Business Daily Media

what are credit ratings and why do they matter?

  • Written by Eliza Wu, Associate Professor in Finance, University of Sydney

A new report has highlighted[1] room for improvement in Australian credit ratings agencies, including potential conflicts of interest, overseas staff producing credit ratings, and failures to meet compliance standards.

Having effective credit ratings agencies is vital for Australia, as they assess the creditworthiness of governments, corporations, banks and other entities that wish to raise funds by issuing debt.

The agencies’ decisions can have knock-on effects throughout the economy. The ability of governments to borrow money has an impact on investors and companies, and companies pass on the cost of borrowing to their customers.

Read more: Why we should be wary of ratings agencies[2]

Ratings agencies are trying to represent not only the ability of borrowers to repay their loans, but also the willingness to repay on time.

Ratings are given as a ranking. AAA is the highest, then AA and A, right through to C and then D (default).

The lower your credit rating the riskier you are deemed to be and the higher the interest rates charged. Some institutional investors (such as pension funds) are not allowed to hold debt with a credit rating of BB or below.

The exact methodology used by the ratings agencies is not publicly released. But ratings are based on a mix of public information and private information provided by the debt issuers.

When it comes to giving the federal government a rating, agencies will use publicly available economic data such as economic growth, income per capita and unemployment and inflation rates. This gives the agency an idea of the current state of the economy, as well as where it might be in the short and long term.

Agencies will also look at the federal government’s budget. They will consider the gap between revenues and expenditures, when the government’s debts are due, and the quality of assets that the government could sell off.

Lastly, the agency will look at the wider economic and political context. This includes the quality of financial regulators and levels of corruption and political stability. It also includes potential internal or external vulnerabilities, such as an economic slowdown in China or the possibility of a trade war.

All of these factors have an impact on the ability and willingness to repay debt, even if they are beyond the government’s control.

Similar considerations are applied to the credit ratings of banks and other large corporations. But the agency would also consider how likely it is that the government would bail out the company in a crisis. There is a perception[3], for example, that the government would bail out the big four banks.

Last year S&P put Australia on a “negative outlook[4]”, meaning the federal government’s AAA credit rating could be downgraded.

The immediate impact of a credit rating downgrade is that the interest rates paid by the federal government will go up. But research shows[5] that a federal government ratings downgrade has wide-ranging impacts.

The credit ratings of both banks and many corporations are tied to the federal government’s. This means a federal government downgrade will have impacts on many companies, investors and individual borrowers.

Share markets would be affected, but so would other borrowers, including foreign governments.

Further, the credit assessments of governments and banks are often intertwined[6], especially in times of financial crises.

Read more: Australia could be about to lose its AAA rating, and here's why[7]

The link between governments and banks can create a negative feedback loop. A downgrade for either banks or governments increases bank borrowing costs. This makes it more likely banks will need to be bailed out by the government in the near future. This puts more pressure on the government’s finances, which could lead to another government credit rating downgrade.

But a downgrade doesn’t affect only banks. Recent research[8] shows that when a government’s credit rating is downgraded, companies with similar credit ratings also see a ratings change, even if there is no fundamental change in their own creditworthiness.

Again, there is a negative feedback loop. A government credit rating downgrade leads to downgrades for corporations. The corporations, faced with increased borrowing costs, will respond by cutting back on new investments, which slows down the real economy. The slowdown in the economy will put more pressure on the government’s credit rating.

And on top of all that, when banks face higher borrowing costs, they either pass this on to households and investors in the form of higher lending rates and/or cut back on their lending[9].

This, of course, also has the effect of slowing down the economy, creating a double whammy.

So you can see that ratings agencies play an important role in the economy.

The Australian Securities and Investment Commission has made a number of recommendations[10] to improve governance within credit ratings agencies, to make them more informative and reliable. Adopting these will go a long way to further restore market confidence in the ratings agencies and improve investor protection.

