A user’s guide to credit ratings

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.