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The Failures of Credit Rating Agencies during the Global Financial Crisis - Causes and Possible Solutions



The adequacy of credit ratings is crucial for normal functioning of debt markets. Failures of credit rating agencies have strengthened the negative effects of global financial crisis, generating additional systemic risk. The errors of the agencies can be explained by many reasons as business models, conflicts of interest and absent or ineffective regulation of their activities. To overcome these major problems, we can apply different approaches. The best solution is to improve regulatory practices, combining it with limiting the regulatory status of rating agencies.
34 Economic Alternaves, issue 1, 2011
The Failures of Credit Rating
Agencies during the Global Financial
Crisis – Causes and Possible Solutions
Chief Assist. Prof. Dimitar Rafailov
Summary: The adequacy of credit ratings
is crucial for normal functioning of debt
markets. Failures of credit rating agencies
have strengthened the negative effects of
global financial crisis, generating additional
systemic risk. The errors of the agencies can
be explained by many reasons as business
models, conflicts of interest and absent or
ineffective regulation of their activities. To
overcome these major problems, we can
apply different approaches. The best solution
is to improve regulatory practices, combining
it with limiting the regulatory status of rating
Key words: credit rang, rang agencies,
financial crisis, regulaon.
JEL: G24.
The development of the global financial
crisis put the credit rang agencies
(CRA) into the center of discussions re-
garding the problems of the financial system.
Unl recently they were considered an instru-
mental factor for the reducon of informa-
on problems of the credit markets and for
beer investment decisions. The Asian crisis
and some big corporate bankruptcies in the
beginning of the decade put into queson the
adequacy of the rangs made. The crash of
mortgage bonds that led to concussions on
the other financial markets and global reces-
sion became the reason to increase the cri-
cism. The agencies that were said to be one
of the main culprits for the crisis were accused
of acng against the investors’ interests and
of generang system risk in their pursuit of
greater profit.
The current problems concerning the
adequacy of the credit ratings revealed the
great importance they have for the normal
functioning of the financial markets. For
issuers looking for financing they provide
access to broad opportunities for financing,
lower price for capital and greater trust on
behalf of their counterparties. For investors
in debt instruments the ratings provide an
assessment of their credit risk, by reducing
the information asymmetry and thus enabling
them to make more efficient decisions. The
regulators of the financial markets use the
credit ratings in case of refinancing by central
banks, determining capital requirements,
restricting the permissible investments
and many more activities of the financial
institutions. The value of ratings combined
with the statutory requirements explain the
crucial role played by CRA on bond markets
as their activity affects all participants1.
1. First indications of problems
Over a long period after their establishment
CRA maintained their high authority and
determined adequate ratings assessing, with
relative exactness, the actual probability
of debtor’s insolvency. The processes of
globalization accompanied by increase of
volatility of financial markets that have been
going on for the past 20 years put into
question the exactness of the credit ratings.
During the Asian financial crisis in late 1990s
the big CRA were too slow to respond to the
processes. They maintained an investment
rating of the most affected countries
(Thailand, Indonesia and South Korea) until
the end of 1997, i.e. 6 months after the
beginning of the crisis2. During the subsequent
response the reduction of ratings was too
great in view of the economic conditions.
This led to significant increase of the price of
external financing and additionally deepened
the economic crisis in those countries [10,
1999, pp. 335-355]. There are also some
objective reasons for the mistakes of the
agencies. Firstly, CRA assessed the Asian
issuers for a relatively short period of time
and the accumulated historical data was not
sufficient to make a reliable rating. Secondly,
the reliability of data used by the agencies
was not quite high for the standards of local
financial markets and the quality of financial
reports of the companies was considerably
lower than the one of the developed nations.
Although these factors explain to a great
extent the inadequate ratings the question
of why CRA did not refuse to assess the
Asian companies and governments provided
they had known of the great risk of mistakes,
remain open.
Another critical point for the CRA are the
bankruptcies of several big corporations in
the developed nations in the beginning of
this century. The first such case was Enron in
2001. The company had an investment rating
of (BBB-) 4 days before the official bankruptcy
despite the fact that the information about
problems had been available months in
advance. In 2002, the agencies awarded
Worldcom an investment rating two months
before bankruptcy and in 2003 Parmalat was
awarded the same 18 days before bankruptcy.
In all three cases the most recent ratings
of the agencies determined the companies
as stable, without any implication hinting
solvency problems. In support of the rating
agencies one could state the argument that
in all three cases there was fraud and that
the information submitted by the companies
was false. In contrast to the auditors CRA
have no powers to examine the correctness
of data and entirely rely on issuer’s good
faith. Save for these popular cases, in that
period, as a whole, they responded slowly
to the considerable fluctuations of the
financial markets. Research shows that the
CRA increased or reduced the rating not
only once but at small steps over time [4,
2004, pp. 2679-2714]. The argument of the
agencies is that by doing so they follow a
policy of “through-the-cycle rating,” where
ratings remain stable in the course of the
economic cycle. For that purpose CRA do
1 The significant importance of CRA is confirmed by the informaon about their acvi. Standard and Poor’s has assessed
debt instruments at par value of more than USD 30 trillion, including more than 1 m securies issued by more than 42,000
issuers in more than 100 countries. The figures for Moody’s are similar [14, 2006, p. 66].
