Financial Notation

The financial notation of the credit rating agencies

The notations go from AAA (triple A) (the highest quality of credit) to D (noted or imminent Non-payment).

The table hereafter details the grids of long-term and short-term notations that the three principal credit rating agencies give.

The short-term notation judges of capacity of the debtor to fill his engagements at one year at the maximum. The long-term notation estimates the capacity of the debtor to fulfill his obligations at more than one year.

As it is seen, the long-term notation is more detailed than the short-term notation. For example, companies having received a notation long run Fitch of " AAA" with " AA-" will receive the same notation " short term; F1+". It is conceived indeed even intuitively that two companies which have in the long run a risk of defect slightly different (more important for the company " AA-" that for the company " AAA") will have, in the short run , an almost identical risk.

Process of notation

Criteria

The criteria on which the agencies are based, even if each one have its own methods, depend on the mission which is entrusted:

undertaken: countable criteria, of management, examination of the risks, economic outlooks,…
state: economic situation, stability, monetary policy and budgetary,…
operation: modeling of the operation and its financial flows allowing an evaluation of the risk of defect and possible loss.

Methodology

In practice, the elected agency has access to the whole of the documents and the persons in charge of its customer. The initial process will last several weeks of contacts and analyzes intensives, at the end which the agency gives a notation to its customer.

This stage, the dissatisfied customer can simply refuse this one, in which case the note will not be published (and the contract with the agency probably broken… after payment of the agreed commission).

If the contract with the agency is maintained (and the notation made public in theory), the agency can re-examine the notation constantly, that it is following the occurence of a particular event (economic evolution, loss of sudden customers,…) or following one of the regular visits at the customer (in general at least once per annum).

The revision can lead to a change in the notation (increase or lowers notation) or to the setting under monitoring. A setting under monitoring is with positive or negative implication and opens one period limited in time during which the agency finalizes its position (generally not more than one month). The agency is completely free in this process. The customer does not have the least possibility of preventing the agency from publishing, without same informing some, a revision of the note. Thus, in 1995, the Canadian government learned, at the same time as the market, than Moody' S placed the note of the country under negative monitoring.

It is not rare to find in the professional press of the echoes of customers nonsatisfied with the financial notation which is given to them, or with the evolution of this one, which is, to some extent, a pledge of the independence of those.

Provision of information

The notations are public and can be consulted on a multitude of sources such as Bloomberg or Fininfo or Internet sites of the agencies.

The credit rating agencies generally place at the disposal, realizing payment, of the complementary tools such as:

statistical analyzes by sector,
tools for collection of the notations by wallet,
study of particular problems holding with the financing of the companies,
reports/ratios detailed by company,
analyzes historical (defects of the companies, stamps migration of the notations,…)
…

Some applicable categories in financial notation

Financial notation - Score of credit

Strictly to speak, the financial notation as described here is a concept which concerns the finance of market and thus the actors of the financial markets: companies, states, etc

There exists however an equivalent in 2 fields:

the field of the companies not - dimensioned PME/TPE (it is the Scoring of credit - within the framework of the risk of counterpart to the difference of the financial notation, the scoring is an automatic notation realized on the basis of information financial and legal.)
of the private individuals, whom one will rather designate under the term of score of credit and which is a coarse measurement of the Capacité of refunding.

So in Europe, this type of score is established by each bank according to its own credit policy and of evaluation of the risks, there exist countries, of which the United States, where there exists of the credit rating agencies specific to this type of risk. The criteria used are, in this case, the existing incomes, appropriations and the history of credit

Notation of debtor - Notation of operations

The financial notation of a debtor is interested in the general capacity of this debtor to fill his engagements.

Such a notation however gives information only on the “current” situation of the debtor, this is why one can also note an individual operation.

An individual operation (such as a loan or a issue of bonds) for example will be noted:

at the time of the conclusion of a new loan (a new loan changes the bilantielle structure of the borrower and, consequently, can affect its capacity of refunding),
when the operation presents a characteristic which makes that its chances of refunding are improved or less good:

the loan is guaranteed for example by a Gage, a Hypothèque or another form of Garantie or Sûreté (reduction of the loss on defect),
the loan is a structured operation (reduction of the probability of defect and loss on defect),
the loan is a subordinate operation (increase in the probability of defect and loss on defect).

