Rating agencies: what they are and how they influence financial markets

What are rating agencies?

Rating agencies are independent entities that are responsible for assessing the soundness and solvency of issuers of securities, such as companies, banks and governments, in the financial market. Through detailed analysis, these agencies assign a score – the rating – that expresses the issuer’s ability to meet its financial commitments. This score allows investors and institutions to understand the degree of risk associated with investing in specific securities. The major international rating agencies, such as Fitch Investors Service, Moody’s, and Standard & Poor’s, are recognized for the authority and independence of their ratings.

How do rating agency ratings work?

The rating agencies’ evaluation process is complex and relies on a series of detailed analyses of the creditworthiness of issuers and securities. Agency analysts examine a wide range of economic and financial indicators, such as balance sheets, economic prospects, and political stability, to determine the issuer’s soundness. The result is a rating, usually expressed in letters, that varies between “AAA” (highest level of safety) and “D” (in default, which is when the issuer fails to honor its commitments).

The rating is not only a static assessment, but can be updated over time based on economic and financial changes. An improvement or deterioration in the rating can have significant effects on the interest paid on the securities issued, and consequently, on the cost of debt to the issuer.

Why are rating agencies important?

Rating agencies play an essential role in financial markets, directly influencing investor confidence and guiding their decisions. A high rating indicates a low probability of default, which can attract investment at favorable interest rates; conversely, a low rating signals higher risk, prompting investors to demand higher rates to offset exposure. For example, a downgrade in a company’s or country’s rating can increase the cost of debt, putting pressure on the issuer’s finances, while a high rating can encourage cheaper access to credit and support economic growth. Although sometimes criticized, rating agencies provide crucial assessments for understanding the financial soundness of issuers and securities, contributing to the stability and transparency of global financial markets.

The usefulness of rating in the financial market

The rating plays a key role in the financial market, as it allows the formation of a concise and immediate judgment on the reliability of the rated entity. This judgment is constructed from a broad analysis of quantitative data, such as company balance sheets or economic statistics of a country, but also from qualitative factors, such as news about the company’s management and reputation. With this rating system, investors can quickly assess the level of risk associated with an investment and better guide their decisions by making use of accessible and centralized information.

The relationship between rating and investment risk

The rating assigned is directly related to the issuer’s probability of default: a high rating indicates a low probability of default, while a low rating suggests a higher risk. As a result, investors will demand a higher risk premium, i.e., a higher interest rate, to compensate for the risk associated with a low-rated security. This principle is based on risk/return theory, which explains how an increase in the risk associated with the investment requires greater compensation. In this way, the rating becomes an important indicator for managing the cost of debt and attracting investors based on the risk profile.

Who funds rating agencies and possible conflicts of interest

Rating agencies, financed primarily through fees paid by the issuers of securities-such as banks and governments-that request a rating themselves, are often criticized for potential conflicts of interest. This structure could affect the impartiality of their analyses, since the agencies are remunerated by the entities they rate. Moreover, their oligopoly position-with Moody’s, Fitch, and S&P Global Ratings dominating almost the entire market-has fueled calls for greater transparency and opening up the industry to other entities to increase competition and improve the reliability of ratings. During the 2008 financial crisis, for example, some of the agencies’ overly optimistic ratings were questioned, prompting many to call for stricter regulation to ensure objectivity and reliability in their ratings.

This article was created and reviewed by the author with the support of artificial intelligence tools. For more information, please refer to our T&Cs.

This article or page was originally written in Italian and translated English via deepl.com. If you notice a major error in the translation you can write to adessoweb.it@gmail.com to report it. Your contribution will be greatly appreciated