The role of credit rating agencies in financial market The case of subprime crisis in the US

In the wake of the recent financial crisis, credit rating agencies (CAR) have been heavily criticized by investors, politicians, and the general public for not putting a red flag on the arising U.S. housing bubble and subsequently the subprime crisis. Yet, only limited research exists on the concrete performance of rating agencies throughout the financial crisis. In this context a rather prominent market segment is U.S. residential mortgagebacked securities (U.S. RMBS): banks mainly used securitization structures to sell off U.S. residential mortgages to worldwide investors and, as we know today, this fuelled the U.S. house price bubble. Because rating agencies acted as their agents and provided a credit rating for each of the issued RMBS, most of which were even rated by multiple agencies and still attested unabated credit quality in the beginning of 2008.

The role of credit rating agencies in financial market The case of subprime crisis in the US Diem Thi Thu Trang Thesis submitted to the faculty of the University of Bordeaux in partial fulfillment of the requirement for the degrees of MASTER BFNI Dr Raphael Chiappini Hanoi, Jan 2017 Contents Contents .2 Introduction Section 1: Overview of financial markets and the role of credit rating agencies in reducing the information asymmetry 1.1 Financial market .5 1.1.1 An overview of financial markets and their functions 1.1.2 An overview of financial markets and their functions 1.1.3 The information asymmetry in the financial markets 1.2 Credit rating agencies 12 1.2.1 The formation of credit rating agencies and rating industry 13 1.2.2 The role of CRA in rating mortgage securities and their shortcomings 18 1.2.3 The credit rating market on the eve of the recent crises 23 1.2.4 Criticism of credit rating agencies 25 Section 2: The subprime mortgage crisis in the US 31 2.1 Overview of subprime mortgage crisis in the US 31 2.2 Analysing of the role of rating agencies in US subprime crisis 33 2.2.1 Rating the structured products and mortages 33 2.2.2 Errors of omission 34 2.2.3 Errors of commission .35 2.2.4 Impact of ratings on credit derivatives and credit default swaps 36 2.2.5 Downgrades by rating agencies .36 2.3 Lessons and experiences from The Failures of Credit Rating Agencies .37 2.3.1 Reasons for the mistakes of rating agencies during US subprime crisis 38 2.3.2 Solutions and recommendations 43 2.4 Conclusion .48 References 49 Introduction In the wa.ke of the re.ce.nt fina.ncia.l cris.is., cre.dit ra.ting a.ge.ncie.s (CA.R) ha.ve be.e.n he.a.vily criticize.d by inve.s.tors., politicia.ns., a.nd the ge.ne.ra.l public for not putting a re.d fla.g on the a.ris.ing U.S hous.ing bubble a.nd s.ubs.e.que.ntly the s.ubprim.e cris.is Ye.t, only lim.ite.d re.s.e.a.rch e.xis.ts on the concre.te pe.rform.a.nce of ra.ting a.ge.ncie.s throughout the fina.ncia.l cris.is In this conte.xt a ra.the.r prom.ine.nt m.a.rke.t s.e.gm.e.nt is U.S re.s.ide.ntia.l m.ortga.ge.ba.cke.d s.e.curitie.s (U.S RM.BS.): ba.nks m.a.inly us.e.d s.e.curitiza.tion s.tructure.s to s.e.ll off U.S re.s.ide.ntia.l m.ortga.ge.s to worldwide inve.s.tors a.nd, a.s we know toda.y, this fue.lle.d the U.S hous.e price bubble Be.ca.us.e ra.ting a.ge.ncie.s a.cte.d a.s the.ir a.ge.nts a.nd provide.d a cre.dit ra.ting for e.a.ch of the is.s.ue.d RM.BS., m.os.t of which we.re e.ve.n ra.te.d by m.ultiple a.ge.ncie.s a.nd s.till a.tte.s.te.d una.ba.te.d cre.dit qua.lity in the be.ginning of 2008 Cre.dit ra.ting bus.ine.s.s firs.tly e.m.e.rge.d in the Unite.d S.ta.te.s (US.) in 1900s a.nd be.ca.m.e a.n im.porta.nt pa.rt of inte.rna.tiona.l fina.ncia.l m.a.rke.ts in pa.ra.lle.l with the globa.liza.tion of fina.ncia.l m.a.rke.ts a.s of m.id-1970s Cre.dit ra.ting a.ge.ncie.s (CRA.) contribute to the e.fficie.ntly functioning of fina.ncia.l m.a.rke.ts by re.ducing the inform.a.tion a.s.ym.m.e.try be.twe.e.n borrowe.rs a.nd le.nde.rs (A.de.ls.on, 2012) But inve.s.tors., policy m.a.ke.rs a.nd gove.rnm.e.nts be.ga.n to inve.s.tiga.te the re.lia.bility of cre.dit ra.tings e.s.pe.cia.lly a.fte.r the re.ce.nt cris.e.s a.nd the CRA.s a.ls.o we.re s.e.e.n a.s a pa.rt of the.s.e cris.e.s S.o the US., E.U (E.urope.a.n Union) a.nd the inte.rna.tiona.l orga.niza.tions que.s.tione.d the functioning of the cre.dit ra.ting m.a.rke.t a.nd m.a.de s.om.e re.gula.tions on the CRA.s to e.lim.ina.te the im.pe.rfe.ctions in the m.a.rke.t The obje.ctive of this s.tudy is to s.tudy the role of CRA in fina.ncia.l m.a.rke.t a.nd its contribution to fina.ncia.l cris.is with the ca.s.e of s.ubprim.e cris.is in the US by cla.rifying two m.a.in re.s.e.a.rch que.s.tions a.s follows.: Wha.t is the curre.nt role., le.ga.l s.ta.tus a.nd functions of Cre.dit Ra.ting A.ge.ncie.s in the fina.ncia.l m.a.rke.t? How doe.s Cre.dit Ra.ting A.ge.ncie.s (CRA.) im.pa.ct to the s.ubprim.e cris.is in the US.? This the.s.is cons.is.ts of two pa.rts a.nd is orga.nize.d a.s follows Lite.ra.ture Re.vie.w S.e.ction pre.s.e.nts a.n ove.rvie.w on the fina.ncia.l m.a.rke.t a.nd the proble.m of inform.a.tion a.s.ym.m.e.try be.twe.e.n borrowe.rs a.nd le.nde.rs This s.e.ction a.ls.o pre.s.e.nts the his.tory of CA.R a.s we.ll a.s the.ir role in s.olving inform.a.tion a.s.ym.m.e.try proble.m.s Ca.s.e S.tudy S.e.ction pre.s.e.nts a.nd a.na.lys.is role a.nd function of CA.R in s.ubprim.e m.ortga.ge cris.is in the US a.ris.ing from burs.ting of s.pe.cula.tive bubble which gre.w up in the US hous.ing m.a.rke.t le.d to the globa.l fina.ncia.l cris.is in 2008 Section 1: Overview of financial markets and the role of credit rating agencies in reducing the information asymmetry 1.1 Financial market 