2 The Asian financial crisis started on July 2, 1997 with the devaluaon of the Thai baht.
The Failures of Credit Rang AgenciesArcles
36 Economic Alternaves, issue 1, 2011
not change their assessments of debtor’s
creditability if only temporary changes have
occurred in his financial condition. Thus the
rating reflects not the current assessment of
the probability of bankruptcy, but the one
in the long run, which better meets the
investors’ interests. An additional argument
to support the ratings’ stability is that by
doing so one contributes to the reduction of
fluctuations of the bond markets. However,
the maintaining of stable ratings must not be
at the expense of their exactness. In times
of great changes of the market conditions
the ratings “lag behind” the actual situation
and in some more extreme cases such as the
aforesaid they can be entirely inadequate.
2. Failures during the global financial
While in the case of the Asian financial
crisis and the concussions in 2001-2003
there were also some objective reasons for
CRA’s wrong decisions, the global financial
crisis of the past three years demonstrated
that the problem concerning the inaccuracy
of the credit ratings could be due entirely to
their mistakes. Some cases again deal with
bankruptcy of big corporations. In September
2008, Lehman Brothers went bankrupt
while the investment bank’s rating was an
investment one (А-). The insurance company
AIG had the same rating (A-), when it was
bailed out by the state’s financial aid and
in both cases no fraud and no submission
of false information has been found, the
companies were public and operated on the
most developed financial market, with the
highest standards of transparency and the
deterioration of their financial condition was
not temporary but permanent. In these cases
the mistake of the rating agencies is beyond
any dispute.
Despite the individual cases of inadequate
ratings the agencies’ ratings of corporate
bonds as a whole do reflect the actual level
of credit risk. For the period 1981-2009 the
average of Gini coefficient used to measure
the adequacy of awarded ratings3 was above
77 % for the bonds in case of a three-year
time horizon. As a whole the index has not
fallen below 75 % over the years4, as in some
years it exceeded 90 % [16, 2010].
The most significant failure of CRA is,
however, the assessment of the risk
mortgage-backed securities and mostly of
collateralised debt obligations (CDO). In
the middle of 2007, Moody’s and Standard
and Poor’s reduced the rating of structured
financial instruments (SFI) to the amount of
USD 26,7 billion issued in 2006. Some of them
were from old tranches that had a rating of
AAA, and a great part of the remaining ones
had an investment arting. Until the end of
the year the agencies reduced the ratings
of securities for another USD 69 billion and
placed instruments amounting to USD 105
billion under monitoring [8, 2008, pp. 81-
110]. By the development of the crisis the
reduction of the ratings on a global scale
affected issues amounting to USD 3 trillion.
The CDO are quite problematic. For the
period 2006-2007, 66 % of the issues had
reduced rating as 44 % the reduction of the
rating was from investment into speculative
one, including insolvency [18, 2008]. Such
large-scale and considerable reduction of the
ratings happening only 1-2 years after their
issuance has not been observed in history in
3 Generally, the meaning of these coefficients is to reflect to what extent the probabili of insolvency assessed by the
rangs coincides with the actual one, see. [12, 2008, pp. 339-341].
4 The excepons are 1982 with a value of 68 % and 2008 when it was 60 %.
other instruments and apparently points to
some crucial mistakes upon observation. The
failure is intensified by the fact that most
SFI were issued with the advice of the rating
agencies so that they have permanent rating
(mostly investment one). The reduction of
the rating evidenced the fully erroneous
concepts of credit risk measurement applied
by the agencies.
The weakness of CRA in the ratings of SFIA
is confirmed by the Gini coefficient. Over the
past 15 years its values have not dropped
below 80 %. However, a dramatic drop was
observed by the start of the global financial
crisis: 67 % in 2008 and 44 % in 2009. The
values of CDO are even lower: in 2009 their
coefficient was only just 15 % [17, 2010].
3. Reasons for the mistakes of rating
Determining inadequate credit ratings,
especially in case of structured
instruments, which considerably contributed
to the scale of the crisis, calls for defining the
reasons that led to such failures. They can be
summarized in the following directions:
“Issuer Pays” business model • and the
conflicts of interests related thereto. The
fees for determining a major part of the
ratings are paid by the issuer of the securities
as CRA become dependent on them. The
agencies have an incentive to overrate the
creditability of the debtors and to determine
a rating higher than the actual one because
by doing so they will attract more clients
and will not lose present ones who would
go to another agency. This is in conflict with
the investors’ interests requiring adequate
assessments of the issuer. The problem with
the business model is aggravated in the case
of SFI because a great part of their issues
are controlled by a few big investment banks
ensuring a substantial portion of CRA’s
The lack of powers to ensure and examine •
the information. The credit ratings are
determined based on information provided
voluntarily by the issuer. CRA have no powers
to examine the veracity of the information,
and they can not require any additional
information by compulsion. Thus, there is a
risk that the issuer can conceal unfavorable
information which enables overrating.
