Rating agency: an essential tool for minimizing risks and international decision-making ____________________________________________________________________
momagri’s objectives are to create and implement world governance for agriculture to respond to the challenges that it is facing. To do this, momagri has first and foremost decided to compensate for the weakness of international agricultural models by creating the momagri model, which will be a real forecasting model dedicated to agriculture and the numerous areas it effects (poverty, innovation, environment, public health, food and supply security) and to provide all negotiators and international decision-makers with a simulation tool that will enable them to make decisions on a credible, realistic and fair basis.
However, world governance for agriculture also needs a framework within which international decisions can be formulated and guided. This “piloting instrument” must therefore be accompanied by an “instrument panel” to improve visibility in order to evaluate situations related to different countries and the effect of national and international decisions.
This is why momagri has decided to create an international rating agency for agriculture and the stakes that are linked to it. This agency, which will begin to function in 2008, will take its inspiration from the evaluation principles, methods and criteria of the different rating agencies in the financial, societal or high-risk country sectors.
Below we present the different agencies, their work and their impact, and in a few months time we will publish more information on the NAR Agency.
The concept of the rating agency originated at the end of the 19th century, when American railway companies tried to raise capital throughout the American territory. An independent organization advised investors on the solvency of companies situated thousands of miles away, and they began to give grades on the ability of companies to pay back contracted loans. Rating is justified because it is necessary to reduce the irregularity of information between those who borrow (whose interest it is to affirm the quality of their project) and those who lend or buy (who do not know the real performance of the organization that borrows or which is for sale). The Moody’s agency published the first ratings in the United States in 1909.
Then, this concept spread to the whole of the financial sector where, since the middle of the last century, major financial rating agencies have become irreplaceable references, whose power, although sometimes contested, is universally recognized, from the Sovereign States to private individuals. In the last ten years or so the rating agencies’ sector of activity has widened even further to include other major issues in world society by penetrating non-financial sectors, which are strategic and central to preoccupations associated with the future of the planet. Several rating agencies have thus been created, intervening in the environmental, ethical and sustainable development sectors.
And because there is a growing interconnection between markets in the world in which we live, the information supplied by these agencies plays a fundamental role, and its impact on economic, social and political decisions is increasing, whatever the sector or the players involved. A newly published fictional economic novel dates in fact the beginning of the collapse of a major country from the moment its grade falls from AAA to BB+.
Whatever the nature of the structures that are being evaluated, or the sector rated, the objective of the different rating agencies remains the same: to evaluate and grade companies, States and international organizations at regular intervals, using indicators and procedures, in order to allow certain players (international decision-makers, investors, companies…) to evaluate the relevance of implemented strategies and/or policies, with their own objectives as a yardstick. To do this, they supply information, giving grades and opinions, which must be transparent, credible, sustainable and responsible.
The rating process is complex because it is based on several indicators, divided into sub-indicators, which are graded and weighted using a mathematical rating model1 , to obtain a final grade. Although each agency has its own rating system (letters, numbers or both), they all use a graduated scale of risks onto which the different attributed grades are placed. A bad grade (for example D) means that certain rules laid down and universally recognized are not being respected. The associated risk profiles are high. On the other hand, a good grade (for example AAA) means that the strategy/policy implemented respects all the rules laid down and strives to improve the common good. The associated risk profiles are lower. Of course, between the two extremes, there is a variety of graduations, giving precise information about the associated index and the judgement of the rating agency on the quality of the rated structure.
Thus, by providing transparent, credible and responsible information, using universally recognized grades and advice, rating agencies can:
> evaluate the relevance of implemented strategies and policies.
> establish the precise mapping of effects.
> classify the different players in one sector.
> improve the functioning of human activities by supplying universally recognized standardized information.
> contribute to regulating international markets taking into account the factors observed.
But above all, by making the results of their investigations available to Institutions, professionals and the public, they guide international decision-making.