1.1.1 An overview of financial markets and their functions Fina.ncia.l m.a.rke.ts pe.rform the e.s.s.e.ntia.l e.conom.ic function of cha.nne.ling funds from hous.e.holds., firm.s., a.nd gove.rnm.e.nts tha.t ha.ve s.a.ve.d s.urplus funds by s.pe.nding le.s.s tha.n the.ir incom.e to thos.e tha.t ha.ve a s.horta.ge of funds be.ca.us.e the.y wis.h to s.pe.nd m.ore tha.n the.ir incom.e (M.is.hkin, 2007) This function is s.hown s.che.m.a.tica.lly in Figure Thos.e who ha.ve s.a.ve.d a.nd a.re le.nding funds., the le.nde.r-s.a.ve.rs., a.re a.t the le.ft, a.nd thos.e who m.us.t borrow funds to fina.nce the.ir s.pe.nding, the borrowe.r-s.pe.nde.rs., a.re a.t the right The principa.l le.nde.r-s.a.ve.rs a.re hous.e.holds., but bus.ine.s.s e.nte.rpris.e.s a.nd the gove.rnm.e.nt (pa.rticula.rly s.ta.te a.nd loca.l gove.rnm.e.nt), a.s we.ll a.s fore.igne.rs a.nd the.ir gove.rnm.e.nts., s.om.e.tim.e.s a.ls.o find the.m.s.e.lve.s with e.xce.s.s funds a.nd s.o le.nd the.m out The m.os.t im.porta.nt borrowe.r-s.pe.nde.rs a.re bus.ine.s.s.e.s a.nd the gove.rnm.e.nt (pa.rticula.rly the fe.de.ra.l gove.rnm.e.nt), but hous.e.holds a.nd fore.igne.rs a.ls.o borrow to fina.nce the.ir purcha.s.e.s of ca.rs., furniture., a.nd hous.e.s The a.rrows s.how tha.t funds flow from le.nde.r-s.a.ve.rs to borrowe.r-s.pe.nde.rs via two route.s Figure 1: Flows of Funds Through the Fina.ncia.l S.ys.te.m In dire.ct fina.nce (the route a.t the bottom of Figure 1), borrowe.rs borrow funds dire.ctly from le.nde.rs in fina.ncia.l m.a.rke.ts by s.e.lling the.m s.e.curitie.s (a.ls.o ca.lle.d fina.ncia.l ins.trum.e.nts.), which a.re cla.im.s on the borrowe.r’s future incom.e or a.s.s.e.ts (Ba.ll, 2007) S.e.curitie.s a.re a.s.s.e.ts for the pe.rs.on who buys the.m., but the.y a.re lia.bilitie.s (IOUs or de.bts.) for the individua.l or firm tha.t s.e.lls (is.s.ue.s.) the.m For e.xa.m.ple., if Boe.ing ne.e.ds to borrow funds to pa.y for a ne.w fa.ctory to m.a.nufa.cture pla.ne., it m.ight borrow the funds from s.a.ve.rs by s.e.lling the.m a bond, a de.bt s.e.curity tha.t prom.is.e.s to m.a.ke pa.ym.e.nts pe.riodica.lly for a s.pe.cifie.d pe.riod of tim.e., or a s.tock, a s.e.curity tha.t e.ntitle.s the owne.r to a s.ha.re of the com.pa.ny’s profits a.nd a.s.s.e.ts The e.xis.te.nce of fina.ncia.l m.a.rke.ts is be.ne.ficia.l e.ve.n if s.om.e.one borrows for a purpos.e othe.r tha.n incre.a.s.ing production in a bus.ine.s.s (Howe.lls & Ba.in, 2008) S.a.y tha.t you a.re re.ce.ntly m.a.rrie.d, ha.ve a good job, a.nd wa.nt to buy a hous.e You e.a.rn a good s.a.la.ry, but be.ca.us.e you ha.ve jus.t s.ta.rte.d to work, you ha.ve not s.a.ve.d m.uch Ove.r tim.e., you would ha.ve no proble.m s.a.ving e.nough to buy the hous.e of your dre.a.m.s., but by the.n you would be too old to ge.t full e.njoym.e.nt from it Without fina.ncia.l m.a.rke.ts., you a.re s.tuck; you ca.nnot buy the hous.e a.nd m.us.t continue to live in your tiny a.pa.rtm.e.nt If a fina.ncia.l m.a.rke.t we.re s.e.t up s.o tha.t pe.ople who ha.d built up s.a.vings could le.nd you the funds to buy the hous.e., you would be m.ore tha.n ha.ppy to pa.y the.m s.om.e inte.re.s.t s.o tha.t you could own a hom.e while you a.re s.till young e.nough to e.njoy it The.n, ove.r tim.e., you would pa.y ba.ck your loa.n If this loa.n could occur, you would be be.tte.r off, a.s would the pe.rs.ons who m.a.de you the loa.n The.y would now e.a.rn s.om.e inte.re.s.t, whe.re.a.s the.y would not if the fina.ncia.l m.a.rke.t did not e.xis.t Fina.ncia.l m.a.rke.ts a.llow funds to m.ove from pe.ople who la.ck productive inve.s.tm.e.nt opportunitie.s to pe.ople who ha.ve s.uch opportunitie.s Fina.ncia.l m.a.rke.ts a.re critica.l for producing a.n e.fficie.nt a.lloca.tion of ca.pita.l (we.a.lth, e.ithe.r fina.ncia.l or phys.ica.l, tha.t is e.m.ploye.d to produce m.ore we.a.lth), which contribute.s to highe.r production a.nd e.fficie.ncy for the ove.ra.ll e.conom.y Whe.n fina.ncia.l m.a.rke.ts bre.a.k down during fina.ncia.l cris.e.s., a.s the.y did during the re.ce.nt globa.l fina.ncia.l cris.is., s.e.ve.re e.conom.ic ha.rds.hip re.s.ults., which ca.n e.ve.n le.a.d to da.nge.rous politica.l ins.ta.bility We.ll-functioning fina.ncia.l m.a.rke.ts a.ls.o dire.ctly im.prove the we.ll-be.ing of cons.um.e.rs by a.llowing the.m to tim.e the.ir purcha.s.e.s be.tte.r The.y provide funds to young pe.ople to buy wha.t the.y ne.e.d a.nd ca.n e.ve.ntua.lly a.fford without forcing the.m to wa.it until the.y ha.ve s.a.ve.d up the e.ntire purcha.s.e price Fina.ncia.l m.a.rke.ts tha.t a.re ope.ra.ting e.fficie.ntly im.prove the e.conom.ic we.lfa.re of e.ve.ryone in the s.ocie.ty 1.1.2 An overview of financial markets and their functions A fina.ncia.l ins.trum.e.nt (or fina.ncia.l products.) is the writte.n le.ga.l obliga.tion of one pa.rty to tra.ns.fe.r s.om.e.thing of va.lue., us.ua.lly m.one.y, to a.nothe.r pa.rty a.t s.om.e future da.te., unde.r s.pe.cife.d conditions (Ce.cche.tti, S.choe.nholtz & Fa.ckle.r, 2006) Fina.ncia.l ins.trum.e.nts ha.ve the following im.porta.nt cha.ra.cte.ris.tics Firs.t, a fina.ncia.l ins.trum.e.nt is a writte.n le.ga.l obliga.tion tha.t is s.ubje.ct to gove.rnm.e.nt e.nforce.m.e.nt Tha.t is., a pe.rs.on (or a firm.) ca.n be com.pe.lle.d to ta.ke the a.ction s.pe.cife.d in the a.gre.e.m.e.nt The e.nforce.a.bility of the obliga.tion is a.n im.porta.nt fe.a.ture of a fna.ncia.l ins.trum.e.nt Without e.nforce.m.e.nt of the s.pe.cife.d te.rm.s., fna.ncia.l ins.trum.e.nts would not e.xis.t S.e.cond, a fina.ncia.l ins.trum.e.nt obliga.te.s one pa.rty to tra.ns.fe.r s.om.e.thing of va.lue., us.ua.lly m.one.y, to a.nothe.r pa.rty By pa.rty, we m.e.a.n a pe.rs.on, com.pa.ny, or gove.rnm.e.nt Us.ua.lly the fina.ncia.l ins.trum.e.nt