Lack of competition• . The ratings market is
an oligopoly of the three biggest companies
(Standard & Poor’s, Moody’s and Fitch), that
control 95 % of it globally [12, 2008, pp.
384-386]. This restricts the possibility that the
investors receive more alternative opinions
as regards an issue, reduces the diversity
of applied risk assessment approaches and
models as well as business models. In an
environment where competition is missing,
cartel agreements could be easily made to
maintain monopolistically high prices for the
services and to conduct coordinated policies
for market segmentation.
Through-the-cycle rating approach• . As
specified, in the case of that approach the
CRA do not get influenced by the current sit-
uation. Such conduct, however, is instrumen-
tal for a slow response and quite late change,
mostly as regards the reduction of ratings.
Moreover, in the case of that approach the
judgment of when the deterioration of cred-
itability is temporary and when it is perma-
nent is, to a great extent, a subjective one.
This problem is aggravated especially in times
of quick changes and crisis situations. The
maintenance of stable rating in SFI has also
procyclic effects. In case of deterioration of
the economic situation, in order to maintain
the same rating the leverage of those securi-
The Failures of Credit Rang Agencies
38 Economic Alternaves, issue 1, 2011
ties must be reduced and the average rate of
return must be increased as a guarantee for
the higher risk. In its turn, such increase will
lead to higher rates of interest on loans and
reduced supply of credit which will addition-
ally deteriorate the situation.
The status of quasi-regulatory bodies• . The
regulators make wide use of the credit ratings
upon their regulation of financial institutions,
as their application is in several directions.
Firstly, a number of financial institutions
(insurance companies, pension funds,
mutual funds on the monetary market) are
allowed to invest in debt instruments only
if they have investment rating made by an
established CRA.
Secondly, when determining the capital
requirements for banks and other financial
institutions the risk weights of various
instruments are determined based on their
credit rating as a higher rating of assets
owned means lower requirements for
minimum capital.
Thirdly, when granting refinancing of
commercial banks the central banks require
that the collateralized debt securities have a
minimum credit rating.
By these regulations, the rating agencies
acquire, in practice, regulatory power as the
change of the credit rating (especially the
reduction thereof below the investment one)
has considerable impact on the decisions of
a number of investors. The regulatory status
of the ratings has especially unfavorable
effect and creates systematic risks because
it stimulates the financial institutions to
invest in overrated securities. Thus, they
can assume risks greater than the regulated
ones, maintain lower capital and realize
greater margin of profit. This effect is
quite strong in the case of SFI which are
used mostly for regulatory arbitrage. The
regulatory status of the ratings enables a
dangerous match of the interests of issuers
and investors towards overrating.
Combining rating and consulting services• .
Usually CRA not only determine issuer’s rating
but they also advice him of how his rating
would be affected by his different actions.
Thus the agency’s dependence on the issuer
increases because it receives additional
income from the issuer. The problem is
quite serious in the case of structured
instruments because there CRA consult
the originator or arranger bank as to what
securitization parameters should be in order
that the securities to be issued have certain
rating. Then, the same agency assesses the
securities’ rating. Obviously, provided that
it gave an opinion and received payment to
structure the transaction the agency could
hardly give an independent assessment of
the rating.
Lack of alternative assessments• . In a
number of cases the ratings are the only
assessment of the credit risk of instruments.
The investors cannot compare them to other
indices and thus they cannot judge their
extent of adequacy. A typical example are
the primary markets for debt instruments.
With respect to investment on secondary
markets of corporate bonds the issue is
not that serious because some of them are
quite liquid in order that one can obtain
information about the spreads of return.
For other bonds the credit risk can also be
assessed by the spreads of Credit Default
Swap (CDS). Again, the most problematic
are SFI for which either there is no secondary
market, or it has quite low liquidity. Thus
the opinion of CRA remains without any
alternative and the exactness of ratings is
of crucial importance.
Use of inadequate mathematical models. •
This problem is typical for the assessment
of structured instruments. In contrast
to traditional bonds where the rating is
awarded based on a fundamental analysis
and expert’s assessment of issuer’s financial
condition, in the case of structured finances
the CRA rely only on mathematical models,
by which the probability of insolvency of
different tranches is modeled. To obtain
an exact rating, the model must take into
account all risk factors. The events during
the global financial crisis showed that in
most cases the models used are incomplete.
They do not account for the presence of
asymmetry of the information among
borrowers, originator banks, financial
institutions securitizing them (arrangers),
rating agencies and investors. A typical
example is the so-called originator risk.
Originator banks have an incentive to deceive
the arrangers and the rating agencies s
regards the true creditability of borrowers.
For the information is not examined, there
is created a moral risk that the originator
banks provide false information as well as
reduce the criteria upon lending of loans.