There are three major types of rating agencies: financial and credit rating agencies, environmental and social rating agencies, and country and sector risk rating agencies. These different categories of rating agencies all intervene in strategic, globalized, imperfect sectors, characterized by a variety of players, where information plays an important role. And each rating agency offers different types of rating, depending on the targeted objectives.
They also make declarative ratings for parties outside the organization concerned. It could for example be an investor, a company, an NGO, or even a country. The declarative rating is an evaluation that consists in establishing a sectoral benchmark for the different parties involved in a particular sector, in order to help them make choices in terms of investments, partnerships and so on.
They also offer solicited ratings, on request from inside the rated entity, for example from the company manager or the government. It is an ad hoc evaluation that consists in offering to managers, at their request, a detailed diagnosis of their structure (policy, processes, means and results) in a particular sector (for example social responsibility) using a criteria reference to enable them understand influential factors and maybe implement progress measures. This therefore is a type of audit carried out on site and is based on a specific area determined by the company. The audit can then be followed up by advice services.
Finally, they carry out non-solicited ratings, which means they evaluate and rate a structure on their own initiative, without inviting the rated entity to take part in the rating process.
However, although rating is their main activity, rating agencies use their experience and their multiple skills to offer their clients other services, such as audits and consulting, and investment products on financial markets.
I. Financial and credit rating agencies (Standard & Poor’s, Moody’s, Fitch ratings)
A. The objectives of financial and credit rating agencies
A financial and credit rating agency is an entity that publishes credit ratings to measure the credit risk2 of issuers: companies, States (sovereign ratings), or financial operations (loans, compulsory loans, structured finance operations…). In principle, rating agencies have two roles: to process information and to certify, the first role being of interest to the market, the second being required by law.
In the same way as a gastronomic guide recommends good restaurants to the most demanding gourmets, financial rating agencies supply information to investors on the default risk of an issuer and on his ability to honour his financial obligations. This practice is an advantage for anyone who signs contracts with a company (suppliers, clients, employees…), and is therefore concerned by this information. The rating agencies play a vital role on world markets, notably in the banking and securities sectors, particularly since the financial disintermediation movement3 that began in the 1980s.
Thus, for issuers, financial rating is an instrument that facilitates access to capital markets. For investors, it is a key criterion in the estimation of risk that an investment entails, particularly in financial markets, which are becoming increasingly globalized, which makes dealing with information and all risk factors more difficult. It also determines their investment policy. Thus 9 management companies representing 45% of the market claim that their asset allocation is determined almost entirely by rating agencies. For financial intermediaries, it is an essential element in the setting up of securitization operations and other complex structured financing. Finally, for regulators, it is a market securitization tool. In France, for example, the FCC4 (debt securitization funds) is subject to compulsory rating.
The financial rating sector is very concentrated and for almost a century, the three same specialists have dominated the sector:
> Standard & Poor’s, subsidiary of the Mc Graw & Hill group since 1966 (United States).
> Moody’s Investors Service, main subsidiary of Moody’s Corporation, an independent company since 2000 (United States).
> Fitch ratings, majority subsidiary of the Fimalac group (France).
In fact, a license from the SEC (Securities and Exchange Commission) is required to carry out this work. In 1975, to guarantee the integrity and the quality of rating agencies, the highest stock exchange authority issued a quality label. Standard & Poor’s, Moody’s and Fitch ratings were awarded it, but as Lawrence White, professor at New York University and one of the best analysists in the profession, reminds us, since then “only four new members have been admitted, which through mergers, have all been taken over by Fitch”.
B. Methodology of financial rating
Financial rating relates to the reimbursement prospects of commitments made by companies, credit establishments, finance companies, local authorities, public establishments, insurance companies and sovereign States to their creditors, in the short term as well as the long term. Short-term rating judges the ability of the debtor to fulfil his commitments within a year. Long-term rating estimates the ability of the debtor to fulfil his obligations in more than a year.
The criteria on which the agencies base their rating depend on the rated structure.
Thus, for companies, ratings are based on information concerning the income flow and the financial situation (particularly debts) of the rated structure. As this information gives an image of the situation at a certain period only, it is confirmed and revised periodically.
