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)
- CRAs lowered the perception of credit risk by giving AAA ratings to the senior tranches of structured finance products like collateralized debt obligations (CDOs), the same rating they gave to government and corporate bonds yielding systematically lower returns.
- Flaws in rating methodologies were the major reason for underestimating the credit default risks of instruments collateralized by subprime mortgages. The report was especially critical of the following factors, which were all felt to have contributed to the poor rating performances of structured products:
- the lack of sufficient historical data relating to the US subprime market,
- the underestimation of correlations in the defaults that would occur during a downturn, and
- an inability to take into account the severe weakening of underwriting standards by certain originators.
- October 2008 also saw the German government appoint Otmar Issing, former Chief Economist at the European Central Bank, to chair a committee to draw up recommendations first for the Group of Twenty (G-20) summit in Washington and then for the follow-up summit in London. The committee's report drew attention to the part played by various unresolved conflicts of interests (Issing Committee 2008). It leveled the following criticisms at CRAs:
- The governance of credit rating agencies did not adequately address issues relating to conflicts of interests and analytical independence. Agencies competing for the business of rating innovative new structures may not have ensured that commercial objectives did not influence judgments on whether the instruments were capable of being rated effectively.
- Rating shopping by issuers contributed to a gradual erosion of rating standards among structured finance products. This negative effect resulted from the right of issuers to suppress ratings that they considered unwelcome, thereby exerting pressure on the agencies.
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):
- The practice of making the models by which agencies rated structured credits transparent to the issuing investment banks created the danger that issuers were “structuring to rating,” i.e., designing specific features of the structure so that it would just clear a certain rating hurdle.
- The shift to an increasingly securitized form of credit intermediation and the increased complexity of securitized credit relied upon market practices that, while rational from the point of view of individual participants, increased procyclicality in the system.
- More securitization meant that a greater proportion of credit assets were held by investors seeking reassurance from credit ratings, and thus increased the potential aggregate effects of forced selling by institutions using predefined investment rules based on ratings.
- The use of market value or rating-based triggers increased in an attempt to improve investor and creditor protection.
- Arrangements that related the level of collateral posted in derivative contracts to the credit ratings of counterparties also had a significant procyclical effect.
In summary, the following elements may be said to have had an adverse influence on the quality of CRAs' work:
- Overreliance on mathematical and statistical methodologies based on inadequate data,
- Insufficient consideration of market and macroeconomic developments as factors influencing ratings,
- Failure to take account of interdependencies,
- Disregard of conflicts of interests, and
- Inadequate disclosure practices with regard to models and model assumptions.
- This outline of the ratings dilemma would be inaccurate if it were to focus only on shortcomings on the part of CRAs. It is also true that investors often accepted ratings uncritically and overestimated their significance. Not enough attention was paid to the fact that ratings are only estimates of the relative probability of default or expected loss on a debt instrument. They are not a detailed assessment of risk and say nothing about an instrument's price quality or liquidity. Ratings are no substitute for investment risk management, particularly as the information provided by CRAs is limited.