s.pe.cife.s tha.t pa.ym.e.nts will be m.a.de For e.xa.m.ple., if you ge.t a ca.r loa.n, you a.re obliga.te.d to m.a.ke m.onthly pa.ym.e.nts of a pa.rticula.r a.m.ount to the le.nde.r A.nd if you ha.ve a.n a.ccide.nt, your ins.ura.nce com.pa.ny is obliga.te.d to fix your ca.r, though the cos.t of the re.pa.ir is le.ft uns.pe.cife.d Third, a fina.ncia.l ins.trum.e.nt s.pe.cife.s tha.t pa.ym.e.nt will be m.a.de a.t s.om.e future da.te In s.om.e ca.s.e.s., s.uch a.s a ca.r loa.n tha.t re.quire.s pa.ym.e.nts the da.te.s m.a.y be ve.ry s.pe.cific In othe.rs., s.uch a.s ca.r ins.ura.nce., the pa.ym.e.nt is trigge.re.d whe.n s.om.e.thing s.pe.cific ha.ppe.ns., like a.n a.ccide.nt Fina.lly, a fina.ncia.l ins.trum.e.nt s.pe.cifie.s conditions unde.r which a pa.ym.e.nt will be m.a.de S.om.e a.gre.e.m.e.nts s.pe.cify pa.ym.e.nts only whe.n ce.rta.in e.ve.nts ha.ppe.n Tha.t is cle.a.rly the ca.s.e with ca.r ins.ura.nce a.nd with s.tocks a.s we.ll The holde.r of a s.tock owns a s.m.a.ll pa.rt of a frm a.nd s.o ca.n e.xpe.ct to re.ce.ive occa.s.iona.l ca.s.h pa.ym.e.nts., ca.lle.d divide.nds., whe.n the com.pa.ny is profita.ble The.re is no wa.y to know in a.dva.nce., howe.ve.r, e.xa.ctly whe.n s.uch pa.ym.e.nts will be m.a.de In ge.ne.ra.l, fina.ncia.l ins.trum.e.nts s.pe.cifies a num.be.r of pos.s.ible continge.ncie.s unde.r which one pa.rty is re.quire.d to m.a.ke a pa.ym.e.nt to a.nothe.r The.re a.re two funda.m.e.nta.l cla.s.s.e.s of fina.ncia.l ins.trum.e.nts The firs.t, unde.rlying ins.trum.e.nts (s.om.e.tim.e.s ca.lle.d prim.itive s.e.curitie.s.), a.re us.e.d by s.a.ve.rs./le.nde.rs to tra.ns.fe.r re.s.ource.s dire.ctly to inve.s.tors./borrowe.rs Through the.s.e ins.trum.e.nts., the fina.ncia.l s.ys.te.m im.prove.s the e.fficie.nt a.lloca.tion of re.s.ource.s in the re.a.l e.conom.y The prim.a.ry e.xa.m.ple.s of unde.rlying s.e.curitie.s or ins.trum.e.nts a.re s.tocks a.nd bonds tha.t offe.r pa.ym.e.nts ba.s.e.d s.ole.ly on the is.s.ue.r’s s.ta.tus Bonds., for e.xa.m.ple., m.a.ke pa.ym.e.nts de.pe.nding on the s.olve.ncy of the firm tha.t is.s.ue.d the.m S.tocks s.om.e.tim.e.s pa.y divide.nds whe.n the is.s.uing corpora.tion’s profits a.re s.ufficie.nt The s.e.cond cla.s.s of fina.ncia.l ins.trum.e.nts is known a.s de.riva.tive ins.trum.e.nts The.ir va.lue a.nd pa.yoffs a.re “de.rive.d” from the be.ha.vior of the unde.rlying ins.trum.e.nts The m.os.t com.m.on e.xa.m.ple.s of de.riva.tive.s a.re future.s., options., a.nd s.tructure.d fina.ncia.l products s.uch a.s m.ortga.ge.-ba.cke.d s.e.curitie.s (or m.orta.ge.s for s.hort) In ge.ne.ra.l, de.riva.tive.s s.pe.cify a pa.ym.e.nt to be m.a.de be.twe.e.n the pe.rs.on who s.e.lls the ins.trum.e.nt a.nd the pe.rs.on who buys it The a.m.ount of the pa.ym.e.nt de.pe.nds on va.rious fa.ctors a.s.s.ocia.te.d with the price of the unde.rlying a.s.s.e.t The prim.a.ry us.e of de.riva.tive.s is to s.hift ris.k a.m.ong inve.s.tors 1.1.3 The information asymmetry in the financial markets Whe.n fina.ncia.l m.a.rke.ts work we.ll, the.y cha.nne.l funds from s.a.ve.rs to inve.s.tors., a.nd the.y he.lp pe.ople re.duce ris.k But fina.ncia.l m.a.rke.ts don’t a.lwa.ys work we.ll S.om.e.tim.e.s the.y bre.a.k down, ha.rm.ing s.a.ve.rs., inve.s.tors., a.nd the e.conom.y The proble.m.s of fina.ncia.l m.a.rke.ts ca.n be com.ple.x, but m.a.ny ha.ve the s.a.m.e root ca.us.e.: a.s.ym.m.e.tric inform.a.tion, a s.itua.tion in which one pa.rticipa.nt in a.n e.conom.ic tra.ns.a.ction ha.s m.ore inform.a.tion tha.n the othe.r pa.rticipa.nt (M.is.kin, 2007; Ce.cche.tti, S.choe.nholtz & Fa.ckle.r, 2006; M.e.rton, 1974) In fina.ncia.l m.a.rke.ts., the a.s.ym.m.e.try ge.ne.ra.lly occurs be.ca.us.e the s.e.lle.rs of s.e.curitie.s ha.ve m.ore inform.a.tion tha.n the buye.rs Two type.s of a.s.ym.m.e.tric inform.a.tion e.xis.t in fina.ncia.l m.a.rke.ts., a.dve.rs.e s.e.le.ction a.nd m.ora.l ha.za.rd A.dve.rs.e s.e.le.ction is the proble.m cre.a.te.d by a.s.ym.m.e.tric inform.a.tion be.fore the tra.ns.a.ction occurs A.dve.rs.e s.e.le.ction in fina.ncia.l m.a.rke.ts occurs whe.n the pote.ntia.l borrowe.rs who a.re the m.os.t like.ly to produce a.n unde.s.ira.ble (a.dve.rs.e.) outcom.e - the ba.d cre.dit ris.ks - a.re the one.s who m.os.t a.ctive.ly s.e.e.k out a loa.n a.nd a.re thus m.os.t like.ly to be s.e.le.cte.d Be.ca.us.e a.dve.rs.e s.e.le.ction m.a.ke.s it m.ore like.ly tha.t loa.ns m.ight be m.a.de to ba.d cre.dit ris.ks., le.nde.rs m.a.y de.cide not to m.a.ke a.ny loa.ns e.ve.n though the.re a.re good cre.dit ris.ks in the m.a.rke.tpla.ce To unde.rs.ta.nd why a.dve.rs.e s.e.le.ction occurs., s.uppos.e tha.t you ha.ve two a.unts to whom you m.ight m.a.ke a loa.n - A.unt Louis.e a.nd A.unt S.he.ila A.unt Louis.e is a cons.e.rva.tive type who borrows only whe.n s.he ha.s a.n inve.s.tm.e.nt s.he is quite s.ure will pa.y off A.unt S.he.ila., by contra.s.t, is a.n inve.te.ra.te ga.m.ble.r who ha.s jus.t com.e a.cros.s a ge.t-rich-quick s.che.m.e tha.t will m.a.ke he.r a m.illiona.ire if s.he ca.n jus.t borrow $1,000 to inve.s.t in it Unfortuna.te.ly, a.s with m.os.t ge.t-rich-quick s.che.m.e.s., the.re is a high proba.bility tha.t the inve.s.tm.e.nt won’t pa.y off a.nd tha.t A.unt S.he.ila will los.e the $1,000 Which of your a.unts is m.ore like.ly to ca.ll you to a.s.k for a loa.n? A.unt S.he.ila., of cours.e., be.ca.us.e s.he ha.s s.o m.uch to ga.in if the inve.s.tm.e.nt pa.ys off You, howe.ve.r, would not wa.nt to m.a.ke a loa.n to he.r be.ca.us.e the.re is a high proba.bility tha.t he.r inve.s.tm.e.nt will turn s.our a.nd s.he will be una.ble to pa.y you ba.ck If you kne.w both your a.unts ve.ry we.ll tha.t is., if your inform.a.tion we.re not a.s.ym.m.e.tric - you wouldn’t ha.ve a proble.m., be.ca.us.e you would know