For States, grades are established by taking into account the economic situation, the stability of the political regime, the monetary and budgetary policy in particular. Apart from the particularities that an analysis of the solvency of the State and its consequences involves (the existence of a debt ceiling for sovereign debt), sovereign rating influences the rating of local companies and their debt limits.
Agencies in fact consider that a company that develops mainly in one country cannot exceed the limits linked to the monetary, fiscal and budgetary policy of that country.
For financial operations, grades are attributed by modelling the operation and the financial flows generated from it in order to have the most precise evaluation of the possible risk and losses.
Once grades have been given to each entity, financial rating agencies classify them according to categories corresponding to different degrees of default risk. To do this, they use broad-spectrum credit quality scales to reflect related risks, i.e. the probability of default.
C. The effects of financial rating
Financial ratings act as extremely powerful indicators for guiding decision-making. Grades can be classified into three categories, corresponding to three possible evolutions in the level of rating for a given player, depending on whether it is increased, maintained or decreased.
Generally, the higher the grade, the lower the cost of the borrowed capital. In the same way, decreasing the grade increases the credit cost.
|The grade and its predicted revision are then published on specialized pages in financial information agencies, continually diffused on stock market information networks, and in publications that are regularly issued by agencies and the financial press. |
The financial rating is a reliable indicator because, according to figures supplied by financial rating agencies over the last ten years, a company graded ‘A’ has defaulted 4 times out of 10,000, whereas a company graded ‘B’ has defaulted almost two times out of 100, which is 50 times more often.
Financial rating has direct and severe consequences on the market because, as well as revealing essential information to all the players and those involved in the company or the entity concerned, the totally independent and recognized judgement made by all rating agencies acts as a “guide” to investors.
Therefore the announcement by an agency of a decrease in an entity’s grade has an immediate impact on its financing cost. And this effect, which is already considerable, is increased by the fact that their rating process agencies are totally free to solicit or not the entity during the rating process. Comments from clients who are not satisfied with the financial rating they have been given are often found in specialized publications, which is proof of the agencies’ independence. The client therefore, in certain cases, cannot prevent an agency from publishing a revision of its grade. Thus, in 1995, the Canadian government learned at the same time as the market, that Moody’s was placing the country’s grade under negative surveillance, which immediately caused strong decline in the Canadian dollar compared to the American dollar.
In addition, from a regulatory point of view, the classification of an issue in the “Investment” category is of considerable importance, particularly in the United States and Japan, because many American financial institutions for example are only authorized to invest in securities that have this rating.
D. Other work and services proposed by financial rating agencies
Although rating is their main activity, many rating agencies use their experience in risk evaluation to propose other financial services to issuers, such as investment advice as well as sectoral statistical analyses, studies of particular problems concerning company financing, detailed reports for companies or historical analyses.
And, although their core work is financial rating, the major financial rating agencies have developed products associated with societal rating, which shows the growing interest for this type of rating.
Thus in 2002, Standard&Poor’s developed a rating product related to corporate governance that reflects the evaluation of corporate governance practices and policies, and the importance given to the financial interests of those concerned in the company with particular focus on shareholders’ interests.
In the same way Moody’s has become interested in corporate governance within the framework of its core credit rating activity.
Finally, Fitch ratings has directly contributed to the capital of CoreRatings, a societal analysis institute.
II. Environmental and societal rating agencies (Vigéo, Oekom, Triodos)
A. The foundations and objectives of societal rating agencies
It is now recognized that financial information alone is not sufficient to evaluate the performance and global relevance of a company’s strategy. Extra-financial factors are also important, and particularly how companies deal with environmental and societal risk.
More and more companies are adopting behaviour codes, publishing reports on their results in the social and environmental sector, employing managers who are specifically responsible for Corporate Social Responsibility (CSR), and joining company networks with a view to share their best practices in this field. Investors are also showing growing interest in CSR, as can be seen by the increase in SRI5 funds and socially responsible stock market indexes.
