Standard & Poor's today released research on the role of credit ratings in the financial system.

The report stated that despite how common credit ratings are in the financial markets, they are often misunderstood.

The confusion regarding what credit ratings are, and the role they play in the financial system, has "sometimes led to their misuse and prevented them from fulfilling their true role," S&P analysts wrote.

Their key role is to help close the information gap between lenders and borrowers by offering independent opinions of creditworthiness.

Through the report, analysts tried to lessen the misunderstanding by addressing these issues both in terms of practical and theoretical applications.

"The real role of credit ratings in the financial system is to improve the functioning of markets by reducing information asymmetry between issuers and borrowers who need funding and the investors and lenders who can provide it," analysts wrote in their conclusion. 

Thus, they said that credit ratings can help make markets become more efficient by placing all lenders and investors on a more equal footing. This lessens the variations in returns that can come from differences in the ability to make sound credit judgments.

Analysts also said that ratings are a type of information in the form of independent opinions regarding the creditworthiness of issuers and securities.

They acually fulfill their role by adding to the mix of data that buyers and lenders can utilize in analyzing and trading securities, S&P analysts said. Rating agencies also sometimes differ in their assessments of a given issuer or security. This is either because in their analysis, they calibrate their rating scales  differently or ascribe greater or lesser weight to various factors in their analyses.

According to S&P analysts, this is a natural result of the inherently complex nature of credit analysis by saying that  "it is not a simple task with a single valid approach." Additionally, seasoned professionals examining the same facts might reasonably come to different conclusions.

Thus, S&P analysts said that the biggest reductions in data asymmetry result from the presence of multiple ratings on a given issuer or security. This is aside from other sources of information and independent analysis.

S&P analysts also looked at the isuses plaguing ratings such as "rating shopping" by issuers, the regulatory use of ratings, and the use of ratings as a substitute for a buyer's own analysis. These have all contributed to distortions of a credit rating's true role, analysts stated.

In extreme instances, those activities can result in ratings increasing instead of reducing information asymmetry.

When these misuses are widespread, analysts said that the market might not realize the full value that credit ratings can provide.

They concluded that unsolicited ratings are the credit rating industry's main response to rating shopping. Additionally, Rule 17g-5 indicates growing regulatory support for unsolicited ratings, at least in the U.S.

The hope is that a greater understanding of what credit ratings really are and what they aim to do can benefit all market players and create a stronger, more efficient financial system, analysts stated.

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