Notation - Notation in foreign currency

The notation without another precision measures the capacity of refunding in general, while the notation in currency measures the capacity of refunding in foreign currency.

This distinction is not necessarily always made, but will appear indirectly for example because of notation of a loan in currencies.

Thus, the notation of a loan in US dollars of a European company will depend on the access of this company to a source of US dollars.

The notation in currency is particularly often present when it is about the notation of a state. In this case, the difference in notation reflects the fact that a state will tend to privilege the refunding of the debts expressed in national currency, which implies in theory a lower notation for the loans in foreign currency.

Sovereign notation - ceiling and concept of " risk pays"

The States (and other communities), just like the companies, can be noted financially, whether it is of developed countries or the third world.

In addition to the characteristics which implies the analysis of the solvency of the State itself (in particular impact of the tax capacity on its capacity of refunding) and its consequences (definition of the ceiling of debt acceptable for the sovereign Dette), the sovereign notation can also influence the notation of the local companies and their limits of debt. The credit rating agencies can consider that a company working mainly in a country would not know, whatever its financial solidity, exceed limits related to the monetary policy, tax and budgetary of the country. The companies of Credit insurance use these notations to evaluate the " risk country " concerning the operations of export in particular.

Impact of the financial notations

Allowance for risk

The financial notation of an actor of the market is an important component in the decision making of investment.

Without being able to replace completely, at least in theory, the personal analysis by the investor, the financial notation of a company is an essential component of the decision making of investment.

At the top of the pyramid, one will find notation AAA, generally reserved in some states. One is there in the field of the investment (virtually) without risk.

An investor will thus agree to invest in a borrower with lower notation only with the help of the payment of a Interest rate including a supposed Allowance for risk to cover the risk of loss.

The scales of financial notation consequently became of the obliged references of the financial markets, with establishment of a scale of allowances for risk.

This scale of allowance for risk is not:

nor fixed: and one will assist according to the economic circumstances is with a widening or a contracting of the allowances for risk,
nor single: if a sector of industry is perceived by the market like riskier, the such telephone sector, the premium for a borrower of this sector will be higher;

However, it will be noted that the scale will always comply with this elementary rule: the lower the financial notation is, the more the premium will be high.

Globalisation

In a total economy in which the capital working freely, the credit rating agencies financial are an important component of development. Without a financial notation in which the investor can make confidence, it is partially illusory to promote freedom of movement of the capital, an implying himself investor only when it includes/understands, or believes to include/understand, the risks with which it is confronted.

It is thus not a chance if the financial notation became more common in Europe since the advent of the Euro and the creation of a financial market in Euro which exceeds the borders of the Member States of the Euro area.

Risk management

Who says total economy said total risk. The regulators of market have thus been confronted for two decades with the problems of the risk management des by the actors of market and of the stability of the financial system.

It is noted that the credit rating agencies became so impossible to circumvent that regulators impose their use to the actors of market.

The example more striking is the current evolution of the international banking regulation.

Thus, the agreement says “Basle II” bench under the aegis of the Committee on the banking supervision of the Bank for International Settlements (BIS), which will be transcribed in the form of a directive imposing itself on the banks of the whole of the European Union, made financial notation of the risks by an agency independent an essential instrument of the management of the credit risk by the banks.

Criticisms

Negative impact on the economy

The financial notations became a so essential element of the market financial that the advertisement by an agency of the fall of a notation has an immediate impact on the cost of financing of the company (or of the state).

Some speak then about a vicious circle: the increase in the credit which can make even more difficult the resolution of the problems of the company, and by creating the new ones.

This criticism could become increasingly acute with time: the implementation of the new European regulation on the banking risk management, according to the reform of Basle II, will increase probably the differential of allowance for risk according to the notation.

Though it does not seem not completely stripped of any base when certain particular cases are examined, it however should be considered that this criticism loses sight of the fact the central objective of an credit rating agency, namely the dissemination of objective financial information which, while making it possible to the investors to measure their risk facilitates the circulation of capital. Therefore, the independent existence of the credit rating agencies is a positive factor for the economy in general.

In addition, to reproach the agency for publishing the note which she believes exact seems to amount reproaching the thermometer for posting the temperature of the patient.

See too

Internal bonds

External bonds

(A) - Bank for International Settlement - Basel Committee
Article of Washington Post on the influence of the credit rating agencies

Key actors of the market

FitchRatings
Moody' S
& Poor' S

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