Although companies have carried out financial reporting for a considerable period of time, many factors have accelerated the spread of societal reporting6 one of these main factors being the increasing regulation in this field. Since 1st January 2003 in France, companies listed on the French Stock Market must publish in their annual report a certain amount of information on the “way in which they take into account the social and environmental consequences of their activities”7 .
It was to satisfy these needs that rating agencies in the societal sector were created. They determine, using different criteria (for example in the case of Vigéo: clients and suppliers, human rights, societal commitment, the environment, company governance or human resources), the level of corporate social responsibility with regard to sustainable development.
Their objective is thus to promote the social responsibility of the company as a measurable managerial exercise, structuring economic performance on the tangible valorization of the environmental and social interests of those associated with the company.
This sector is expanding rapidly and now includes about thirty players, the largest in Europe being: Oekom in Germany, Triodos in the Netherlands, and the Vigéo group in France.
B. The methodology of societal rating
Societal rating measures the degree to which a company takes into account social responsibility stakes when defining and implementing its strategy in its sector. It therefore measures the performance in terms of social responsibility relative to the sector to which the company belongs.
The analysis is carried out using an evaluation grid that varies according to the given objectives and the rating agencies. In general, the following sectors are examined: human resources policies, relations with clients, suppliers and sub-contractors, the environment, corporate governance and relations with civil society. Thus, in the case of Vigéo, rating is carried out using a generic reference consisting of 38 responsibility criteria, evaluating the behaviour of the company using 298 indicators.
Societal rating provides synthetic information concerning the situation of the company, according to a set of defined social criteria, destined mainly for company managers, asset managers and institutional investors:
> For company managers, environmental and societal rating enables them to reduce their environmental and social costs, to stimulate interest and confidence in clients and investors and to improve the quality of their products and processes.
> For asset managers, it enables them to measure company performance from an angle other than a financial one. For example Vigéo measures company performance in six areas: human resources, clients, suppliers and sub-contractors, societal commitment, environment, corporate governance, human rights.
> For institutional investors, it enables them to optimize the control and monitoring of a portfolio.
But societal rating is also used for other organizations such as foundations and NGOs, and all civil society.
In fact, some foundations and NGOs use the services of societal rating agencies to choose their partners or their sponsors to avoid the risk of being associated with companies that have conflicting practices. This is the case of EIRIS, an English agency, which offers a selection service for donors and sponsors. And to guide consumers in their choices, some organizations produce guides to inform them on companies’ practices and methods used to manufacture the products they consume. This type of guide publicly denounces companies with the least responsible practices.
C. The effects of societal rating
As with financial rating agencies, the publication of environmental and societal ratings has direct impact on the markets. As the grades attributed show the agencies’ opinion on the ability of companies to deal with the extra-financial challenges facing them, the effects of rating are numerous and can be assessed in many ways.
However, we can consider that there are three main effects of societal rating on a company or a country.
Societal rating has first and foremost a direct influence on skills migration and the attractivity of the company for its clients and partners. In fact, a good grade, or the revision of a grade, is a positive signal for the market showing that the company is noteworthy because of its strong assets, recognized by employees and others associated with the company such as clients, suppliers or sub-contractors. This could give the company a competitive advantage over its main competitors. Also, a good grade has positive and immediate consequences on the attractivity of a country or a region, especially because at the moment there is a dual wave of globalization and decentralization. Thus, a good environmental and social rating gives potential investors a positive assessment that could sway their decision to set up a company, which is an advantage for the region concerned.
Societal rating also gives a company the opportunity to differentiate its activity from its main competitors, particularly in terms of image. The market and the different parties associated with companies are now becoming more and more aware of respecting societal and environmental standards, such as the fight against child labour. We remember how Nike’s image was disgraced in the eyes of the public in the 1990s when it was shown that this multinational company employed children in its factories. A wave of unprecedented protest and boycott followed, and the financial health of the group was seriously affected.