tha.t A.unt S.he.ila is a ba.d ris.k a.nd s.o you would not le.nd to he.r S.uppos.e., though, tha.t you don’t know your a.unts we.ll You a.re m.ore like.ly to le.nd to A.unt S.he.ila tha.n to A.unt Louis.e be.ca.us.e A.unt S.he.ila would be hounding you for the loa.n Be.ca.us.e of the pos.s.ibility of a.dve.rs.e s.e.le.ction, you m.ight de.cide not to le.nd to e.ithe.r of your a.unts., e.ve.n though the.re a.re tim.e.s whe.n A.unt Louis.e., who is a.n e.xce.lle.nt cre.dit ris.k, m.ight ne.e.d a loa.n for a worthwhile inve.s.tm.e.nt M.ora.l ha.za.rd is the proble.m cre.a.te.d by a.s.ym.m.e.tric inform.a.tion a.fte.r the tra.ns.a.ction occurs M.ora.l ha.za.rd in fina.ncia.l m.a.rke.ts is the ris.k (ha.za.rd) tha.t the borrowe.r m.ight e.nga.ge in a.ctivitie.s tha.t a.re unde.s.ira.ble (im.m.ora.l) from the le.nde.r’s point of vie.w, 10 The curre.nt proble.m.s conce.rning the a.de.qua.cy of the cre.dit ra.tings re.ve.a.le.d the gre.a.t im.porta.nce the.y ha.ve for the norm.a.l functioning of the fina.ncia.l m.a.rke.ts For is.s.ue.rs looking for fina.ncing the.y provide a.cce.s.s to broa.d opportunitie.s for fina.ncing, lowe.r price for ca.pita.l a.nd gre.a.te.r trus.t on be.ha.lf of the.ir counte.rpa.rtie.s For inve.s.tors in de.bt ins.trum.e.nts the ra.tings provide a.n a.s.s.e.s.s.m.e.nt of the.ir cre.dit ris.k, by re.ducing the inform.a.tion a.s.ym.m.e.try a.nd thus e.na.bling the.m to m.a.ke m.ore e.fficie.nt de.cis.ions The re.gula.tors of the fina.ncia.l m.a.rke.ts us.e the cre.dit ra.tings in ca.s.e of re.fina.ncing by ce.ntra.l ba.nks., de.te.rm.ining ca.pita.l re.quire.m.e.nts., re.s.tricting the pe.rm.is.s.ible inve.s.tm.e.nts a.nd m.a.ny m.ore a.ctivitie.s of the fina.ncia.l ins.titutions The va.lue of ra.tings com.bine.d with the s.ta.tutory re.quire.m.e.nts e.xpla.in the crucia.l role pla.ye.d by CRA on bond m.a.rke.ts a.s the.ir a.ctivity a.ffe.cts a.ll pa.rticipa.nts Ba.s.e.d on the a.na.lys.is of the role of CA.R in US s.ubprim.e cris.is., the a.uthor outline the re.a.s.ons a.nd re.com.m.e.nd s.om.e s.olutions be.low 2.3.1 Reasons for the mistakes of rating agencies during US subprime crisis De.te.rm.ining ina.de.qua.te cre.dit ra.tings., e.s.pe.cia.lly in ca.s.e of s.tructure.d ins.trum.e.nts., which cons.ide.ra.bly contribute.d to the s.ca.le of the cris.is., ca.lls for de.fining the re.a.s.ons tha.t le.d to s.uch fa.ilure.s The.y ca.n be s.um.m.a.rize.d in the following dire.ctions.:  “Is.s.ue.r Pa.ys.” bus.ine.s.s m.ode.l a.nd the conflicts of inte.re.s.ts re.la.te.d the.re.to The fe.e.s for de.te.rm.ining a m.a.jor pa.rt of the ra.tings a.re pa.id by the is.s.ue.r of the s.e.curitie.s a.s CRA be.com.e de.pe.nde.nt on the.m The a.ge.ncie.s ha.ve a.n ince.ntive to ove.rra.te the cre.dita.bility of the de.btors a.nd to de.te.rm.ine a ra.ting highe.r tha.n the a.ctua.l one be.ca.us.e by doing s.o the.y will a.ttra.ct m.ore clie.nts a.nd will not los.e pre.s.e.nt one.s who would go to a.nothe.r a.ge.ncy This is in conflict with the inve.s.tors.’ inte.re.s.ts re.quiring a.de.qua.te a.s.s.e.s.s.m.e.nts of the is.s.ue.r The proble.m with the bus.ine.s.s m.ode.l is a.ggra.va.te.d in the ca.s.e of S.FI be.ca.us.e a gre.a.t pa.rt of the.ir is.s.ue.s a.re controlle.d by a fe.w big inve.s.tm.e.nt ba.nks e.ns.uring a s.ubs.ta.ntia.l portion of CRA.’s incom.e 38  The la.ck of powe.rs to e.ns.ure a.nd e.xa.m.ine the inform.a.tion The cre.dit ra.tings a.re de.te.rm.ine.d ba.s.e.d on inform.a.tion provide.d volunta.rily by the is.s.ue.r CRA ha.ve no powe.rs to e.xa.m.ine the ve.ra.city of the inform.a.tion, a.nd the.y ca.n not re.quire a.ny a.dditiona.l inform.a.tion by com.puls.ion Thus., the.re is a ris.k tha.t the is.s.ue.r ca.n conce.a.l unfa.vora.ble inform.a.tion which e.na.ble.s ove.rra.ting  La.ck of com.pe.tition The ra.tings m.a.rke.t is a.n oligopoly of the thre.e bigge.s.t com.pa.nie.s (S.ta.nda.rd & Poor’s., M.oody’s a.nd Fitch), tha.t control 95 % of it globa.lly This re.s.tricts the pos.s.ibility tha.t the inve.s.tors re.ce.ive m.ore a.lte.rna.tive opinions a.s re.ga.rds a.n is.s.ue., re.duce.s the dive.rs.ity of a.pplie.d ris.k a.s.s.e.s.s.m.e.nt a.pproa.che.s a.nd m.ode.ls a.s we.ll a.s bus.ine.s.s m.ode.ls In a.n e.nvironm.e.nt whe.re com.pe.tition is m.is.s.ing, ca.rte.l a.gre.e.m.e.nts could be e.a.s.ily m.a.de to m.a.inta.in m.onopolis.tica.lly high price.s for the s.e.rvice.s a.nd to conduct coordina.te.d policie.s for m.a.rke.t s.e.gm.e.nta.tion  Through-the.-cycle ra.ting a.pproa.ch A.s s.pe.cifie.d, in the ca.s.e of tha.t a.pproa.ch the CRA not ge.t influe.nce.d by the curre.nt s.itua.tion S.uch conduct, howe.ve.r, is ins.trum.e.nta.l for a s.low re.s.pons.e a.nd quite la.te cha.nge., m.os.tly a.s re.ga.rds the re.duction of ra.tings M.ore.ove.r, in the ca.s.e of tha.t a.pproa.ch the judgm.e.nt of whe.n the de.te.riora.tion of cre.dita.bility is te.m.pora.ry a.nd whe.n it is pe.rm.a.ne.nt is., to a gre.a.t e.xte.nt, a s.ubje.ctive one This proble.m is a.ggra.va.te.d e.s.pe.cia.lly in tim.e.s of quick cha.nge.s a.nd cris.is s.itua.tions The m.a.inte.na.nce of s.ta.ble ra.ting in m.ortga.ge.s ha.s a.ls.o procyclic e.ffe.cts In ca.s.e of de.te.riora.tion of the e.conom.ic s.itua.tion, in orde.r to m.a.inta.in the s.a.m.e ra.ting the le.ve.ra.ge of thos.e s.e.curi tie.s m.us.t be re.duce.d a.nd the a.ve.ra.ge ra.te of re.turn m.us.t be incre.a.s.e.d a.s a gua.ra.nte.e for the highe.r ris.k In its turn, s.uch incre.a.s.e will le.a.d to highe.r ra.te.s of inte.re.s.t on loa.ns a.nd re.duce.d s.upply of cre.dit which will a.dditiona.lly de.te.riora.te the s.itua.tion  The s.ta.tus of qua.s.i-re.gula.tory bodie.s The re.gula.tors m.a.ke wide us.e of the cre.dit ra.tings upon the.ir re.gula.tion of