The problem further deteriorates due to
the fact that after securitization the lending
banks do not assume the credit risk any
more. Thus, there is no incentive for them
to maintain high standards upon lending.
As a result of that risk the actual probability
of insolvency under individual loans is bigger
than the one implied in the model and the
credit rating is too optimistic.
Missing or insufficient information• . For
the determination of the credit rating of SFI
depends entirely on mathematical models,
the quality of the final result depends on
the quality of input information. For many
parameters of securitized loans there is no
information or the information is available
for relatively short periods of time, in which
different possible scenarios are not realized.
For instance, in the case of the mortgage
loans the information covers a past period
when the prices of real estates have not
fallen significantly. Thus in the models
are included too optimistic parameters as
regards the insolvency under individual loans
and the correlations among them as a result
of which the SFI’s rating is too high.
Missing or inefficient regulation of CRA’s •
business. Although the credit ratings play an
important role for the normal functioning of
the financial system, their business was not
regulated for a long time depending entirely
on self-regulation. This situation is paradoxi-
cal if it is considered that the supervisory
bodies award “official status” to the credit
ratings upon the regulation of many finan-
cial institutions. The aforesaid problems
could be hardly resolved only on the basis of
CRA’s voluntary action as confirmed by the
practice. The first formal regulations were
introduced in the USA in 1975 as in order
that the ratings are recognized the CRA
must be approved by the Securities and Ex-
change Commission (SEC). For there are no
clear rules as to how such approval is made
the regulation actually deepens the prob-
lems for it creates an additional barrier for
entry of new competitors. Moreover, there
are virtually no requirements concerning
transparency, conflict of interests and qual-
ity of CRA’s business. It was not until 2006
that such requirements were introduced and
then supplemented in 2010. In Europe, the
approach has been liberal for a longer time.
Until 2009, the agencies; operations were
subject to self-regulation by voluntarily com-
pliance with the Code of Conduct of the In-
ternational Organization of Securities Com-
missions (IOSCO), in force since 2004. [11,
2004]. It was not until September 2009 that
the EU adopted a regulation to regulate the
business of CRA in detail.
The Failures of Credit Rang Agencies
40 Economic Alternaves, issue 1, 2011
The specified problems explain the reasons
for which CRA determine inaccurate ratings.
Taking into consideration the fact that such
problems are especially serious in the case of
SFI the agencies’ failure in that field is natural.
This failure substantially contributed to the
rise and scale of the present global financial
crisis. The issue and investments in overrated
risk mortgage-backed securities would not be
of that great volume without the CRA. On
the one hand, the investors would not have
invested large amounts into such securities if
they weren’t overrated because their return
would not be that high compared to the risk
assessment. On the other hand, the banks
would not have that inclination to securitize
their loans because at a lower (realistic)
rating they would have obtained lower prices
for them. thirdly, the big investment banks
arranging that process would have made
less profit because the spread between the
return they receive under securitized loans
and the one they pay under tranches would
have been lower if the tranches’ rating were
lower. The adequacy of the credit rating
is of crucial importance for the motives
of each of the parties and its overrating
artificially stimulates the issue of SFI, thus
creating conditions for the rise of a large-
scale financial crisis. The situation is further
deteriorated by the agencies’ slow response
to adjust the ratings at the beginning of the
crisis due to their policy of “through-the-
cycle rating.” Although the agencies warned
in their reports of some problems concerning
the risk mortgage-backed loans was early
as in the beginning of 2005, they failed to
correctly account for the scale of economic
downturn and did not reduced the ratings
until mid 2007. This enabled the issuance
of much greater amount of overrated SFI
and consequently the loss for the financial
institutions having invested in them was
much greater5.
4. Possible approaches for addressing
the credit rating issues
The critical role played by the CRA for the
stability of present-day financial markets
requires that a number of measures be taken
to overcome the problems related to their
business. A number of proposals have been
suggested to reform the sector, which can
be summarized in three possible approaches:
1) a radical change of the existing system; 2)
improvement of the existing system by means
of stricter regulations; 3) establishment of
alternatives to credit ratings.
The first approach aims at a sweeping change
of the way to determine and pay for the
ratings. There are various proposals here:
Elimination of the “issuer pays” model •
and restoration of the “investor pays”
model. Thus the conflict of interests will be
eliminated because the agencies will not be
interested in overrating. If their ratings are
incorrect they will lose clients. The problem
with that approach is that the ratings are
public gods and their consumption may not
be excluded for the information about the
ratings quite easily becomes accessible to
the general public. In order to overcome
that shortcoming the ratings could be issued
with the participation of a government body
selecting an agency by auction. The costs
for the rating issuance will then be covered
by fees to be paid by investors upon the
purchase of securities [13, 2009, pp. 1011-
1089]. Thus, the process gets considerably
complicated and there are no guarantees
5 Indeed the main poron of the loss realized by the financial instuons during a crisis is due to the investments in risk
mortgage-backed securies issued in 2005-2007.
that the State will select the agencies on a
transparent, unbiased and competition basis.
