Risk,Regulation and Compliance Assignment Help

1.Definition and description of credit rating agencies and their major operations within the global financial system. Do they satisfy these roles in terms of anticipating future financial turmoils?

2. Many commentators state that misleading credit ratings had a direct and immense impact on the development of global financial crisis. Provide your personal view on this statement, using examples from the recent crisis to support your arguments.

3. Given the above criticism of credit rating agencies, the idea of the creation of a European Credit Rating Agent has been put forward by some European policy makers. Describe and discuss the potential positive and negative effects of this proposal.

4. What would be your suggestions, as regulatory experts, to improve Credit Rating Agents' performance in risk assessments?

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Introduction

This assignment critically analyzes the challenges to the global financial system that arise from the way in which credit rating agencies currently operate. It defines credit rating agencies. It does a critical analysis of whether they are succeeding in fulfilling their role in the global financial system or not. It suggests some ways in which functioning of credit rating agencies and their risk assessments can be improved. 

1.Definition and description of credit rating agencies and their major operations within the global financial system. Do they satisfy these roles in terms of anticipating future financial turmoils?

Credit rating agencies give credit rating to debt and debt securities of companies and organizations. These credit ratings indicate the degree of risk of investing in the debt of companies and organizations (Samuelson & Nordhaus, 2018). When an entity takes debt there is the credit risk for the lender that has given the debt. Credit risk is the risk that the borrower will not pay the interest or principal of the loan when they become due. Credit rating agencies measure the credit risks of the different debt securities or of giving loan to an individual or entity. 

The higher the credit rating, the lower is the credit risk of the entity to which debt is being given. Here it is important to understand how companies and organizations raise debt. A company raises debt in two ways. One way is to take the debt directly from a bank or financial institution. The second way is to raise debt from the capital markets by floating or selling bonds or debt securities (Chandra, 2017). Investors who buy these bonds or debt securities are the lenders while the company that sells them is the borrower. 

Credit rating agencies are mainly concerned with giving credit ratings to the bonds and debt securities of companies. When banks or financial institutions give loan directly to a company, they use their own internal credit risk assessment process. Sometimes they may also rely on credit ratings given by a credit rating agency to the company, while making the decision regarding whether to give the loan to the company or not (Kiesel, 2019).

Credit rating agencies also give credit ratings to individual borrowers. A large number of banks and financial institutions make the decision regarding whether to give loan to an individual or not based on her credit history and credit rating (The Economist, 2015). Many credit rating agencies compile credit histories of individual citizens.

The role or function that credit rating agencies play in the global financial system is a very important one. The credit ratings that they give have a very significant impact on the decision of investors or lenders regarding whether to invest in the debt of a company or not. The interest that investors want on the debt of a company is also determined by the credit rating given by the credit rating agencies (Jonathan & Peter,  2017). Higher the credit rating given to a debt security, lower its credit risk in the eyes of investors. And because of lower credit risk, the interest rate demanded by them is also lower. Companies with higher credit ratings have lower cost of capital. They are able to raise capital at a cheaper rate of interest. Lower cost of capital adds to profitability of the company. 

 Companies whose debt securities are assigned lower credit ratings have to pay or give higher interest rates when they raise debt from capital markets. A company with a non-investment grade credit rating may find it hard or difficult to raise debt from capital markets (Amtenbrink, 2014). Many institutional investors, such as large pension funds, cannot invest in debt securities that are rated as non-investment grade by credit rating agencies.

This explains the importance of credit rating agencies in the global financial system. A lot of capital allocation decisions are made on the basis of ratings assigned by these companies. Credit rating agencies also assign ratings to the sovereign debt of countries. Sovereign debt is the debt that is raised by treasuries or governments of countries. 

Credit rating agencies give or assign credit ratings by using credit rating models. The outcomes of these models are based on a number of inputs such as the operating cash flows of the company, earnings before interest and taxes – to- interest obligation ratio etc (Scheinert, 2016).

The top three credit rating agencies in the world are Standard & Poor’s, Moody’s, and Fitch group. Credit Rating Agency Reform Act in United States requires credit rating agencies to register and get license from Securities and Exchange Commission. 

The highest credit rating given by Standard & Poor’s is Aaa while the highest credit rating given by Moody’s is AAA. Ratings between Aaa and Baa3 of Standard and Poor’s are considered to be investment grade credit ratings. Ratings below Baa3 are considered to be non-investment grade ratings by Standard & Poor’s. Ratings between AAA and BBB- given by Moody’s are considered to be investment grade ratings. Ratings below BBB- are considered to be non-investment grade ratings, according to Moody’s (Thompson, 2019).

