Credit Rating Agencies Role in the Unfolding of the Global Financial Crisis - Essay Example

Executive Summary The scope of the present report is to explain the contribution of credit rating agencies in the unfolding of the global crisis based on the analysis of their features and activity and further to emphasize the need of a stronger regulation in order to prevent another systemic crisis. In line with the international legislative efforts, the Australian authorities have strengthened the framework for CRAs regulation. The report comprises seven sections and the supporting bibliography includes the Reserve Bank of Australia studies, Australian Securities and Investments Commission papers, articles, textbook and internet websites. In the light of past and present experiences, the findings of this study emphasize that CRAs reputational capital alone is not enough to ensure the credibility and integrity of CRA market or to support smooth, efficient and transparent functioning of their business model. Having in mind CRAs implications in the rise and contagion of the global crisis, the need for a stronger regulation at the international level becomes an imperative, with the Australian example proving worldwide interest in strengthening the legislative CRAs framework, aiming to avoid the appearance of another similar crisis. Table of contents EXECUTIVE SUMMARY…………………………………………………………………..1 TABLE OF CONTENTS…………………………………………………………………….2 I. INTRODUCTION…………………………………………………………………3 II. Background on credit rating agencies………………………….3 III. Credit rating agencies role in the unfolding of The global financial crisis…………………………………………….3 IV. New regulation of Credit rating agencies. Necessity and perspectives………………………………………………………………….4 V. CONCLUSION……………………………………………………………………5 REFERENCE LIST………………………………………………………………………….6 I. Introduction The implications of the global financial crisis have raised uncertainty and scepticism on the credit rating agencies (CRAs) ability to identify potentially risk-carrying elements, which have led to chaos and pushed the financial arena on the verge of collapse (Ryan, 2012). The performance and credibility of CRAs has been widely discussed even before the onset of the international financial turmoil. The experience of high-profile collapse of Enron and WorldCom in the US underlined the drawbacks of CRAs activity in terms of timeliness and predictive accuracy of their ratings (Reserve Bank of Australia, 2004, p.12). This is similar to the Australian scenario, where HIH Insurance enjoyed an investment-grade rating only a few weeks the company faced insolvency. The fact that CRAs are major actors in the financial markets should make them subject to a strict conduct code to reduce potential conflicts of interest, ensure a high quality and sufficient transparency to the process of setting ratings and for ratings themselves. II. Background on credit rating agencies Based on assigned ratings, CRAs signal the quality of borrowers and loan instruments in terms of default likelihood and recovery opportunities. The existence and development of CRAs in capital markets are generally explained by their capacity to enhance transparency and market efficiency by reducing information asymmetry between issuers and investors. There is a large body of literature arguing that credit rating agencies limit the problems of adverse selection and moral hazard. By its very nature, credit rating has a prospective informational vocation, as it measures not only the risk, but also the possibility of claims recovery. Investors who use ratings predict quite well the temporal evolution of securities translated into efficiency levels and economic losses. Information provided by financial markets is aggregated by CRAs in order to carry out both short and long term forecasts. The short-run notes only reflect the issuers ability to meet commitments for a limited period, without taking into account the specific conditions of the market or the exchange rate risk. Credit rating agencies provide value added to financial markets and enhance investor confidence by assigning different structures accurate and timely ratings. The trust of market players towards the relevance of information subject to scoring is essential. Thus, credit rating agencies are a tool to assist investors’ decisions. III. Credit rating agencies role in the unfolding of the global financial crisis Credit rating agencies have played a major role, both in case of the financial crisis and the sovereign debt. First, they failed to anticipate the shocks and systematic risks such as the crush of the U.S. housing market and contagion in financial markets through securitization (pooling of credit portfolios, both safe and very high risk / subprime) and insufficient understanding of complex derivatives, which have resulted in inter-bank lending freeze and the falling of good asset prices. More important however, CRAs actions have been marked by strong conflicts of interest. Agencies were paid by the very institutions subject to rating assessment, CRA market being dominated by three American institutions: Fitch, Moodys and Standard & Poors (S&P). As regards the Eurozone debt crisis, CRAs have favoured volatility, speculation and contagion in southern European states, lowering ratings of troubled states in a moment when they