Another shortcoming is that not only the
purchasers of debt benefit from the ratings
and thus the costs are not fairly allocated.
Moreover, the “investor pays” model creates
incentives for awarding lower-than-actual
Preservation of the “issuer pays” model •
but creation of a centralized mechanism for
selection of CRA [15, 2009, pp. 101-115]. In
such case the issuer willing to obtain a rating
turns to a specialized centralizing institution
and pays it a fee. In its turn, the institution
assigns the rating to a licensed agency. The
selection can be random or based on quality
criteria. This model also has some serious
problems because if the selection is made on
a random basis the CRA have no incentive to
improve the quality of their performance. If
based on quality requirements, the problem
arises as to the objectivity of such criteria.
Public funding of ratings. The argument •
is that the ratings bear the characteristics
of public goods and thus the conflicts of
interest are eliminated. The shortcoming of
that proposal is that funding through taxes
will place burden on all individuals while only
a small part of them will make use of the
benefits from the ratings. Moreover, there
are no guarantees that there will actually be
funded the top quality agencies making the
most adequate ratings.
Establishment of a government credit •
rating agency6. The idea is that the
competition among the existing big agencies
will thus increase because such agency will
give an alternative independent opinion. The
problem here is whether the government
agency will manage to generate quality
ratings to be used by the investors because
the profit and reputation-related incentive is
missing. Another shortcoming is the inability
of governmental organization to follow
financial innovations which is a major part of
CRA’s operations [6, 2003, pp. 1-73].
Most ideas of a total change of the present-
day system, on the one hand, resolve
existing problems, but, on the other hand,
they create new ones. This gives rise to
great uncertainties and their application
would threaten the stability of the financial
system. In this regard, the second approach
aiming at the improvement of the existing
practice by changing the regulations is less
risky. Proceeding from the fact that when
regulation was weak or missing the CRA made
some serious mistakes the states turned to
much more detailed and stricter regulations
that limit the possibilities of new failures in
the future7.
This process started in the USA where in
2006 a special law8 introduced requirements
on the transparency, conflicts of interest and
quality of CRA’s performance. The regulations
of CRA were further developed and detailed
in mid 2010 when the bill reforming the US
financial system was signed into law9.
In September 2009, EU adopted a special
regulation [3, 2009] which regulates in detail
the operations of the CRA and contains
mechanisms ensuring the quality of ratings. In
6 There is a similar proposal for establishment of a European Credit Rang Agency which is considered by the European
Commission. See [5, 2010].
7 The evoluon of regulaon process is examined in more detail by R. Kirilov [1, 2006].
8 Credit Rang Agency Reform Act of 2006 [7, 2006]. The law has effecvely applied since mid 2007 aer the adopon of
the respecve delegated legislaon.
9 Dodd–Frank Wall Street Reform and Consumer Protecon Act [9, 2010].
The Failures of Credit Rang Agencies
42 Economic Alternaves, issue 1, 2011
June 2010, the European Commission brought
a proposal for amendment of the regulation
to the European Parliament [2, 2010] in
view of the improvement of supervision, and
especially the supervision of SFI, and it is
expected that the proposal will be adopted
until the end of the year.
In addion to the USA and EU, the remaining
developed naons have also introduced similar
legislaon to regulate CRA. As a whole the rules
applied by different countries are similar and
aim at resolving the problems in the following
Increase of competition. To that end •
there have been established some clear
statutory rules for registration of CRA that
are equally applied to all. The CRA are
prohibited to make the issuers use their
services by reducing the ratings or selectively
change the methodologies used to determine
the ratings. The use of unsolicited ratings
is regulated. In the case of structured
instruments the CRA are obliged to ensure
access to all available information that is used
to determine the rating of an instrument to
any other registered agency willing to get
such access.
Restriction of conflicts of interest. As a •
general rule the CRA are obliged to make
clear all conflicts of interests that may lead to
determination of inadequate ratings and to
organize their operations so as to avoid such
conflicts. In particular, any persons related to
or receiving remuneration from the issuer or
other party interested therein are prohibited
from participating in the determination of the
rating. Moreover, the remuneration of persons
preparing the ratings may not be dependent
on the income received by the agencies from
the companies under assessment. A rotation
of credit specialists has been introduced
so that an expert does not participate in
determining the rating of an issuer for a
continuous period. The CRA are prohibited
to provide additional consulting services with
respect to any maters directly influencing the
credit rating, including with respect to the
design of SFI. CRA are obliged to appoint a
compliance officer to see to the compliance
lf all statutory requirements as well as to
maintain a review function monitoring the
adequacy of the applied methodologies. The
activity and remuneration of the compliance
officer and the review function must be
independent from the rating award activity,
including with respect to payment.