Finally, societal rating can be a powerful tool for the institutional communication of a group or country. The increase in companies’ demands to be rated by societal and ethical agencies is proof of this.
Although the impact of societal rating on the image or the attractivity of an entity can be defined, it is however much more difficult to establish a formal link between the stock market performance of a company and its “societal performance”. In fact, the market can have two conflicting reactions following the announcement of an increase in a company’s grade in the environmental and societal sector. It can react positively, believing that respecting environmental and societal standards is a guarantee of the sustainability of the current strategy, which will give the company a certain competitive advantage in the medium term. Thus, efforts made by the company in the environmental and societal sector can lead to a rise in stock prices. On the other hand, the market can consider that allocating funds to satisfy societal objectives is detrimental to investors, which would guarantee for the company a competitive advantage in the short term compared with its competitors. The market would therefore react negatively and stock prices would fall.
D. Other work and services proposed by societal rating agencies
The activity of societal rating agencies is not limited to the rating of companies alone. Most agencies have extended their functions to several activities linked to rating to meet the needs of their clients and investors. These include research, investment consultancy and various investment products.
Societal analysis organizations draw up reports and studies on thematic and sectoral issues for their clients. And some organizations offer their clients advice on investment and investment products. Thus, Vigéo has created the ASPI Eurozone® index composed of 120 companies listed on the stock market in the euro zone with the best performances according to sustainable development criteria. It has been developed to become the European benchmark for companies and investors that wish to make a commitment to sustainable and socially responsible corporate development.
III. Country and sectoral risk rating agencies (Coface8 , Nord Sud export, Credit Risk International)
The globalization of economies increases commercial opportunities for companies, which are becoming more and more numerous in wanting efficient tools that are adapted to their needs in order to manage in real time, safely and more cheaply, the relations they develop with their clients and suppliers. The information and ratings issued by country and sectoral rating agencies are therefore requested by the market more frequently.
By definition, a country and sectoral risk rating agency measures the average level of the risk of non-payment in the short term by companies in a country or sector. Country risk rating indicates to what extent the financial commitment of a company is influenced by the economic, financial and political prospects of the country concerned. The sectoral risk rating indicates, for a given sector of activity, how the short-term prospects and the average financial situation of companies influence payment behaviour in short-term commercial transactions.
However at the moment, there is no country or sectoral risk rating agency to rate the agricultural, ag-food and environmental sectors.
B. Methodology of country and sectoral risk rating
International trade operators know that there are good companies in bad countries and bad companies in good countries, and therefore the global risk depends on both the specificities of the company and those of the country in which it operates. The country risk rating complements the rating that is usually carried out on companies, giving a better global appreciation of the risk of an operation.
For this, country risk rating agencies have dual expertise:
> Macroeconomic expertise in the appreciation of country risk using financial and political macroeconomic indicators.
> Microeconomic expertise through the monitoring of different company databases throughout the world.
In the case of the Coface, rating is carried out with indicators grouped into 7 families, each one allocating an individual grade: the vulnerability of the situation, the risk of currency liquidity, external debts, the financial vulnerability of the State, the fragility of the banking sector, the fragility of the political environment and company governance and payment behaviour.
This synthetic rating is given to each of the 166 countries monitored. The grades are classified into 7 levels, in a similar way to financial rating agencies:
| C. The effects of rating |
The grades attributed show the opinion of country and sectoral risk rating agencies on the probability of default by companies in a country or a sector. Just like financial and societal rating agencies, the effects of grades issued differ according to whether these grades are increased, maintained or decreased.
In general, the effects of rating are as follows:
| D. Other work and services proposed |
As well as country and sectoral rating, country rating agencies offer other services. Coface’s objective for example is to facilitate exchanges between companies throughout the world. To do this, it offers all companies seven services to manage, finance and protect their accounts receivable, that is all of the 30, 60 (and sometimes more) day credits that they grant to other companies with which they trade.
> Credit-insurance: To protect domestic or export transactions against the risk of non-payment, Coface offers adapted, global or tailor-made solutions (insurance for short, medium or long-term commercial and/or political risks).