References

  1. ^ highlighted (asic.gov.au)
  2. ^ Why we should be wary of ratings agencies (theconversation.com)
  3. ^ a perception (fsi.gov.au)
  4. ^ negative outlook (www.globalcreditportal.com)
  5. ^ research shows (isiarticles.com)
  6. ^ often intertwined (onlinelibrary.wiley.com)
  7. ^ Australia could be about to lose its AAA rating, and here's why (theconversation.com)
  8. ^ research (onlinelibrary.wiley.com)
  9. ^ lending (academic.oup.com)
  10. ^ recommendations (asic.gov.au)

Authors: Eliza Wu, Associate Professor in Finance, University of Sydney

Read more http://theconversation.com/explainer-what-are-credit-ratings-and-why-do-they-matter-79336

Business Today

Utilising communication tech to alleviate employee burn out

Hybrid work solidified into the business model in 2021 – plain and simple. Jabra research revealed 42 per cent of employees last year requested leadership to help make their virtual workspace more comfortable. Employees are ...

Space Machines readies for liftoff securing launch services deal with SpaceX

SpaceX to carry Space Machines' Optimus Orbital Transfer Vehicle as part of its April 2023 mission. Optimus is one of the largest spacecraft built in Australia and furthers Australia’s sovereign capabilities toward in-space...

Deliver business benefits through operational excellence

As Australian businesses emerge from the pandemic lockdowns and draw up plans for growth, increasing numbers are adopting a strategy of operational excellence. Operational excellence involves everyone in an organisation and f...

Modern slavery conference to take on the criminal enterprises and address global injustices

Influential experts from around the world will take part in a unique international online summit targeting modern slavery being hosted by Australian charity Freedom for Humanity later this month. Modern slavery is a process...

Unit4 Appoints Tania Garrett as Chief People Officer

 Unit4, a leader in enterprise cloud applications for people-centric organisations, today announced the appointment of Tania Garrett as Chief People Officer. Tania will oversee the company’s people success function wh...

FIVE reasons why you should set up an instant office instead of a fixed lease

Australia is now on the cusp of very volatile economic period. As the world tries to pick up the pieces after two years of global lockdowns and constant setbacks, we continue to face the aftermath of COVID on many levels. Acc...

Business Daily Media Business Development

Utilising communication tech to alleviate employee burn out

Hybrid work solidified into the business model in 2021 – plain and simple. Jabra research revealed 42 per cent of employees last year requested leadership to help make their virtual wo...

David Piggott, Managing Director ANZ at Jabra - avatar David Piggott, Managing Director ANZ at Jabra

Space Machines readies for liftoff securing launch services deal with SpaceX

SpaceX to carry Space Machines' Optimus Orbital Transfer Vehicle as part of its April 2023 mission. Optimus is one of the largest spacecraft built in Australia and furthers Australia’...

Business Daily Media - avatar Business Daily Media

India's employee hostels are often like prisons – but young women garment workers don't always see it that way

Kavitha, 18, earns a living at a clothing factory in the southern Indian state of Tamil Nadu. Like many of her colleagues, she lives in accommodation provided by the factory, where she share...

Andrew Crane, Professor of Business and Society, University of Bath - avatar Andrew Crane, Professor of Business and Society, University of Bath

Shortage of workers threatens UK recovery – here’s why and what to do about it

For the first time since records began, there are more job vacancies in the UK than unemployed people, according to the latest monthly labour market figures. This has been driven mainly by a...

Donald Houston, Professor of Economic Geography, University of Portsmouth - avatar Donald Houston, Professor of Economic Geography, University of Portsmouth

A central bank digital euro could save the eurozone – here's how

Blockchain bailout?4K_HeavenThe European Central Bank and its counterparts in the UK, US, China and India are exploring a new form of state-backed money built on similar online ledger techno...

Guido Cozzi, Professor of Macroeconomics, University of St.Gallen - avatar Guido Cozzi, Professor of Macroeconomics, University of St.Gallen

Deliver business benefits through operational excellence

As Australian businesses emerge from the pandemic lockdowns and draw up plans for growth, increasing numbers are adopting a strategy of operational excellence. Operational excellence in...

Chris Ellis, Director Pre-Sales at Nintex - avatar Chris Ellis, Director Pre-Sales at Nintex



NewsServices.com

Content & Technology Connecting Global Audiences

More Information - Less Opinion