Ensuring transparency of CRA’s •
operations. In relation thereto the
regulations require the agencies to disclose
detailed information about: the legal
structure and ownership, big clients, income
from rating assessments, income from
additional services; the potential conflicts of
interests and the system to overcome them;
the awarded ratings, the methodology used;
the quantitative models and the assumptions
therein; the percentage of companies having
gone insolvent by separate rating categories
as well as other data necessary for the
assessment of ratings’ adequacy; the results
from the assessment of compliance with the
regulations, etc.
CRA’s liability. In case of breach of the •
requirements of the law the regulatory
bodies have powers to seek liability from
the CRA, including by imposing different
penalties such as fines, periodic financial
sanctions, temporary ban to award credit
ratings, suspension of the use of ratings for
regulatory purposes, termination of agency’s
registration. In USA where a practice used
to exist to protect CRA against individual
claims, the affected persons were granted an
opportunity to seek indemnity for suffered
damages at the court.
Indisputably, these detailed regulations will
significantly reduce the errors and bad business
practices of the CRA. The stricter rules are,
however, related to three problems:
Firstly, there are no guarantees that the
regulatory bodies will effectively apply them.
As shown by the events from the past years
one of the reasons for the rise of the crisis
is precisely the regulators’ inability to carry
out supervision of the compliance with the
existing rules.
Secondly, the strict regulations reduce
the agencies’ flexibility in relation to the
organization of their structures and operations
which increases the costs for determination
of the ratings.
Thirdly, restricts the innovations with respect
to the development of new, more efficient
methods for assessment of creditability. The
great transparency and publicity of CRA’s
operations greatly reduces the value of their
investments in intellectual products such as
the one offered by them.
In order to limit such problems the
development of regulations must be
combined with increase of the purely
market mechanisms for disciplining the CRA.
This third approach requires their market
power to be reduced by restricting or
eliminating their regulatory status. To that
end the supervisory bodies must repeal the
requirements to the financial institutions,
based on credit ratings and replace them by
their own internal mechanisms for credit risk
assessment. Thus, the opinion of CRA will
not have the force of a final “verdict” and
the interest in the artificial maintenance of
high rating will disappear. For the presence
of certain rating will not be a sufficient
condition of security, the investors will
start to look for alternative approaches for
credit risk assessment. One of the options
is to develop their own methodologies for
internal ratings or to base their approach on
the information obtained from the spreads
under the bonds or CDS. The other option
is to turn to external advisors (including
the existing CRA) and pay them for the
prepared assessments. The investors’
desire to pay for such services will create
conditions for entry of new participants and
increase of competition, application of new
business models overcoming the conflict of
interests10, stimulation of innovations and
improvement of the methodologies used.
Regardless of what the selection of the
financial institutions will be the supervisory
bodies will have to assess whether the
applied approaches correctly assess the risks
and whether the risks assumed are not too
Although the approach to limit the ratings’
regulatory status is the most efficient one,
it is still unable to generate support on a
global scale. Among the bigger nations only
the USA apply them in practice. The law
reforming the financial system adopted in
2010 removes the statutory requirements for
use of external credit ratings and obliges all
federal regulatory bodies to do the same in
their federal legislation within one year. In
contrast to the USA, EU is still discussing the
issue and no single opinion has been made.
10 The CRA business is quite similar to the one of the media and especially the one of the newspapers. The present “issuer
pays” model is quite similar to the model of free newspapers supported by adversing only. The “investor pays” model is
the same as the one used by a newspaper supported only by income generated from sales to readers. The third opon is
the model where both pares (issuer and investor) pay for the rang similarly to a newspaper that receives income from
sales to readers and adversing. The “adverser pays” model, where the informaon about rangs is accompanied by paid
adversing, could be borrowed from the electronic media [15, 2009, pp. 110-111].
The Failures of Credit Rang Agencies
44 Economic Alternaves, issue 1, 2011
For a long me the CRA have demonstrated
their reputaon and ensured important
informaon for the parcipants in the
bond markets. The inadequate regulaon
made credit rangs a crical component of
the financial system, without introducing
mechanisms aiming to ensure their objecvi.
This set up condions for the rise of a number
of conflicts of interests which smulated many
market parcipants to create or invest in
overrated financial instruments. The process
inevitably ended by a global financial crisis,
which made the queson of resolving the
problems related to CRA’s operaons a crical
one. The stricter regulaons introduced can
be an answer only if accompanied by measures
for a greater importance of the alternaves to
credit rangs.
Кирилов, Р., Подходи за регулиране дей-1.
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Public Law 109-291, Sept. 29, 2006.
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Dodd-Frank Wall Street Reform and 9.
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Default Study And Rating Transitions, 2010
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Downgrades Accelerate In 2009 Due To
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Rating Transitions, and Default Updates as of
June 20, 2008, 2008.
... The CRA firms did not disclose entities (clients) from which they get high percentages of revenue and their staff did not disclose interests in rated companies. To aggravate the conflict of interest, the ratings were paid for by the issuers of the securities which created an incentive to CRAs to give higher ratings and were not backed by an appropriate level of diligence (Rafailov, 2011). ...