fina.ncia.l ins.titutions., a.s the.ir a.pplica.tion is in s.e.ve.ra.l dire.ctions 39  Firs.tly, a num.be.r of fina.ncia.l ins.titutions (ins.ura.nce com.pa.nie.s., pe.ns.ion funds., m.utua.l funds on the m.one.ta.ry m.a.rke.t) a.re a.llowe.d to inve.s.t in de.bt ins.trum.e.nts only if the.y ha.ve inve.s.tm.e.nt ra.ting m.a.de by a.n e.s.ta.blis.he.d CRA  S.e.condly, whe.n de.te.rm.ining the ca.pita.l re.quire.m.e.nts for ba.nks a.nd othe.r fina.ncia.l ins.titutions the ris.k we.ights of va.rious ins.trum.e.nts a.re de.te.rm.ine.d ba.s.e.d on the.ir cre.dit ra.ting a.s a highe.r ra.ting of a.s.s.e.ts owne.d m.e.a.ns lowe.r re.quire.m.e.nts for m.inim.um ca.pita.l  Thirdly, whe.n gra.nting re.fina.ncing of com.m.e.rcia.l ba.nks the ce.ntra.l ba.nks re.quire tha.t the colla.te.ra.lize.d de.bt s.e.curitie.s ha.ve a m.inim.um cre.dit ra.ting By the.s.e re.gula.tions., the ra.ting a.ge.ncie.s a.cquire., in pra.ctice., re.gula.tory powe.r a.s the cha.nge of the cre.dit ra.ting (e.s.pe.cia.lly the re.duction the.re.of be.low the inve.s.tm.e.nt one.) ha.s cons.ide.ra.ble im.pa.ct on the de.cis.ions of a num.be.r of inve.s.tors The re.gula.tory s.ta.tus of the ra.tings ha.s e.s.pe.cia.lly unfa.vora.ble e.ffe.ct a.nd cre.a.te.s s.ys.te.m.a.tic ris.ks be.ca.us.e it s.tim.ula.te.s the fina.ncia.l ins.titutions to inve.s.t in ove.rra.te.d s.e.curitie.s Thus., the.y ca.n a.s.s.um.e ris.ks gre.a.te.r tha.n the re.gula.te.d one.s., m.a.inta.in lowe.r ca.pita.l a.nd re.a.lize gre.a.te.r m.a.rgin of profit This e.ffe.ct is quite s.trong in the ca.s.e of m.ortga.ge.s which a.re us.e.d m.os.tly for re.gula.tory a.rbitra.ge The re.gula.tory s.ta.tus of the ra.tings e.na.ble.s a da.nge.rous m.a.tch of the inte.re.s.ts of is.s.ue.rs a.nd inve.s.tors towa.rds ove.rra.ting  Com.bining ra.ting a.nd cons.ulting s.e.rvice.s Us.ua.lly CRA not only de.te.rm.ine is.s.ue.r’s ra.ting but the.y a.ls.o a.dvice him of how his ra.ting would be a.ffe.cte.d by his diffe.re.nt a.ctions Thus the a.ge.ncy’s de.pe.nde.nce on the is.s.ue.r incre.a.s.e.s be.ca.us.e it re.ce.ive.s a.dditiona.l incom.e from the is.s.ue.r The proble.m is quite s.e.rious in the ca.s.e of s.tructure.d ins.trum.e.nts be.ca.us.e the.re CRA cons.ult the origina.tor or a.rra.nge.r ba.nk a.s to wha.t s.e.curitiza.tion pa.ra.m.e.te.rs s.hould be in orde.r tha.t the s.e.curitie.s to be is.s.ue.d ha.ve ce.rta.in ra.ting The.n, the s.a.m.e a.ge.ncy a.s.s.e.s.s.e.s the s.e.curitie.s.’ ra.ting Obvious.ly, provide.d tha.t it ga.ve a.n opinion a.nd re.ce.ive.d 40 pa.ym.e.nt to s.tructure the tra.ns.a.ction the a.ge.ncy could ha.rdly give a.n inde.pe.nde.nt a.s.s.e.s.s.m.e.nt of the ra.ting  La.ck of a.lte.rna.tive a.s.s.e.s.s.m.e.nts In a num.be.r of ca.s.e.s the ra.tings a.re the only a.s.s.e.s.s.m.e.nt of the cre.dit ris.k of ins.trum.e.nts The inve.s.tors ca.nnot com.pa.re the.m to othe.r indice.s a.nd thus the.y ca.nnot judge the.ir e.xte.nt of a.de.qua.cy A typica.l e.xa.m.ple a.re the prim.a.ry m.a.rke.ts for de.bt ins.trum.e.nts With re.s.pe.ct to inve.s.tm.e.nt on s.e.conda.ry m.a.rke.ts of corpora.te bonds the is.s.ue is not tha.t s.e.rious be.ca.us.e s.om.e of the.m a.re quite liquid in orde.r tha.t one ca.n obta.in inform.a.tion a.bout the s.pre.a.ds of re.turn For othe.r bonds the cre.dit ris.k ca.n a.ls.o be a.s.s.e.s.s.e.d by the s.pre.a.ds of Cre.dit De.fa.ult S.wa.p (CDS.) A.ga.in, the m.os.t proble.m.a.tic a.re m.ortga.ge.a for which e.ithe.r the.re is no s.e.conda.ry m.a.rke.t, or it ha.s quite low liquidity Thus the opinion of CRA re.m.a.ins without a.ny a.lte.rna.tive a.nd the e.xa.ctne.s.s of ra.tings is of crucia.l im.porta.nce  M.is.s.ing or ins.ufficie.nt inform.a.tion For the de.te.rm.ina.tion of the cre.dit ra.ting of m.ortga.ge de.pe.nds e.ntire.ly on m.a.the.m.a.tica.l m.ode.ls., the qua.lity of the fina.l re.s.ult de.pe.nds on the qua.lity of input inform.a.tion For m.a.ny pa.ra.m.e.te.rs of s.e.curitize.d loa.ns the.re is no inform.a.tion or the inform.a.tion is a.va.ila.ble for re.la.tive.ly s.hort pe.riods of tim.e., in which diffe.re.nt pos.s.ible s.ce.na.rios a.re not re.a.lize.d For ins.ta.nce., in the ca.s.e of the m.ortga.ge loa.ns the inform.a.tion cove.rs a pa.s.t pe.riod whe.n the price.s of re.a.l e.s.ta.te.s ha.ve not fa.lle.n s.ignifica.ntly Thus in the m.ode.ls a.re include.d too optim.is.tic pa.ra.m.e.te.rs a.s re.ga.rds the ins.olve.ncy unde.r individua.l loa.ns a.nd the corre.la.tions a.m.ong the.m a.s a re.s.ult of which the m.ortga.ge.’s ra.ting is too high  M.is.s.ing or ine.fficie.nt re.gula.tion of CRA.’s bus.ine.s.s A.lthough the cre.dit ra.tings pla.y a.n im.porta.nt role for the norm.a.l functioning of the fina.ncia.l s.ys.te.m., the.ir bus.ine.s.s wa.s not re.gula.te.d for a long tim.e de.pe.nding e.ntire.ly on s.e.lf-re.gula.tion This s.itua.tion is pa.ra.doxica.l if it is cons.ide.re.d tha.t the s.upe.rvis.ory bodie.s a.wa.rd “officia.l s.ta.tus.” to the cre.dit ra.tings upon the re.gula.tion of m.a.ny fina.ncia.l 41 ins.titutions The a.fore.s.a.id proble.m.s could be ha.rdly re.s.olve.d only on the ba.s.is of CRA.’s volunta.ry a.ction a.s confirm.e.d by the pra.ctice The firs.t form.a.l re.gula.tions we.re introduce.d in the Unite.d S.ta.te.s in 1975 a.s in orde.r tha.t the ra.tings a.re re.cognize.d the CRA m.us.t be a.pprove.d by the S.e.curitie.s a.nd E.xcha.nge Com.m.is.s.ion (S.E.C) For the.re a.re no cle.a.r rule.s a.s to how s.uch a.pprova.l is m.a.de the re.gula.tion a.ctua.lly de.e.pe.ns the proble.m.s for it cre.a.te.s a.n a.dditiona.l ba.rrie.r for e.ntry of ne.w com.pe.titors M.ore.ove.r, the.re a.re virtua.lly no re.quire.m.e.nts conce.rning tra.ns.pa.re.ncy, conflict of inte.re.s.ts a.nd qua.lity of CRA.’s bus.ine.s.s It wa.s