> Marketing information: Coface offers services for optimizing customer capital and conquering new customers by targeting prospects with strong potential.
> Company information: Coface has a database of 8.2 million registered establishments updated 15,000 times daily.
> Debt management: To decrease outstanding debts and payment delays in particular, Coface offers to manage the whole of a company’s operating cycle: search for new clients, credit risk management, compensation for outstanding debts, invoice management and debt collection by amicable or if necessary legal means.
> Financing and factoring: Coface offers tools to companies to finance their development, particularly in periods of growth or for seasonal requirements, and enables them to finance their export and DomTom (French overseas territories) receivables.
> Other guarantees and services: Coface offers guarantees and services to cover companies for foreign exchange risk, insure political risks linked to investments up to 15 million euros and insure the transport of their products.
> Public procedures: Since 1946, Coface has managed on behalf of the Government a wide range of guarantees to encourage and back French exports. It insures risks that are noninsurable by the private market for companies that prospect on the export market and sell products and services that come mainly from France. Coface also manages agreements made within the framework of the Club de Paris to consolidate public debts contracted by debtor countries.
Rating agencies have become essential to assist decision-making and minimize risks, while offering universally recognized and quasi-institutional points of reference. To do this, they comply with deontological rules, which are becoming increasingly strict, making it difficult for their judgement and impartiality to be called into question.
These rules stipulate that their analysts must not divulge or use for purposes other than rating non-public information they receive from clients, and that they must declare their portfolio regularly.
In the same way, they forbid analysts and their families to prevent or make transactions on the portfolios issued by companies in their sector of analysis, to receive clients or give gifts other than symbolic ones, and to have an activity outside their work that could create a conflict of interest.
Agencies have therefore implemented various legal procedures to protect themselves against any conflict of interest such as:
> The absence of a link with the rated entities, or between agencies and any financial establishment carrying out transactions on company securities or acting as advisor or merchant banker for the entities or candidates to be rated.
> The impartiality of analysists when awarding the grade in order to avoid any insider trading that could harm the credibility of the agency.
> The exemption from notice when an employee resigns, in order to preserve the confidentiality of the work and the preparatory rating documents.
Although rating agencies have been created in the financial, environmental and societal, ethical and state sectors, there are no agencies responsible for evaluating the relevance of governmental policies and strategies implemented in the agricultural and ag-food sectors.
And this is even more unusual because like the financial and societal sectors, these sectors not only have the characteristics that justify the creation of a rating agency, but they also have parallel effects on well-being, preservation of the environment, public health, security of supplies…
This is why, to remedy the lack of an agency such as this in the agricultural sector, taking into account all the effects it would have: security of supplies and strategic independence, protection of the environment, development, innovation…, momagri has decided to create the NAR agency, which will lead to the improvement of choices on a national and international level, where today, disinformation and strategic errors of appreciation are all too frequent.
1 A mathematical rating model is a mathematical tool, which, using representative indicators, defines the mapping of effects (risks, advantages, constraints, impact) associated with a player (company, State, international organization, NGO…), and conveys the global level of effects by a grade (generally a letter of the alphabet).
2 Credit risk is the risk of loss due to a debtor’s non-payment of interests and/or principal of a debt.
3 Financial disintermediation is the replacing of bank financing by market financing. The role of rating agencies became more important because they reduced the cost of investor information.
4 The FCC is a mutual debt fund whose sole purpose is the acquisition of receivables and the issuance of units representative of these receivables.
5 SRI (Socially Responsible Investment) refers to all financial investment made, according to arbitration based not only on the financial performance of the securities concerned, but also on social criteria, such as company behaviour in relation to its economic and social environment.
6 Societal reporting is the distribution of social and environmental information produced by companies for those concerned, simultaneously or independently of the financial community.
7 This obligation was introduced by the article 116 of the law of 15th May 2001 called the NER law.
8 French Insurance Company for Foreign Trade