... Singled out for criticism were the inadequate historical data (Hoogeboom, 2010), which significantly increased model risk, and the fact that CRAs had not taken sufficient account of deteriorating lending standards (Rafailov, 2011). The CRAs were also criticized for their failure to publish verifiable data about their rating performance (Andrlikov, 2010). ...
Full-text available
DBA Working Paper: Credit Rating Agencies and the Global Financial Crisis of 2008-9
... A lot of the assets that banks held during the crisis got safe ratings, causing market participants to view them as safe. As such, credit rating agencies were pinned as one of the main culprits in the global financial crisis, for creating such a misleading depiction of banks' health (Rafailov, 2011). In my interviews supervisors made it clear that reality is chaotic, and despite all their efforts it would be a tall order to discern whether banks were healthy or not. ...
Full-text available
In a sense, the 2008 financial crisis was a crisis of theory. Regulators, banks, and financial markets all had encompassing theoretical models about how the economy worked, but they all failed to predict the looming crisis. As such, regulators increasingly turn to big data to understand banks' health. Despite the prominence of big data in society, its use in the public sector remains grossly understudied. This paper explores the regulatory use of big data in the case of the EU-wide banking stress test, a key regulatory indicator. The paper draws on interviews with supervisors at the European Central Bank (ECB), European Banking Authority (EBA) and National Bank of Belgium (NBB), as well as with consultants and risk directors in Belgian banks, to explain how big data-driven regulation affects the relationship between regulators and regulated entities. It draws particular attention to the epistemological component of using large data sets in decision-making: a big data state of mind. The article more specifically shows how the underlying epistemology, rather than simply the bigness of datasets, affects the relationship between regulators and regulated entities, and the regulatory process at large. The paper concludes that regulators' big data state of mind calls for new practical and legal guidelines regarding the validity of data-driven knowledge claims. Moreover, it shows how accountability based on descriptive transparency no longer makes sense in the 'age of the algorithm', suggesting a shift towards relational transparency and joint knowledge production.
Full-text available
Counterparty risk is the most significant part of the credit risk. Credit risk can be explained by two different types of risk: issuer risk and counterparty risk. The importance of counterparty risk increased in the COVID-19 pandemic as lots of counterparties have met difficult economic conditions. This article presents the main issues related to the counterparty risk. Firstly, we try to identify the main concept of counterparty risk by analyzing different scientific views. We present various aspects of counterparty risk and we try to point how a counterparty risk should be understood in the context of credit risk. Then we make a short analysis of changes in credit quality and finally, we offer a framework for counterparty risk management. According to the latest data, we see a high probability of counterparty risk increase, especially in the energy and finance sectors. So because of that counterparty risk management framework is very important for every institution. Despite sometimes it can require higher costs for counterparty risk monitoring, every organization taking into account financial abilities must choose the right way for counterparty risk management.
Full-text available
هدفت الدراسة إلى تسليط الضوء على وكالة التصنيف الإسلامية الدولية (IIRA) وتقييم عملها، ولتحقيق أهدافها استعرضت الدراسة التصنيف الائتماني ووكالاته وآليات عمله، وأهداف تأسيس وكالة التصنيف الإسلامية الدولية، وآليات عملها والمشاكل التي تعترض سبيلها. وقد توصلت الدراسة إلى وجود جوانب قصور في العمل، كالحصول على مقابل لخدماتها من الجهات المصنفة مباشرة، واقتصار خدماتها على التصنيف الائتماني، واتسام سوق التصنيف الإسلامي بالاحتكار التام، وبناء التصنيف على المعلومات المقدمة طوعا من المؤسسات، والاعتماد على التحليل الساكن الذي لا يراعي التغيرات المؤثرة في درجة التصنيف، واقتصار التقييم الشرعي على مدى التزام المؤسسة بآراء هيئة الرقابة المشرفة عليها. وقد قدمت الدراسة مجموعة من التوصيات التي قد تساهم في تطوير عمل الوكالة، وتجاوز المشكلات التي وقعت بها الوكالات التي سبقتها في هذا المجال. الكلمات المفتاحية: وكالة التصنيف الإسلامية الدولية، التصنيف الائتماني، التصنيف الشرعي.
The credit rating agencies (CRAs) have received a great deal of media, political, and regulatory attention since the early summer of 2007. With 2008 financial crisis, there was a common argument that CRAs had not been held accountable for the poor performance that resulted in flawed outcomes. Literature review on CRAs' role in the Europe sovereign debt further strengthened this argument. Through an in-depth study of extensive literature available, we focus on how the rating announcements affected the markets. We also highlight the EU regulations that came into force after a series of downgrades in the Eurozone.
