84. Role of credit ratings in financial services market

A credit rating is an evaluation of the credit worthiness of a debtor, especially a business (company) or a government, but not individual consumers. The evaluation is made by a credit rating agency of the debtor's ability to pay back the debt and the likelihood of default.

Companies that seek credit from lenders, or give credit to accounts, are part of the vast global network of commercial borrowers and lenders. Every day, among the millions of businesses that operate in every corner of the world, billions of dollars in cash are loaned, and goods and services worth billions more are provided on credit. To keep this high level of commercial activity moving smoothly, companies must have a commonly accepted method for evaluating the creditworthiness of commercial enterprises. It is impossible for individual companies to make credit determinations on every trading partner. The solution is to use business credit ratings.

In short, credit ratings can help reduce the knowledge gap, or "information asymmetry," between borrowers (issuers) and lenders (investors). The essential subject matter of this information asymmetry is a borrower's creditworthiness. In this way, credit ratings regulate financial market risk. By protecting investors from fraud, it reduce the likelihood of financial crisis, they have contributed to the markets’ efficiency and growth.

85. How credit ratings evaluate a credit worthiness of a company?

Rating agencies, or credit rating agencies, evaluate the creditworthiness of organisations that issue debt in public markets.  This includes the debts of corporations, nonprofit organisations, and governments, as well as “securitised assets” – which are assets that are bundled together and sold as a security to investors.  Rating agencies assign a letter grade to each bond, which represents an opinion as to the likelihood that the organisation will be able to repay both the principal and interest as they become due.

Ratings are made on a descending scale: AAA is the highest, then AA, A, BBB, BB, B, etc.  A rating of BB or below is considered a “junk bond,” because it is likely to default.  Many factors go into the assignment of ratings, including the profitability of the organisation and its total indebtedness.

Credit ratings are not based on mathematical formulas Instead, credit rating agencies use their judgment and experience in determining what public and private information should be considered in giving a rating to a particular company or government.

A poor credit rating indicates a credit rating agency's opinion that the company or government has a high risk of defaulting, based on the agency's analysis of the entity's history and analysis of long term economic prospects There are very few AAA rated companies in the world.  Examples include ExxonMobil, Johnson & Johnson, and Microsoft.  The governments of the United States, the United Kingdom, and Germany are also rated AAA.  Organisations with a AAA rating are able to issue debt at very low interest rates.

There are many companies with low credit ratings.  General Motors had a “junk” credit rating for many years before it declared bankruptcy in 2009.  Companies with a low credit rating generally pay a much higher interest rate on their debt, and may find it difficult to sell new bonds.   The methodology of the ratings agencies is not without flaws, and they are under considerable scrutiny regarding the inaccuracy of many ratings categories during the financial crisis.