A User's Guide to Credit Ratings

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This article explains how credit ratings can be used by individual investors to make informed investment decisions, and the benefits of credit ratings to the financial system. A credit rating is an independent assessment of the financial capability and willingness of an entity to meet its financial obligations as they fall due (i.e., its creditworthiness). The obligation to disclose credit ratings has been a feature of New Zealand's prudential supervision of registered banks since 1996. It became mandatory for all banks to have a credit rating from an approved rating agency in 2002. Similar obligations have been introduced for most non-bank deposit takers, and Cabinet has recently decided to require all insurers (not just disaster and property insurers) to obtain credit ratings in the future. Credit ratings play a useful role in encouraging sound management of financial institutions and in supporting market participants' ability to make informed choices about credit risk. Notwithstanding these benefits, and the usefulness to investors of credit ratings as a simple measure of credit risk, investors need also to be aware of the limitations of ratings. We highlight some of the key issues that investors should consider when using ratings as a tool in their decision making.

1 Introduction

This article explains how credit ratings can be used by individual investors to make informed investment decisions, and the benefits of credit ratings in improving the soundness and efficiency of the financial system. Since 1996, the Reserve Bank has required every registered bank with a rating from an approved credit rating agency to disclose the rating in its quarterly disclosure statement. In 2002, the Bank made it mandatory for every registered bank in New Zealand to obtain a credit rating from an approved rating agency.

The obligation to obtain a credit rating from an approved agency has recently been extended to non-bank deposit takers (e.g., finance companies and building societies), with effect from 1 March 2010. (1) Cabinet has also decided to introduce credit ratings as a key component of the prudential regulation of insurers that is currently being developed. (2)

Section 2 of this paper discusses what credit ratings are. In section 3, we outline some of the key issues that investors should consider when using ratings as a tool in their decision making. In section 4, we explain the benefits that credit ratings can provide to the financial system more generally. Section 5 concludes.

2 What are credit ratings?

Credit ratings produced by the major credit rating agencies aim to indicate the relative creditworthiness of entities - i.e., their ability to meet their debt-servicing obligations.

A credit rating gives investors and analysts an estimated likelihood that the issuer will be able to meet its financial obligations on time and in full (e.g., to fully repay a loan). A poor credit rating indicates a higher risk of non-repayment (default). All other things being equal, a higher risk of default should lead an investor to demand a higher rate of return in recognition of the additional risk. Ultimately, the investor may refuse to provide funding if the investor views the default risk to be too high to bear.

Ratings agencies synthesise and simplify a wide variety of complex risk factors into a single measure that allows investors, customers and suppliers to assess relative creditworthiness or financial strength. Credit ratings take into account both quantitative and qualitative factors. Financial measures are a core component of any rating, but ratings will also consider a range of economic, industry and business fundamentals, including the quality of an institution's risk management and governance structures.

A rating represents the rating agency's independent opinion of an institution's or a product's creditworthiness. Different agencies employ different rating methodologies, but they all essentially seek to capture the likelihood of default over any given period. …