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FinTech in Credit Rating Agencies: Evolutionary or Revolutionary?

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Along with the continuous developments of technological innovations, technological integration has become essential in almost every sector, but even more so for financial institutions. In today's world, FinTech has become a very important technology because it has not only had an effect on financial institutions' operations, but also on individuals' daily lives. Moreover, FinTech drives and encourages financial institutions to change and differentiate the way they provide their services.

CREDIT RATING AGENCIES

The Rise of CRAs

As a result of this need, in 1841 the Mercantile Agency was established to provide reports on business creditworthiness, followed by another agency called the Bradstreet Agency in 1849 (Madison, 1974). The American Railroad Journal, established in 1832, was one of the first specialized publications. However, at some point these institutions became insufficient to certify the creditworthiness and quality of borrowers due to the rapid growth of issues and issuers (Sylla, 2002).

Credit Rating Agencies and Their Ratings

Each credit rating agency uses its own methods to assess the credibility of an issuer and publishes its opinion through a specific rating measure. This thesis will generally focus on the three largest global credit rating agencies, S&P, Moody's and Fitch, as they dominated the industry. The credit rating market is highly concentrated market due to the economies of scale in the market, as the high cost of collecting related data and its analysis results in a potential barrier to market competition (Host, Cvečić, & Zaninović, 2012).

Introduction of the Biggest Rating Agencies – The Big Three

  • MOODY'S CORPORATION (MOODY'S)
  • STANDARDS & POOR’S GLOBAL RATING (S&P)
  • FITCH RATINGS INC. (FITCH)

According to a report published by the European Securities and Markets Authority (ESMA) in December 2020, Moody's has a 33.12% market share in EU-registered rating agencies in terms of annual revenue generated from rating activities. The company issued its first credit rating under the name Poor's Publishing Company, after Moody's, in 1916. According to a report by ESMA, Fitch has a market share of 17.55% at the end of 2020 and continued operations in third place. largest credit rating agency.

Traditional Rating Methodology of CRAs

  • Business Risk Profile
  • Financial Risk Profile
  • Supplementary Rating Drivers
  • The Final Rating

When a rating agency conducts in-depth analysis, one of the most important analyzes is to examine the company's environment: the business risk profile. It is critical to accurately analyze the company's business risk because understanding risk can be seen as a prerequisite for evaluating financial risk. The final step of the credit rating process is the outcome of a company's credit risk, namely the rating that represents the company's credit quality and solvency (Langohr &. Langohr, 2008).

The Main Historical Events that Shape Today’s CRAs

However, the 1970s finally began with the bankruptcy of the Penn Central Transportation Company, which was not only the largest railroad company, but also the 6th largest in the United States. It was an important event for the time, causing a shocking effect on the commercial paper market (Goldman Sachs, n.d.). Furthermore, it was the largest financial failure in US history until the Enron Scandal in 2001 (Duggan, 2018).

The Effects of Credit Rating Agencies

On the other hand, the effect of rating agencies on investors is also an influential tool to minimize the risk of their investments (Solovjova, 2016). There are many researchers investigating the effect of rating agencies' opinions and their ratings on countries, their creditworthiness, their macroeconomic and indirectly microeconomic balances. However, despite the much research on the impact of CRAs on countries and the country's financial market players (investors, lenders, issuers and companies), there is also another involved party that is not as researched but should not be neglected: individuals and households.

FINANCIAL TECHNOLOGIES (FINTECH)

The Rise of Fintech and its Definition

Fintech and its dimensions

The second dimension consists of the digital finance technologies and technology concepts that cover the technologies and their concepts that enable functions from the first dimensions. Finally, the third dimension is digital financial institutions, representing both FinTech companies and the traditional financial institutions. Two of them are a function of Fintech, because not only Fintech companies drive the change in digital finance, but also traditional financial institutions provide new Fintech services that adopt new technologies (Gomber, Peter; Koch, Jascha-Alexander; Siering , Michael;, 2017).

Fintech Applications

BCBS places market support services in different categories because the technologies and innovations used in this segment are not directly related to the financial sector, but play an important role in the development of fintech (Basel Committee on Banking Supervision, 2018). Since fintech has wide applications, this thesis will be focused on only fintech technologies and its products related to the credit rating agencies. Therefore, in the next part, the technologies used in credit rating evaluation will be explained.

The Main Technologies in Credit Rating Evaluation

  • Big Data Analytics
  • Artificial Intelligence
  • Game Theory

The important function of random forest is the algorithm used to predict missing data in dataset. Therefore, its application will be explained from the methodology used in Modefinance which is a credit rating agency. In this part, the main technologies used in credit rating determination, credit scoring have been explained.

Fintech Credit Rating Agencies: modeFinance

  • Company Introduction and Its Ratings
  • The Rating Methodology of modeFinance

First, there is the evaluation of modeFinance's MORE model (Multi Objective Rating Evaluation) and second, there is the evaluation of the company's analyst. The MORE model uses this collected data and provides advice on the creditworthiness of companies by producing a risk class (MORE class). This chart was created by comparing the company's financial ratio from the annual accounts with the average values ​​from the industry average values.

The dashed line in Figure 1 represents the company's score for each ratio, while the bars show shifts that may cause score change. If the bars are red, these ratio scores are lower than the company's overall score; if it's green, it's the other way around. For example, according to Figure 2, financial leverage ratio has the highest contribution compared to the total score, and its ratio is lower than the company's total score.

