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Monday, 19 January 2015 10:14

A fresh approach to credit ratings

Written by Wendy Adams
Students from the Department of International Relations at the University of the Witwatersrand Students from the Department of International Relations at the University of the Witwatersrand Photo © Riona Judge McCormack/ SAIIA

Over the past few years there have been discussions amongst the BRICS (Brazil, Russia, India, China, South Africa) countries to open up their own rating agency that will compete with the 'big three' credit rating agencies - that is, Standard and Poor’s (S&P), Moody’s and the Fitch Group. S&P and Moody’s are based in the US.

Since the 2008 global crisis the big three credit rating agencies have been under tight scrutiny, following risky mortgage-related securities that contributed to the collapse of the US housing market. The crisis began when thousands of US homeowners stopped paying interest on their mortgages. The crisis spread because thousands of bankers and fund managers had imprudently backed those mortgages. They did this partly through their own lack of foresight and diligence, but also because of the ratings agencies failure to warn them of the risks involved.

As a result both banks and funds lost a great deal of money. In the run up to 2008, a staggering proportion of mortgage-based debts were rated AAA, when in fact they were essentially 'junk'. Ratings given by rating agencies start from AAA (the highest rating), then comes AA1 and so on down the scale to C. Anything below BBB is known as 'junk'.

This blog forms part of a special series of student articles on global governance.

Due to the financial crisis, the big three rating agencies are being criticised for their perceived lack of awareness of the risks which led to the crisis, and for the dominance they have on the market. The credit rating agencies rate the creditworthiness of companies and currencies, and through this they give investors an idea which investments are safest to make. Credit rating agencies are important and they have a major impact on today’s financial markets, since rating actions impact on borrowers, issuers and governments: for example, sovereign ratings play a crucial role for the rated country, and a downgrade can have the immediate effect of making a country’s borrowing more expensive.

Although the BRICS have yet to open their own agency, in 2012 five international rating agencies across Asia, Africa, Europe and Latin America entered into a joint venture to create a new global rating agency, ARC Ratings, which is meant to cater to the ‘new multi-polar world’ in direct competition with US-centric agencies.

Three of these rating agencies are from the BRICS bloc – Brazil’s SR Rating, CARE Rating of India and GCR of South Africa. They are partnering with CPR of Portugal and MARC of Malaysia. ARC Ratings will be challenging the dominance of the world’s big three, which at present account for over 95% share of the global ratings market.

Representing four continents, ARC aims to rebuild and enhance reliability and transparency in the international credit rating industry which has suffered an immense loss of credibility in the wake of the financial crisis.

A rating from credit rating agencies is important for African companies as this helps to boost investors’ confidence across all assets and further helps with the development of Africa’s capital market. However African companies are struggling to afford the hefty fee charged by the big three rating agencies, which is between US$1,500 and US$2,500 for the privilege, depending on the size of the company. This is one of the reasons why the big three rating agencies are not more active on the African continent.

Furthermore, in order to issue an opinion you need to have conducted research activities on the company. One can say that there is no incentive for the big three to have operations on the ground as they know it would not benefit them financially to rate African companies, as they believe the market is not mature enough. The instability of African countries is also a factor. South Africa, however, does pay for a few services by the rating agencies.

South Africa’s Global Credit Rating (GCR), as well as being a founding partner of ARC Ratings, is a market leader on the African continent, rating more credits than the previously mentioned big three international agencies on the African continent. GCR recognises that emerging markets operate differently to the already established markets; hence they apply a different methodology compared to that used by the big three. GCR aims to be a credit rating agency for emerging markets.

As ARC Ratings is newly established, whether or not it will become a real competitor to the major three rating agencies is still unknown. The call for new rating agencies and the gap in emerging market ranking should help boost this agency. ARC Ratings claims its methodology will be dynamically adapted to keep pace with market needs according to the different levels of risk. Emerging markets are said to be under-served by the big three, and mid-sized corporates from these markets with ambitions to access international capital markets are currently the clients of ARC Ratings.

ARC Ratings faces an uphill battle to establish market share as a new entrant. It can, however, be a positive metamorphic force in the global rating landscape with its strong governance structure, considering its partners and its global collaborative approach to the ratings.

The rise of ARC Ratings and with GCR as a founding partner should increase ratings activity across the region. The credibility of any ratings agency lies in the strength of its analysis and the ratings. Many African companies are not comprehensively audited so the more ratings penetrate the continent the more comfortable investors will be about getting into the market. This will help African companies to be benchmarked on an international scale.

African markets are known to not be mature enough; however, this is changing. Demand for ratings is growing and supply needs to follow from African ratings agencies, and agencies such as ARC Ratings which have an African presence.

Wendy Adams is an MA student at the Department of International Relations at the University of the Witwatersrand (#WitsIR). This blog forms part of a special series of student articles.

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