We demonstrate that credit rating agencies aggravated the East Asian crisis. In fact, having failed to predict the emergence of the crisis, rating agencies became excessively conservative. They downgraded East Asian crisis countries more than the worsening in these countries' economic fundamentals would justify. This unduly exacerbated, for these countries, the cost of borrowing abroad and caused the supply of international capital to them to evaporate. In turn, lower than deserved ratings contributed – at least for some time – to amplify the East Asian crisis. Although this goes beyond the scope of our paper, we also propose an endogenous rationale for rating agencies to become excessively conservative after having made blatant errors in predicting the East Asian crisis. Specifically, rating agencies would have an incentive to become more conservative, so as to recover from the damage these errors caused to them and to rebuild their own reputation.
Investors face myriad investment alternatives and seemingly limitless information concerning those alternatives. Not surprisingly, many commentators contend that investors frequently fall short of the ideal investor posited by the rational actor model. Investors are plagued with a variety of behavioral biases (such as, among others, the hindsight bias, the availability bias, loss aversion, and overconfidence). Even securities market institutions and intermediaries may suffer from biases, led astray by groupthink and overconfidence. The question remains whether regulators should focus on such biases in formulating policy. An omnipotent regulatory decisionmaker would certainly improve on flawed investor decisionmaking. The alternative we face, however, is a behaviorally-flawed regulator, the Securities and Exchange Commission (SEC). Several behavioral biases may plague SEC regulators including overconfidence, the confirmation bias, framing effects, and groupthink. While structural solutions are possible to reduce biases within the agency, we argue that such solutions are only partially effective in correcting these biases. Instead of attempting to determine when the behavioral biases of regulators outweigh those within the market, we take a different tactic. Because behaviorally flawed (and possibly self-interested) regulators themselves will decide whether market-based biases outweigh regulatory biases, we propose a framework for assessing such regulatory intervention. Our framework varies along two dimensions. The more monopolistic the regulator (such as the SEC), the greater is the presumption against intervention to correct for biases in the market. Monopolistic regulatory agencies provide a fertile environment for behavioral biases to flourish. Second, the more regulations supplant market decisionmaking, the greater is the presumption against such regulations. Market supplanting regulations are particularly prone to entrenchment, making reversal difficult once such regulations have become part of the status quo.
This article argues that an absence of accountability and interconnections of interest between rating agencies and their debt issuer clients fostered a system of lax ratings that provided false assurances on the risk exposure of subprime mortgage-backed securities and collateralized debt obligations. It lays out an innovative, yet practical pathway for reform by suggesting how debt purchasers, the primary beneficiaries of ratings, may bear both the burdens and benefits of rating agency accountability by financing ratings through an SEC-administered user fee system in exchange for enforceable rights. The SEC user fee system would require rating agencies both to bid for the right to rate debt issues and to assume certification and mandatory reporting duties to creditors. The article suggests how empowering creditors to seek capped damages against rating agencies for gross negligence, while reserving enforcement discretion with the SEC to pursue negligence actions, would create incentives for rating agency compliance, yet pose a manageable burden.
Introduction -- Quality and integrity of the rating process -- CRA independence and avoidance of conflicts of interest -- CRA responsibilities to the investing public and issuers -- Disclosure of the code of conduct and communication with market participants
Surveys on the use of agency credit ratings reveal that some investors believe that rating agencies are relatively slow in adjusting their ratings. A well-accepted explanation for this perception on the timeliness of ratings is the through-the-cycle methodology that agencies use. According to Moody’s, through-the-cycle ratings are stable because they are intended to measure default risk over long investment horizons, and because they are changed only when agencies are confident that observed changes in a company’s risk profile are likely to be permanent. To verify this explanation, we quantify the impact of the long-term default horizon and the prudent migration policy on rating stability from the perspective of an investor – with no desire for rating stability. This is done by benchmarking agency ratings with a financial ratio-based (credit-scoring) agency-rating prediction model and (credit-scoring) default-prediction models of various time horizons. We also examine rating-migration practices. The final result is a better quantitative understanding of the through-the-cycle methodology.
How and Why Credit Rating 14
  • F Partnoy
Partnoy, F., How and Why Credit Rating 14.
Wall Street Reform and 9. Consumer Protection Act, Public Law 111-203
  • Dodd-Frank
Dodd-Frank Wall Street Reform and 9. Consumer Protection Act, Public Law 111-203, July 21, 2010.
Brookings Institution Press and Nomura Institute Of Capital Markets Research
  • M Richardson
  • L White
Agencies Are Not Like Other Gatekeepers, in: Financial Gatekeepers: Can They Protect Investors? (Y. Fuchita, R. Litan eds.), Brookings Institution Press and Nomura Institute Of Capital Markets Research, 2006, pp. 59-99, p. 66. Richardson, M., L. White, The Rating 15. Agencies: Is Regulation the Answer?. In: Restoring financial stability: how to repair a failed system (Acharya, V., V. Richardson ed.), John Wiley & Sons, Inc., Hoboken, New Jersey, 2009, pp. 101-115.
Remarks of President Barroso 5. at the Press conference with Commissioners Rehn and Barnier Press conference Brussels
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Barroso, J., Remarks of President Barroso 5. at the Press conference with Commissioners Rehn and Barnier Press conference Brussels, SPEECH/10/287, 2 June 2010.