The evidence of recent years clearly shows that credit rating agencies are not satisfying their roles in terms of anticipating or foreseeing future financial turmoils.  Credit rating agencies are largely failing in doing this job both at the level of individual companies and both at the macro-economic level. No credit rating agency was able to foresee the subprime housing crisis in US and the ensuing global financial crisis in 2008. In fact many of the collateralized debt obligation (CDO) securities that turned into junk as soon as the crisis started were given investment grade rating by credit rating agencies, just before the unraveling of the crisis (Chandra, 2017). 

In case of ratings of individual companies, many times credit rating agencies have been found to have given investment grade ratings to debt of companies, just before a credit event took place. Credit event, in the language of credit rating agencies means, default by the company on its debt.

This failure may also be attributed to the conflict of interest that is involved in the credit rating process. Credit rating companies depend on the companies whose debt that they rate for their revenues. Since they charge fee for giving credit rating to the debt of a company, there is always pressure from the company’s side to give a better credit rating than what the security of the company actually deserves. 

When credit rating agencies act under this pressure and start giving better credit rating agencies to debt securities than they actually deserve , then they also fail in foreseeing systematic financial turmoils like the 2008 Global financial crisis. Here it is important to understand the process through which credit rating agencies can foresee future financial turmoils. They assign credit rating to the debt securities and debts of a large number of companies in the system (European Securities and Markets Authority, 2019). When during this credit analysis process they see debt of a large number of companies failing to meet the investment grade rating, then this is an indicator that a future financial turmoil is coming. But when they assign wrong ratings to debt of companies, they fail to foresee such a systematic financial turmoil. 

Credit rating agencies may also be failing more because they have not widened the scope of the models that they use to include Environmental, Social and Governance (ESG) risks, while doing risk assessments of debt securities 

2. Many commentators state that misleading credit ratings had a direct and immense impact on the development of global financial crisis. Provide your personal view on this statement, using examples from the recent crisis to support your arguments.

This statement, in my personal view, is correct. Misleading credit ratings had a direct and immense impact on the development of global financial crisis. Many of debt securities such as Collateralized Debt Obligations (CDOs) whose defaults triggered the financial crisis were rated as investment grade by these credit rating agencies (Blanchard ,2018). If correct credit rating had been given by these companies, then many investors would not have invested in these securities. This would have prevented the contagion from spreading across the entire system when defaults started happening on these securities.

 Because of misleading credit ratings, investors who had invested in these securities could not factor in the risk properly that these investments brought. They therefore did not make enough provisions to tolerate the losses in case the risks materialized. 

Misleading credit ratings caused mispricing of these securities. One of the most important roles that credit rating agencies play or fulfill in the global financial system is that they help in pricing risk. When credit ratings are inaccurate, they result in mispricing of risk. And mispricing of risk means mispricing of securities (European Securities and Markets Authority,2019). And when mispricing of securities happens it results in wrong investment decisions being made. Wrong investment decisions when taken across the system result in systematic crises like the global financial crisis.

The evidence that exists clearly points in the direction that credit rating agencies assigned inaccurate ratings to mortgage backed securities. This in turn was among the main triggers of the global financial crisis. 

In 2006, Moody’s had given AAA rating to $ 869 billion worth of mortgage backed securities. Just one year later, in 2007, when the subprime crisis started, Moody’s downgraded 83% of these $ 869 billion worth of mortgage backed securities to non-investment grade.  In 2006 , Moody’s had earned $800 million in revenues from rating these mortgage backed securities (Chandra, 2017). The surprising thing in this entire episode is that mortgage backed securities that were given highest investment ratings consisted of even those securities that were backed by home loans given to subprime borrowers. Subprime borrowers were those borrowers who did not meet or fulfill the minimum criteria for getting a home loan in the first place. The risk of default of these borrowers was therefore higher. Loans were given to subprime borrowers because of the policy of US government to increase home ownership among American citizens. This policy was initiated under the administration of President Bush Junior. 

The interest and principal obligations on the mortgage backed securities were paid from the interest and principal payments by borrowers of these home loans. When the borrowers started defaulting, these mortgage-backed securities also started defaulting.

 Foreseeing this risk inherent in mortgage-backed securities was not something very difficult to see for credit rating agencies. It is surprising to accept that the credit rating models that they used did not factor in this risk. That is why many have alleged that credit rating agencies used dubious and unreliable models for assigning the credit ratings (Mills, 2008). Moody’s was not alone in this errant behavior.  The other major credit rating agencies had also assigned completely inaccurate credit ratings. They had given high credit ratings to even very risky mortgage backed securities.