most needed investor confidence and were to enter into loan agreements with IMF or the ECB, committed to fiscal consolidation programs. Moreover, rumours and rating "mistakes" have created significant market fluctuations. Greece, for example, was rated below Pakistan, which led to the worsening of the financial crisis and to accelerated debates on a new rescue package. Ireland and Portugal are also in the "junk" category making it almost impossible for the governments of both countries to access funds in international markets. Leading Australian banks continue to enjoy relatively good ratings assigned by the international CRAs. The revised rating methodology of Standard& Poor boosts the importance of perceived economic and funding imbalances and of investment banking to an institution’s business model. As a result of their analyses, S&P modified Australia’s “banking industry country risk assessment” from Group 1 (low level of risk) to Group 2 (out of 10 ratings categories). To summarise, these are just some elements that explain the implications of CRAs in the raising of the global financial tensions: CRAs rating models were unrealistic. Between 2004 and 2007, Moodys and S&P used "inappropriate" figures to estimate the scale of residential mortgages risks. Competitive pressures made CRAs employees to falsely rate the performance of their clients; Although they knew that inaccurate ratings may mislead investors, rating agencies continued to operate with incorrect figures and models; Despite large profits, CRAs did not invested resources to improve their way of scoring; When they massively lowered ratings for thousands of companies in July 2007 and then in January 2008, CRAs caused a shock in financial markets, leading to substantial losses and worsening the crisis. Sometimes ratings were reduced directly from AAA to junk. In other cases, although staff didn’t recommended good ratings CRAs offered an AAA score to certain products in order to keep the client (it is the case of UBS). IV. New regulation of credit rating agencies. Necessity and perspectives The existence of prescriptive operational rules is imperative for addressing various conflicts of interest that arise in the issuer-pays arena, especially in the case of complex financial operations. Strong regulation and supervision regime is thus vital for having a credible issuer-pay business model and for maintaining CRAs prestige. The previous regulation of credit rating agencies did not adequately address several major issues related to CRAs activities and use of ratings. These include the risk that financial market participants put an excessive trust in CRAs, the high degree of CRA market concentration, CRAs liability towards investors, the conflicts of interest related to the “issuer pays" model and the ownership structure of credit rating agencies. Peculiarities of sovereign ratings, that became evident during the debt crisis, were also not specifically addressed in the current CRAs regulation. Australian legal authorities and the Australian Securities and Investments Commission carefully analysed some of the new operational measures proposed by the US and the EU regulatory bodies and removed CRAs exemption from the requirement to hold a specific licence. Thus, ASIC and the Australian Treasury jointly studied CRAs activity parameters and required them to have an Australian Financial Services License as well as prepare an annual report indicating the harmonization with the new international code of conduct. Figure 1: Enhanced credit rating agencies supervision under the new Code of Conduct Source: authorial calculation after Reserve Bank of Australia, March 2009, Financial Stability Review, p.62 In the light of the CRAs’ role in the unfolding of the global crisis, especially in terms of their ratings accuracy of complex financial products, the international reviews and in particular the vision of the International Organization of Securities Commissions (IOSCO) emphasizes the need for stronger regulation and supervision (Reserve Bank of Australia, 2009). V. Conclusion The realities of the global financial crisis highlighted a whole plethora of structural and operational drawbacks of credit rating agencies current business architecture and rating methodologies. CRAs are important participants in financial markets and thus, must be subject to an adequate legal framework. Under the impact of recent international systemic events, the creation of an external oversight board considering the example of the US Sarbanes-Oxley Act which would increase the transparency of governance and restore CRAs reputation seems like a good plan. In addition, the ratings’ transparency and quality could be improved by strengthening the rules on CRAs published methodologies, by introducing a process of development and approval of used methodologies, including the requirement that credit CRAs communicate and justify their reasons for changing them and to inform issuers in a timely manner before the publication of a rating. Reference lists 1. Creighton, A., (2004): “Reserve Bank of Australia Bulletin”, April 2. Ryan, J., (2012): “The negative impact of credit rating agencies and proposals for better regulation”, SWP Working Paper FG, No. 01, Berlin 3. ***Reserve Bank of Australia. (2009): “Financial Stability Review”, March Read More