Source: This graph is taken from [Sensitivity analysis: how to assess the financial stability of the company], by modeFinance, 2018. This is because the ratio of company Y is worse compared to companies in its country, country Y (Bureau Van Dijk, 2017). The main country of the assessed company, its commercial description and its sectoral activities should be clear.

The analyst must investigate these characteristics that may cause a potential change in the company's final valuation.

The Effects of Fintech

METHODOLOGY

Main Philosophy of The Research

  • Positivism and Interpretivism
  • Assumptions of paradigms

Furthermore, he suggested that interpretivism perspective is suitable for the research on marketing, organizational behavior and management (Saunders, Lewis, & Thornhill, 2009). Therefore, interpretivism perspective is closer to the paradigm of this thesis's research, since the aim is to gain a deeper understanding of the effect of Fintech on CRAs, but also the assumptions under positivism will also be applied. This thesis is subject to the social reality of ontological assumptions as this study depends on the knowledge of the survey participants and interviewers.

Under the positivist axiological approach the research is carried out value-free and researcher is independent of the data and remains objective while under interpretivism researcher is part of the type of research being carried out and researcher cannot be separated and will therefore have a subjective point of view (Saunders , Lewis, & Thornhill, 2009). Axiological assumption under interpretivism is more appropriate for this thesis, since the hypothesis, the question of survey and interview are structured by me as author of this thesis with assumption about the subject and this research. The fourth is the rhetorical assumption represents the language used in the research (Saunders, Lewis, & Thornhill, 2009).

The rhetorical assumption, which is complementary to the first three assumptions, but can also be written which is acceptable to the supervisor or examiners (Collis & Hussey, 2014). Finally, the fifth assumption is methodological which is related to the process of the research (Collis & Hussey, 2014). It represents the techniques of the data analysis and study that inform the researcher's choice of the method (Rehman & Alharthi, 2016).

Part 3.2 will explain in detail the research carried out in this thesis, its process and data collection.

A General View of The Research

The third assumption concerns axiological assumptions, which represent the philosophical approach to making decisions about the value or right decision regarding the research (Kivunja & Kuyini, 2017). Positivist study mainly uses a formal style that expresses passively, while interpretivist study uses the less clear format and can be written either passively or in the first person (Collis & Hussey, 2014). In general, positivists are more likely to provide a methodological concept that can be measured and described, focusing on more objective facts and stated hypotheses. period (Collis & Hussey, 2014).

On the other hand, a research can be divided according to its purpose which are exploratory, descriptive and explanatory. Qualitative research can be defined as an approach to explore and understand the nature of a problem that is done by generally collecting and analyzing qualitative data such as published texts or interviews, while quantitative research refers to an approach to test theories by collecting quantitative data. and using statistical methods. to analyze variables (Creswell, 2014; Collis & Hussey, 2014). The main purpose of this thesis is to investigate the potential impact of fintech on CRA.

As the fintech is relatively a new topic and there is no earlier study, as much as the literature has been scanned, on its effect on CRAs and further, the purpose of this study is to search for ideas and develop hypothesis, but rather than to test and find a specific solution. to the problem an exploratory study was used to add to the existing information. To explore the idea, this thesis used qualitative methodology through structured surveys with non-professionals and professionals, and semi-structured interviews with financial professionals. I started the research by gathering general opinions from non-professionals through a structured survey before narrowing down to get insights from professionals and financial professionals.

The research procedure, methodology and results will be explained and detailed in Part 3.3.

The Three Stages of The Research

  • Survey with Non-Professionals
  • Survey with Professionals
  • Interviews

As a result of the test, it can be seen in Figure A.3, p-value shows that the difference between two variables is statistically significant, as p-value is lower than 0.05. As a result of the KW test, it can be seen in Figure B.3, p-value shows that the difference between variables is not statistically significant, as p-value is higher than 0.05. As a result of the test, it can be seen in Figure C.2, p-value shows that the difference between variables is not statistically significant, as p-value is higher than 0.05.

As a result of the test, it can be seen in Figure D.2, the p-value shows that the difference between the variables is not statistically significant as the p-value is higher than 0.05. As a result of the test, it can be seen in Figure F.3, the p-value indicates that the difference between the two variables is statistically significant as the p-value is lower than 0.05. Therefore, the null hypothesis of “Significance Level of CRA is not related to gender” can be rejected.

As a result of the test, it can be seen in Figure G.3, p-value shows that the difference between two variables is statistically significant, as p-value is lower than 0.05. Therefore, the null hypothesis that “the level of reliability of CRA is not related to the profession” can be rejected. The result of the first test indicates that it can be seen in Figure I.3, the p-value shows that the difference between variables is statistically significant, as the p-value is lower than 0.05.

As a result of the tests, it can be seen in figure a.3, the p-value for test 1 shows that the difference between the two variables is not statistically significant as the p-value is higher than 0.05. Therefore, the null hypothesis of "CRA reliability level is not related to degree level" cannot be rejected. As a result of the test, it can be seen in figure c.3, the p-value shows that the difference between the two variables is statistically significant as the p-value is lower than 0.05.As a result of the test, it can be seen in figure d.3, the p-value shows that the difference between the two variables is statistically significant as the p-value is lower than 0.05.

As the test result can be seen from figure e.2, the p-value shows that the difference between two variables is not statistically significant as the p-value is higher than 0.05. As the result of the test, it can be seen from Figure f.2, the p-value shows that the difference between two variables is not statistically significant, as the p-value is higher than 0.05.

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