Credit ratings organizations

Group Work:

Topic 1: Do we need to regulate credit rating
organizations, and if yes, how?

We will develop a presentation in four parts:

1. Rating agencies presentation and history

– History: where they come from and why they have been created

– Presentation of the three most important CROs

– Notation Methodology

2. Problems with CROs

– Duopoly

– Agencyproblem and Conflicts of interests

– reputational capital and Resource constraints

3. Regulation of CROs

– No regulation before 2006

– CRARA 2006 and the results

– International initiatives

4. Conceivable solutions and consequences

– Market solutions

– Anti-market solutions

– Current concrete proposals

1) Rating agencies presentation and history

The use ofcredit ratings appeared in the U.S. because of the investing class wanted to have more information about the many new securities – especially railroad bonds – that were being issued and traded. In the middle of the 19th century, the U.S. railroad industry began expanding across the continent and into undeveloped territories. The industry’s demand for capital exceeded the ability or willingness ofbanks and direct investors to provide it.

In order to reach a broader and deeper capital market, railroads and other corporations began raising new capital through the market for private corporate bonds. The growth in the sale of many different corporate bonds to a broad investing public generated the need for better, cheaper and more readily available information about these debtors and debtsecurities.

In response to this development, Henry Varnum Poor first published in 1868 the Manual of the Railroads of the United States. His publication contained operating and financial statistics for the major railroad companies, and provided an independent source of information on the business conditions of these corporate borrowers.

John Moody took the process another step forward in1909 by issuing the first credit ratings in the United States. Prior to this independent source of information, banks played a key role in shaping investor perceptions of corporate borrowers.

After all, banks had greater knowledge from the inside information they obtained in their role as direct lenders and as bond underwriters. By lending and underwriting, banks were putting their money andreputations on the line. If the borrower failed to meet its obligations, the reputation of the bank would be damaged and that would make it harder for the bank to retain existing and attract new clients. In essence the bank certified the quality of the bonds to the public with the bank’s reputation. Alternatively, the bank as creditor would become more involved in the business of the corporation andbecome an insider. Bond investors, however, did not have the same access to information. (There were no disclosure requirements prior to the securities acts of 1933 and 1934.). This created an asymmetry in the availability of information in the U.S. capital markets. The impact of rating agencies was to help level the playing field and improve the efficiency of capital markets. The role of creditratings and rating agencies would go on to solve other asymmetric information problems.

According to the BIS, there are 130 to 150 credit rating agencies worldwide. Many of these agencies are smaller and focus on a niche market based on sector or geography. The three most prominent credit rating agencies that rate sovereign countries are Standard & Poor’s, Moody’s and Fitch Ratings. Only a feware officially recognized by governments for regulatory purposes. On average, the 10 member countries of the Basel Committee for Banking Supervision (BCBS) recognize six agencies. In the U.S., the Securities and Exchange Commission (SEC) recognizes only four.

The official certification is granted by the Securities and Exchange Commission’s Division of Market Regulation through the issue of…

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