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Credit rating agencies originated in the US market. While bond markets and capital markets had existed in the UK, the US and other parts of the world for over three centuries, and some markets were global for more than two centuries (Sylla, 2002), the emergence of formal credit rating agencies dates back over a century. The key feature of these credit rating agencies, i.e., the appraisal of creditworthiness is, however, not a modern concept. This is, and was, routine in all lending and borrowing activities for a long time, specifically in banks for their loan business (Sinclair, 2005). Other small institutions also provided

financial information regarding firms. However, in the early 20th century, due to the

expansion of financial activities in the US and globally, apart from investors, financial regulators were also demanding wider disclosure in terms of firms’ financial standings. Moody’s, recognising the need, formed the first formal rating agency in 1909 (Sinclair, 2005). Following Moody’s, Standard Statistics Company and Fitch Publishing Company also emerged in this period.

Since their inception, credit rating agencies gradually became an important intermediary specialising in the provision of reliable appraisals of the creditworthiness of the firms and countries. Due to the desired attributes and general acceptability of credit rating agencies within the financial markets, they soon gained recognition from regulatory bodies. For example, in the 1930s, for the first time, the US Treasury Department and US Federal Reserve prohibited banks to hold securities below a certain quality threshold (Langohr and

Langohr, 2008). Banks were forced solely to use the judgment of the ‘recognised rating

manuals’ (White, 2010, p.213) which essentially represented the formal rating agencies. Regulatory dependence continued in the US market and important criterions were established based on the credit ratings supplied by the external agencies. Such dependencies continued to enhance the overall impression of the importance of the rating agencies among the market participants.

Until the 1940s, rating agencies experienced a rapid growth in the US. The period from the

1940s to the 1960s however, was characterized by slow growth5 but they re-emerged in the

mid 1970s and experienced exploding growth up until the present day. In 1975, for example, Partnoy (2002) states that only 600 new bond issues were rated. The Standard and

5 _{This may be attributable to stable economic conditions in the US market. In this phase, the US market was}

21 Poor’s agency had fewer than 50 professional employees. However, by the year 2000, Standard and Poor’s and Moody’s rated 20,000 public and private issuers in the US market

with $5 trillion worth of rated debt outstanding. By 2011, statistics from Standard and

Poor’s show that there are approximately 4,300 people employed worldwide by Standard and Poor’s, dealing with US$32 trillion of rated debt and approximately 870,000 ratings

(Standard and Poor’s, 2011) in more than 100 countries.6 The compound annual growth rate

of Moody’s and Standard and Poor’s revenues during 2002 to 2007 was also high at 17% and 14.5% respectively, indicating tremendous growth over the years.

Though the early period from 1900 to 1930 saw the development of rating agencies in the US market, the period from 1970 to 2009 showed significant expansion of the credit rating

agencies around the world. According to Caouette et al. (2008), in 1920, the proportion of

international firms among the total rated firms by Moody’s was 6% which has risen to approximately 50% by 2006, with revenues earned from international operations increased to 49% of the total revenues of Moody’s. Studies generally cite four main reasons for the successful expansion of rating agencies, within the US and globally. Apart from the successful track record of the credit rating agencies (Basel Committee on Banking Supervision, 2000), financial globalization (Langohr and Langohr, 2008) and the switching to an issuer-paying model by rating agencies (Packer and Cantor, 1994), the most argued reason is the widespread use of credit ratings in legislation and the endorsement of the US regulatory bodies (Partnoy, 1999, 2002). The rating agencies capitalising on the reputation earned in the US market also successfully penetrated other markets. Following the US, regulatory authorities around the world also outsourced several regulatory functions to the credit rating agencies, thus enhancing their scope, the dependence upon them, and the overall impression of credit rating agencies as a vital component of the financial system without any legal responsibility on the part of such intermediaries (Langohr and Langohr, 2008).

Although credit rating agencies have largely been successful in the past, they have always been criticised for the value addition of the information they provide (Partnoy, 2001; Cantor, 2004; Amato and Furfine, 2004; Altman and Rijken, 2004), for errors of judgment (Covitz and Harrison, 2003; Haan and Amtenbrink, 2011) and for a perceived lack of

6 _{As comparable statistics are not available from any reliable source, it is believed that Moody’s will have}

similar statistics due to their equal market share. White (2010) confirms that Moody’s and S&P have a 40% market share each while Fitch has a 15% share of the market.

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objectivity and independence (Mathis et al., 2009; Partony, 2006; Frost, 2007). Specifically

following the default of Enron in 2001 followed by the Worldcom collapse and the recent financial crisis of 2008, rating agencies have again been in the spotlight. They are blamed as major culprits of the current crisis, which has resulted in a new argument from the regulatory bodies, investors and academic community concerning the credibility of the rating agencies themselves in terms of their independence, transparency and accuracy.

Notwithstanding the fact that criticisms of credit rating agencies may seem valid, the intermediary role they have played in the financial markets over the years should not be disregarded. This is evident from recent developments regarding the role of rating agencies and measures taken by regulatory authorities to improve their functioning. Following the recent crises, the regulatory bodies in the US, the EU and the rest of the world are still attempting to improve the functionality of rating agencies rather than condemning them altogether. For example, the Basel III accord up until now allows the use of credit ratings from external rating agencies (see for example Bank of International Settlements, 2010; Standard and Poor’s, 2010b, for more details). The European Commission also acknowledges the role of rating agencies in the financial markets and has recently focused on measures to improve the functioning of rating agencies in terms of their competition, transparency and vigilance. Brooks (2011) also argues that rating agencies, following the financial crisis, are still dominant in financial markets and are as important as they were three years ago.

The widespread recognition which these rating agencies have gained over time signifies the importance of these institutions in shaping the knowledge structure of the participants and community as a whole, whether they are investors, policy makers or issuing firms. It is not because credit ratings are necessarily accurate but for the reason that they are believed to come from an authoritative source of judgement (Sinclair, 2005). The opinion of credit rating agencies are respected by market participants and their actions correspond to such beliefs. Thus, it can be argued that market and debt-issuing firms have a strong incentive to consider credit ratings in their decision-making processes.