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The Role Played by Credit Rating Agencies in the Financial Crisis
The growth of the international financial markets over the last twenty years would have been unthinkable without CRAs. Only because of the availability of clear, internationally accepted indicators of the risk of default were investors willing to invest in international securities—whether corporate or government bonds—whose credit quality they would have been virtually unable to assess on their own. The CRAs worked for decades on designing a simple and readily understandable system that would allow any investor to invest in international securities with which they were not directly familiar. Where corporate and government bonds are concerned, this system has proved reliable and enabled investors to diversify their portfolios.
In the markets for structured products, by contrast, the role of the CRAs goes far beyond eliminating information asymmetry. Markets for structured products could not have developed without the quality assurance provided by CRAs to unsophisticated investors about inherently complex financial products. CRAs have operated as trusted gatekeepers. However, the ratings for structured credit turned out to be much less robust predictors of future developments than were the ratings for traditional single name securities.
Over the past two years, changes in the ratings of structured credit have been far more volatile than the historical record for single name credits, and far more weighted toward downgrades. The resulting instability of ratings has not only had direct procyclical effects, but has undermined confidence in the future stability of credit ratings. Against this backdrop, calls for CRAs to be regulated in a new and more stable world financial order fell on fertile ground, all the more so given that the CRAs could be accused of making some serious errors. A number of official European reports have now described in detail how certain flaws in the rating process and the conditions governing the financial markets contributed to the crisis.
The first comprehensive analysis appeared on 7 April 2008, when the Financial Stability Forum (FSF) published its report on enhancing market and institutional resilience (Financial Stability Forum 2008). This report concluded that the CRAs' substantial underestimation of the risk inherent in structured finance products was partly due to methodological shortcomings. Singled out for criticism were the inadequate historical data, which significantly increased model risk, and the fact that CRAs had not taken sufficient account of deteriorating lending standards.
The report took a positive view of the measures already introduced by the CRAs; nevertheless, a need was seen for further steps to improve internal governance, the transparency of rating procedures, and compliance with international codes of conduct. There was criticism, too, of CRAs' failure to publish verifiable data about their rating performance. The agencies were urged to disclose this information in as standardized a form as possible.
The report also called for a distinction to be made between ratings of structured finance products and other corporate bonds in order to highlight the differences in the methodologies used and the significantly different risk characteristics involved. The FSF felt, however, that more in-depth analysis was needed of the implications of such a step for the functioning of the market and the regulation of the industry.
In addition, the FSF report criticized CRAs for failing to adequately monitor the quality of securitized products. More rigorous scrutiny of lending practices was therefore called for. And last but not least, investors and supervisors were called on to examine whether they may have placed too much confidence in ratings.
Further reports by expert bodies and regulators were published over the course of the following twelve months. In October 2008, the President of the European Commission, José Manuel Barroso, mandated Jacques de Larosière to chair a committee to give advice on the future of European financial regulation and supervision. In February 2009, the committee published a report that cited the following shortcomings (de Larosière Group 2009)1:
In March 2009, the United Kingdom (UK) Financial Services Authority published the Turner Review, which also highlighted the responsibility of CRAs in its analysis of the causes of the financial crisis. The review came to the following conclusions (Financial Services Authority 2009):
In summary, the following elements may be said to have had an adverse influence on the quality of CRAs' work:
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