not until 2006 tha.t s.uch re.quire.m.e.nts we.re introduce.d a.nd the.n s.upple.m.e.nte.d in 2010 In E.urope., the a.pproa.ch ha.s be.e.n libe.ra.l for a longe.r tim.e Until 2009, the a.ge.ncie.s.; ope.ra.tions we.re s.ubje.ct to s.e.lf-re.gula.tion by volunta.rily com.plia.nce with the Code of Conduct of the Inte.rna.tiona.l Orga.niza.tion of S.e.curitie.s Com.m.is.s.ions (IOS.CO), in force s.ince 2004 It wa.s not until S.e.pte.m.be.r 2009 tha.t the E.U a.dopte.d a re.gula.tion to re.gula.te the bus.ine.s.s of CRA in de.ta.il The s.pe.cifie.d proble.m.s e.xpla.in the re.a.s.ons for which CRA de.te.rm.ine ina.ccura.te ra.tings Ta.king into cons.ide.ra.tion the fa.ct tha.t s.uch proble.m.s a.re e.s.pe.cia.lly s.e.rious in the ca.s.e of S.FI the a.ge.ncie.s.’ fa.ilure in tha.t fie.ld is na.tura.l This fa.ilure s.ubs.ta.ntia.lly contribute.d to the ris.e a.nd s.ca.le of the pre.s.e.nt globa.l fina.ncia.l cris.is The is.s.ue a.nd inve.s.tm.e.nts in ove.rra.te.d ris.k m.ortga.ge.-ba.cke.d s.e.curitie.s would not be of tha.t gre.a.t volum.e without the CRA On the one ha.nd, the inve.s.tors would not ha.ve inve.s.te.d la.rge a.m.ounts into s.uch s.e.curitie.s if the.y we.re.n’t ove.rra.te.d be.ca.us.e the.ir re.turn would not be tha.t high com.pa.re.d to the ris.k a.s.s.e.s.s.m.e.nt On the othe.r ha.nd, the ba.nks would not ha.ve tha.t inclina.tion to s.e.curitize the.ir loa.ns be.ca.us.e a.t a lowe.r (re.a.lis.tic) ra.ting the.y would ha.ve obta.ine.d lowe.r price.s for the.m thirdly, the big inve.s.tm.e.nt ba.nks a.rra.nging tha.t proce.s.s would ha.ve m.a.de le.s.s profit be.ca.us.e the s.pre.a.d be.twe.e.n the re.turn the.y re.ce.ive unde.r s.e.curitize.d loa.ns a.nd the one the.y pa.y unde.r tra.nche.s would ha.ve be.e.n lowe.r if the tra.nche.s.’ ra.ting we.re lowe.r The a.de.qua.cy of the cre.dit ra.ting is of crucia.l im.porta.nce for the m.otive.s of e.a.ch of the pa.rtie.s a.nd its ove.rra.ting a.rtificia.lly s.tim.ula.te.s the is.s.ue of m.ortga.ge.s., thus 42 cre.a.ting conditions for the ris.e of a la.rge.s.ca.le fina.ncia.l cris.is The s.itua.tion is furthe.r de.te.riora.te.d by the a.ge.ncie.s.’ s.low re.s.pons.e to a.djus.t the ra.tings a.t the be.ginning of the cris.is due to the.ir policy of “through-the.cycle ra.ting.” A.lthough the a.ge.ncie.s wa.rne.d in the.ir re.ports of s.om.e proble.m.s conce.rning the ris.k m.ortga.ge.-ba.cke.d loa.ns wa.s e.a.rly a.s in the be.ginning of 2005, the.y fa.ile.d to corre.ctly a.ccount for the s.ca.le of e.conom.ic downturn a.nd did not re.duce.d the ra.tings until m.id 2007 This e.na.ble.d the is.s.ua.nce of m.uch gre.a.te.r a.m.ount of ove.rra.te.d m.ortga.ge.s a.nd cons.e.que.ntly the los.s for the fina.ncia.l ins.titutions ha.ving inve.s.te.d in the.m wa.s m.uch gre.a.te.r 2.3.2 Solutions and recommendations The critica.l role pla.ye.d by the CRA.s for the s.ta.bility of pre.s.e.nt-da.y fina.ncia.l m.a.rke.ts re.quire.s tha.t a num.be.r of m.e.a.s.ure.s be ta.ke.n to ove.rcom.e the proble.m.s re.la.te.d to the.ir bus.ine.s.s A num.be.r of propos.a.ls ha.ve be.e.n s.ugge.s.te.d to re.form the s.e.ctor, which ca.n be s.um.m.a.rize.d in s.om.e pos.s.ible s.olutions a.nd re.com.m.e.nda.tions be.low  E.lim.ina.tion of the “is.s.ue.r pa.ys.” m.ode.l a.nd re.s.tora.tion of the “inve.s.tor pa.ys.” m.ode.l Thus the conflict of inte.re.s.ts will be e.lim.ina.te.d be.ca.us.e the a.ge.ncie.s will not be inte.re.s.te.d in ove.rra.ting If the.ir ra.tings a.re incorre.ct the.y will los.e clie.nts The proble.m with tha.t a.pproa.ch is tha.t the ra.tings a.re public gods a.nd the.ir cons.um.ption m.a.y not be e.xclude.d for the inform.a.tion a.bout the ra.tings quite e.a.s.ily be.com.e.s a.cce.s.s.ible to the ge.ne.ra.l public In orde.r to ove.rcom.e tha.t s.hortcom.ing the ra.tings could be is.s.ue.d with the pa.rticipa.tion of a gove.rnm.e.nt body s.e.le.cting a.n a.ge.ncy by a.uction The cos.ts for the ra.ting is.s.ua.nce will the.n be cove.re.d by fe.e.s to be pa.id by inve.s.tors upon the purcha.s.e of s.e.curitie.s Thus., the proce.s.s ge.ts cons.ide.ra.bly com.plica.te.d a.nd the.re a.re no gua.ra.nte.e.s tha.t the S.ta.te will s.e.le.ct the a.ge.ncie.s on a tra.ns.pa.re.nt, unbia.s.e.d a.nd com.pe.tition ba.s.is A.nothe.r s.hortcom.ing is tha.t not only the purcha.s.e.rs of de.bt be.ne.fit from the ra.tings a.nd thus the cos.ts a.re not fa.irly a.lloca.te.d M.ore.ove.r, the “inve.s.tor pa.ys.” m.ode.l cre.a.te.s ince.ntive.s for a.wa.rding lowe.r-tha.n-a.ctua.l ra.tings 43  Pre.s.e.rva.tion of the “is.s.ue.r pa.ys.” m.ode.l but cre.a.tion of a ce.ntra.lize.d m.e.cha.nis.m for s.e.le.ction of CRA.s In s.uch ca.s.e the is.s.ue.r willing to obta.in a ra.ting turns to a s.pe.cia.lize.d ce.ntra.lizing ins.titution a.nd pa.ys it a fe.e In its turn, the ins.titution a.s.s.igns the ra.ting to a lice.ns.e.d a.ge.ncy The s.e.le.ction ca.n be ra.ndom or ba.s.e.d on qua.lity crite.ria This m.ode.l a.ls.o ha.s s.om.e s.e.rious proble.m.s be.ca.us.e if the s.e.le.ction is m.a.de on a ra.ndom ba.s.is the CRA ha.ve no ince.ntive to im.prove the qua.lity of the.ir pe.rform.a.nce If ba.s.e.d on qua.lity re.quire.m.e.nts., the proble.m a.ris.e.s a.s to the obje.ctivity of s.uch crite.ria  Public funding of ra.tings The a.rgum.e.nt is tha.t the ra.tings be.a.r the cha.ra.cte.ris.tics of public goods a.nd thus the conflicts of inte.re.s.t a.re e.lim.ina.te.d The s.hortcom.ing of tha.t propos.a.l is tha.t funding through ta.xe.s will pla.ce burde.n on a.ll individua.ls while only a s.m.a.ll pa.rt of the.m will m.a.ke us.e of the be.ne.fits from the ra.tings M.ore.ove.r, the.re a.re no gua.ra.nte.e.s tha.t the.re will a.ctua.lly be funde.d the top qua.lity a.ge.ncie.s m.a.king the m.os.t a.de.qua.te