, we add another important section to the article that delves deeper into the role of CRAs in the context of recent economic crises and explains why their actions have been so controversial. This gives the reader a more critical and historical perspective.

The role of credit rating agencies in the 2008 financial crisis

The credentials and ethical issues of credit rating agencies came to the fore particularly sharply during the global financial crisis of 2008. This event exposed major flaws in the rating system and raised the question of whether agencies are part of the problem or part of the solution.

The main cause of the crisis was the collapse of the subprime mortgage market in the United States. Banks were lending to people with low solvency by packaging these loans into complex financial products (e.g. mortgage-backed securities). CDOs or collateralized debt obligations). What is striking, however, is that even the riskiest of these products have been rated by rating agencies AAA ratings, which is intended only for the safest investments.

When the housing market collapsed and loans became insolvent, AAA-rated financial products also became worthless. Investors who had trusted the ratings of credit rating agencies lost billions.

This led to the conclusion that agencies were either:

Incompetent assess new and complex financial instruments.
Motivated by give high ratings so as not to lose customers (banks that sold financial products and paid fees to agencies). This was a classic conflict of interest that was called into public question.

In the aftermath of the crisis, agencies were widely criticised and forced to reform their methodologies and internal rules. Governments and regulators, such as the US Securities and Exchange Commission (SEC), began to monitor agencies' activities much more closely.

This piece of history is important because it shows that credit rating agencies are not just objective analysts, but part of a system that has both enormous power and great responsibility. It reminds investors that blind faith can be extremely dangerous.

Summary

Credit rating agencies, especially the big three, are an integral part of the financial system. Their ratings remain an important indicator for investors and have a direct impact on the price and availability of capital. At the same time, it is important to understand that they are not infallible gods. They have their own shortcomings, conflicts of interest and concentrations of power that require constant critical analysis.

Smart investors never just look at ratings, they also analyse the background information and make informed decisions. Ratings are a useful tool, but they are not the only truth.