ra.tings  E.s.ta.blis.hm.e.nt of a gove.rnm.e.nt cre.dit ra.ting a.ge.ncy The ide.a is tha.t the com.pe.tition a.m.ong the e.xis.ting big a.ge.ncie.s will thus incre.a.s.e be.ca.us.e s.uch a.ge.ncy will give a.n a.lte.rna.tive inde.pe.nde.nt opinion The proble.m he.re is whe.the.r the gove.rnm.e.nt a.ge.ncy will m.a.na.ge to ge.ne.ra.te qua.lity ra.tings to be us.e.d by the inve.s.tors be.ca.us.e the profit a.nd re.puta.tion-re.la.te.d ince.ntive is m.is.s.ing A.nothe.r s.hortcom.ing is the ina.bility of gove.rnm.e.nta.l orga.niza.tion to follow fina.ncia.l innova.tions which is a m.a.jor pa.rt ope.ra.tions of CRA.s M.os.t ide.a.s of a tota.l cha.nge of the pre.s.e.ntda.y s.ys.te.m., on the one ha.nd, re.s.olve e.xis.ting proble.m.s., but, on the othe.r ha.nd, the.y cre.a.te ne.w one.s This give.s ris.e to gre.a.t unce.rta.intie.s a.nd the.ir a.pplica.tion would thre.a.te.n the s.ta.bility of the fina.ncia.l s.ys.te.m In this re.ga.rd, the s.e.cond a.pproa.ch a.im.ing a.t the im.prove.m.e.nt of the e.xis.ting pra.ctice by cha.nging the re.gula.tions is le.s.s ris.ky Proce.e.ding from the fa.ct tha.t whe.n re.gula.tion wa.s we.a.k or m.is.s.ing the CRA m.a.de s.om.e s.e.rious m.is.ta.ke.s the s.ta.te.s turne.d to m.uch m.ore de.ta.ile.d a.nd s.tricte.r re.gula.tions tha.t lim.it the pos.s.ibilitie.s of 44 ne.w fa.ilure.s in the future This proce.s.s s.ta.rte.d in the US.A whe.re in 2006 a s.pe.cia.l la.w introduce.d re.quire.m.e.nts on the tra.ns.pa.re.ncy, conflicts of inte.re.s.t a.nd qua.lity of CRA.’s pe.rform.a.nce The re.gula.tions of CRA we.re furthe.r de.ve.lope.d a.nd de.ta.ile.d in m.id 2010 whe.n the bill re.form.ing the US fina.ncia.l s.ys.te.m wa.s s.igne.d into la.w In S.e.pte.m.be.r 2009, E.U a.dopte.d a s.pe.cia.l re.gula.tion which re.gula.te.s in de.ta.il the ope.ra.tions of the CRA a.nd conta.ins m.e.cha.nis.m.s e.ns.uring the qua.lity of ra.tings In June 2010, the E.urope.a.n Com.m.is.s.ion brought a propos.a.l for a.m.e.ndm.e.nt of the re.gula.tion to the E.urope.a.n Pa.rlia.m.e.nt in vie.w of the im.prove.m.e.nt of s.upe.rvis.ion, a.nd e.s.pe.cia.lly the s.upe.rvis.ion of m.orga.ge.s., a.nd it is e.xpe.cte.d tha.t the propos.a.l will be a.dopte.d until the e.nd of the ye.a.r In a.dditon to the Unite.d S.ta.te.s a.nd E.U, the re.m.a.ining de.ve.lope.d na.tons ha.ve a.ls.o introduce.d s.im.ila.r le.gis.la.ton to re.gula.te CRA.s A.s a whole the rule.s a.pplie.d by diffe.re.nt countrie.s a.re s.im.ila.r a.nd a.im a.t re.s.olving the proble.m.s in the following dire.ctons.:  Incre.a.s.e of com.pe.tition To tha.t e.nd the.re ha.ve be.e.n e.s.ta.blis.he.d s.om.e cle.a.r s.ta.tutory rule.s for re.gis.tra.tion of CRA tha.t a.re e.qua.lly a.pplie.d to a.ll The CRA a.re prohibite.d to m.a.ke the is.s.ue.rs us.e the.ir s.e.rvice.s by re.ducing the ra.tings or s.e.le.ctive.ly cha.nge the m.e.thodologie.s us.e.d to de.te.rm.ine the ra.tings The us.e of uns.olicite.d ra.tings is re.gula.te.d In the ca.s.e of s.tructure.d ins.trum.e.nts the CRA a.re oblige.d to e.ns.ure a.cce.s.s to a.ll a.va.ila.ble inform.a.tion tha.t is us.e.d to de.te.rm.ine the ra.ting of a.n ins.trum.e.nt to a.ny othe.r re.gis.te.re.d a.ge.ncy willing to ge.t s.uch a.cce.s.s  Re.s.triction of conflicts of inte.re.s.t A.s a ge.ne.ra.l rule the CRA a.re oblige.d to m.a.ke cle.a.r a.ll conflicts of inte.re.s.ts tha.t m.a.y le.a.d to de.te.rm.ina.tion of ina.de.qua.te ra.tings a.nd to orga.nize the.ir ope.ra.tions s.o a.s to a.void s.uch conflicts In pa.rticula.r, a.ny pe.rs.ons re.la.te.d to or re.ce.iving re.m.une.ra.tion from the is.s.ue.r or othe.r pa.rty inte.re.s.te.d the.re.in a.re prohibite.d from pa.rticipa.ting in the de.te.rm.ina.tion of the ra.ting M.ore.ove.r, the re.m.une.ra.tion of pe.rs.ons pre.pa.ring the ra.tings m.a.y not be de.pe.nde.nt on the incom.e re.ce.ive.d by the a.ge.ncie.s from the com.pa.nie.s unde.r a.s.s.e.s.s.m.e.nt A rota.tion of cre.dit s.pe.cia.lis.ts ha.s be.e.n introduce.d s.o tha.t a.n e.xpe.rt 45 doe.s not pa.rticipa.te in de.te.rm.ining the ra.ting of a.n is.s.ue.r for a continuous pe.riod The CRA a.re prohibite.d to provide a.dditiona.l cons.ulting s.e.rvice.s with re.s.pe.ct to a.ny m.a.te.rs dire.ctly influe.ncing the cre.dit ra.ting, including with re.s.pe.ct to the de.s.ign of S.FI CRA a.re oblige.d to a.ppoint a com.plia.nce office.r to s.e.e to the com.plia.nce lf a.ll s.ta.tutory re.quire.m.e.nts a.s we.ll a.s to m.a.inta.in a re.vie.w function m.onitoring the a.de.qua.cy of the a.pplie.d m.e.thodologie.s The a.ctivity a.nd re.m.une.ra.tion of the com.plia.nce office.r a.nd the re.vie.w function m.us.t be inde.pe.nde.nt from the ra.ting a.wa.rd a.ctivity, including with re.s.pe.ct to pa.ym.e.nt  E.ns.uring tra.ns.pa.re.ncy of CRA.’s ope.ra.tions In re.la.tion the.re.to the re.gula.tions re.quire the a.ge.ncie.s to dis.clos.e de.ta.ile.d inform.a.tion a.bout: the le.ga.l s.tructure a.nd owne.rs.hip, big clie.nts., incom.e from ra.ting a.s.s.e.s.s.m.e.nts., incom.e from a.dditiona.l s.e.rvice.s.; the pote.ntia.l conflicts of inte.re.s.ts a.nd the s.ys.te.m to ove.rcom.e the.m.; the a.wa.rde.d ra.tings., the m.e.thodology us.e.d; the qua.ntita.tive m.ode.ls a.nd the a.s.s.um.ptions the.re.in; the pe.rce.nta.ge of com.pa.nie.s ha.ving gone ins.olve.nt by s.e.pa.ra.te ra.ting ca.te.gorie.s a.s we.ll a.s othe.r da.ta ne.ce.s.s.a.ry for the a.s.s.e.s.s.m.e.nt of ra.tings.’ a.de.qua.cy; the re.s.ults from the a.s.s.e.s.s.m.e.nt of com.plia.nce with the re.gula.tions., e.tc  CRA.’s lia.bility In ca.s.e of bre.a.ch of the re.quire.m.e.nts of the la.w the re.gula.tory bodie.s ha.ve powe.rs to s.e.e.k lia.bility from the CRA., including by im.pos.ing diffe.re.nt pe.na.ltie.s s.uch a.s fine.s., pe.riodic fina.ncia.l s.a.nctions., te.m.pora.ry ba.n to a.wa.rd cre.dit ra.tings., s.us.pe.ns.ion of the us.e of ra.tings for re.gula.tory purpos.e.s., te.rm.ina.tion of a.ge.ncy’s re.gis.tra.tion In US.A whe.re a pra.ctice us.e.d to e.xis.t to prote.ct CRA a.ga.ins.t individua.l cla.im.s., the a.ffe.cte.d pe.rs.ons we.re gra.nte.d a.n opportunity to s.e.e.k inde.m.nity for s.uffe.re.d da.m.a.ge.s a.t the court Indis.puta.bly, the.s.e de.ta.ile.d re.gula.tions will s.ignifica.ntly re.duce the e.rrors a.nd ba.d bus.ine.s.s pra.ctice.s of the CRA The s.tricte.r rule.s a.re., howe.ve.r, re.la.te.d to thre.e proble.m.s.: 46 Firs.tly, the.re a.re no gua.ra.nte.e.s tha.t the re.gula.tory bodie.s will e.ffe.ctive.ly a.pply the.m A.s s.hown by the e.ve.nts from the pa.s.t ye.a.rs one of the re.a.s.ons for the ris.e of the cris.is is pre.cis.e.ly the re.gula.tors.’ ina.bility to ca.rry out s.upe.rvis.ion of the com.plia.nce with the e.xis.ting rule.s S.e.condly, the s.trict re.gula.tions re.duce the a.ge.ncie.s.’ fle.xibility in re.la.tion to the orga.niza.tion of the.ir s.tructure.s a.nd ope.ra.tions which incre.a.s.e.s the cos.ts for de.te.rm.ina.tion of the ra.tings Thirdly, re.s.tricts the innova.tions with re.s.pe.ct to the de.ve.lopm.e.nt of ne.w, m.ore e.fficie.nt m.e.thods for a.s.s.e.s.s.m.e.nt of cre.dita.bility The gre.a.t tra.ns.pa.re.ncy a.nd publicity of CRA.’s ope.ra.tions gre.a.tly re.duce.s the va.lue of the.ir inve.s.tm.e.nts in inte.lle.ctua.l products s.uch a.s the one offe.re.d by the.m In orde.r to lim.it s.uch proble.m.s the de.ve.lopm.e.nt of re.gula.tions m.us.t be com.bine.d with incre.a.s.e of the pure.ly m.a.rke.t m.e.cha.nis.m.s for dis.ciplining the CRA.s This third a.pproa.ch re.quire.s the.ir m.a.rke.t powe.r to be re.duce.d by re.s.tricting or e.lim.ina.ting the.ir re.gula.tory s.ta.tus To tha.t e.nd the s.upe.rvis.ory bodie.s m.us.t re.pe.a.l the re.quire.m.e.nts to the fina.ncia.l ins.titutions., ba.s.e.d on cre.dit ra.tings a.nd re.pla.ce the.m by the.ir own inte.rna.l m.e.cha.nis.m.s for cre.dit ris.k a.s.s.e.s.s.m.e.nt Thus., the opinion of CRA.s will not ha.ve the force of a fina.l “ve.rdict” a.nd the inte.re.s.t in the a.rtificia.l m.a.inte.na.nce of high ra.ting will dis.a.ppe.a.r For the pre.s.e.nce of ce.rta.in ra.ting will not be a s.ufficie.nt condition of s.e.curity, the inve.s.tors will s.ta.rt to look for a.lte.rna.tive a.pproa.che.s for cre.dit ris.k a.s.s.e.s.s.m.e.nt One of the options is to de.ve.lop the.ir own m.e.thodologie.s for inte.rna.l ra.tings or to ba.s.e the.ir a.pproa.ch on the inform.a.tion obta.ine.d from the s.pre.a.ds unde.r the m.orga.ge.s The othe.r option is to turn to e.xte.rna.l a.dvis.ors (including the e.xis.ting CRA.s.) a.nd pa.y the.m for the pre.pa.re.d a.s.s.e.s.s.m.e.nts The inve.s.tors.’ de.s.ire to pa.y for s.uch s.e.rvice.s will cre.a.te conditions for e.ntry of ne.w pa.rticipa.nts a.nd incre.a.s.e of com.pe.tition, a.pplica.tion of ne.w bus.ine.s.s m.ode.ls ove.rcom.ing the conflict of inte.re.s.ts., s.tim.ula.tion of innova.tions a.nd im.prove.m.e.nt of the m.e.thodologie.s us.e.d Re.ga.rdle.s.s of wha.t the s.e.le.ction of the fina.ncia.l ins.titutions 47 will be the s.upe.rvis.ory bodie.s will ha.ve to a.s.s.e.s.s whe.the.r the a.pplie.d a.pproa.che.s corre.ctly a.s.s.e.s.s the ris.ks a.nd whe.the.r the ris.ks a.s.s.um.e.d a.re not too high A.lthough the a.pproa.ch to lim.it the ra.tings.’ re.gula.tory s.ta.tus is the m.os.t e.fficie.nt one., it is s.till una.ble to ge.ne.ra.te s.upport on a globa.l s.ca.le A.m.ong the bigge.r na.tions only the Unite.d S.ta.te.s a.pply the.m in pra.ctice The la.w re.form.ing the fina.ncia.l s.ys.te.m a.dopte.d in 2010 re.m.ove.s the s.ta.tutory re.quire.m.e.nts for us.e of e.xte.rna.l cre.dit ra.tings a.nd oblige.s a.ll fe.de.ra.l re.gula.tory bodie.s to the s.a.m.e in the.ir fe.de.ra.l le.gis.la.tion within one ye.a.r In contra.s.t to the Unite.d S.ta.te.s., E.U is s.till dis.cus.s.ing the is.s.ue a.nd no s.ingle opinion ha.s be.e.n m.a.de 2.4 Conclusion For a long tim.e the CRA ha.ve de.m.ons.tra.te.d the.ir re.puta.ton a.nd e.ns.ure.d im.porta.nt inform.a.ton for the pa.rtcipa.nts in the bond m.a.rke.ts The ina.de.qua.te re.gula.ton m.a.de cre.dit ra.tings a critca.l com.pone.nt of the fina.ncia.l s.ys.te.m., without introducing m.e.cha.nis.m.s a.im.ing to e.ns.ure the.ir obje.ctivitie.s This s.e.t up conditions for the ris.e of a num.be.r of conflicts of inte.re.s.ts which s.itm.ula.te.d m.a.ny m.a.rke.t pa.rtcipa.nts to cre.a.te or inve.s.t in ove.rra.te.d fina.ncia.l ins.trum.e.nts The proce.s.s ine.vita.bly e.nde.d by a globa.l fna.ncia.l cris.is., which m.a.de the que.s.tion of re.s.olving the proble.m.s re.la.te.d to CRA.’s ope.ra.tons a critica.l one The s.tricte.r re.gula.tons introduce.d ca.n be a.n a.ns.we.r only if a.ccom.pa.nie.d by m.e.a.s.ure.s for a gre.a.te.r im.porta.nce of the a.lte.rna.tve.s to cre.dit ra.tings 48 References Adelson, M H (2012) The Role of credit ratings in the financial system Retrieved June 6, 2013, from: http://www.standardandpoors.com/ratings/articles/en/us/? 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The formation of credit rating agencies and rating industry 13 1.2.2 The role of CRA in rating mortgage securities and their shortcomings 18 1.2.3 The credit rating market on the eve of the. .. Criticism of credit rating agencies 25 Section 2: The subprime mortgage crisis in the US 31 2.1 Overview of subprime mortgage crisis in the US 31 2.2 Analysing of the role of rating. .. overview of financial markets and their functions 1.1.2 An overview of financial markets and their functions 1.1.3 The information asymmetry in the financial markets 1.2 Credit rating agencies