If the credit rating agencies had given accurate credit ratings to these risky mortgage backed securities they might not have become so popular. Investors would not have invested in these securities to the extent that they had invested. This in turn would not have caused a systematic liquidity crisis when defaults started happening on these securities.

Therefore it can be concluded without doubt that misleading credit ratings had a direct and very significant impact on the development of global financial crisis. This resulted in the passing of Dodd- Frank Wall Street Reform and Consumer Protection Act, 2010 (Sun, Stewart, & Pollard, 2011). One of the provisions of this act is that credit rating agencies should be held responsible where it is found that these agencies deliberately gave a favorable rating to a debt issue.

Some controversy also erupted when during the sovereign or government debt crisis in Euro zone, the credit rating agencies not only downgraded the debt of troubled economies of Greece, Portugal etc but also downgraded the debt of stronger and larger economies such as France. Many then said that this downgrade by credit rating agencies was incorrect and it intensified the sovereign debt crisis.

However, the role of other factors in causing this crisis cannot be ignored. The focus of the government policy brought during the years of President George W. Bush was to provide home ownership to every American household. The government policy encouraged banks and financial institutions to lend home loans to even borrowers who were not credit –worthy. These borrowers who were not credit –worthy in the first place, but were still given home loans, were the ones who defaulted most on the loans, leading to the crisis. 

Securitization also had a role to play. Securitization means bundling of loans on a bank’s books into securities and then selling these securities to investors. By using securitization, banks were able to transfer the risks from these loans to the investors. This encouraged even more risk – taking by banks and lending institutions. Government institutions, Freddie Mac (The Federal Home Loan Mortgage Corporation) and Fannie Mae (The Federal National Mortgage Association) encouraged this risk taking behavior by banks by providing guarantees on many of the  securities backed by home loans, that were issued by banks and lending institutions (Jonathan & Peter, 2017). 

3. Given the above criticism of credit rating agencies, the idea of the creation of a European Credit Rating Agent has been put forward by some European policy makers. Describe and discuss the potential positive and negative effects of this proposal.

The failure of credit rating agencies that led to the unraveling of global financial crisis brought much criticism for them. The proposal for a publicly financed European Credit Rating agency then came from some quarters. Being publicly financed means that this agency will be financed by taxpayers’ money. It will not have to rely on charging revenues from companies issuing debt for rating them. Therefore the inherent conflict in the current business model of credit rating agencies will be eliminated (Scheiner, 2016). Since there will be no conflict of interest, this European Rating Agency will be able to perform its credit rating function more objectively. This is a big potential advantage of the new proposal. 

One disadvantage of this European Credit Rating Agency is that since it will be financed by taxpayers’ money it may not have access to same kind of finances that large , private credit rating agencies have. These agencies earn revenues and profits annually that run into billions of dollars. Since the European Credit Rating Agency is likely to have much lesser access to finance than the private credit rating agencies, it may find it more difficult to attract the best talent out there, in the area of credit rating. It will need the best talent available in order to perform its intended objective of accurate and objective credit rating. 

The credit rating models that the proposed European Credit Rating Agency uses should be better than the models that are used by top credit rating agencies. If the same credit rating models are used as those being used by credit rating agencies then the proposed agency may not be able to improve the accuracy of risk measurement and credit rating by too much (Bergh & Pacces,  2012).

This proposed credit rating agency will be more tightly regulated by the European Commission. This regulation by European Commission can create a conflict of interest where the assessments of the credit rating agency go against the policy goals of European Commission in times of crisis, like during the more recent subprime debt crisis. It is therefore important that the new agency should be completely autonomous. It should not be concerned about the macroeconomic implications of the credit ratings that it gives. Its sole focus should be on giving credit ratings that are as accurate as possible.

The European Securities and Markets Authority (ESMA) already issued a new regulation directive for credit rating agencies in 2009. Agencies that comply with this directive have been authorized by ESMA to do credit rating work in EU (European Securities and Markets Authority , 2019). A public European Credit Rating Agency should be in compliance with this new regulation of ESMA. It should not be a monopoly and private credit rating agencies should also be allowed to operate. 

4. What would be your suggestions, as regulatory experts, to improve Credit Rating Agents’ performance in risk assessments?

One suggestion is that credit rating agencies should switch to investor pays business model from issuer pays business model. In issuer pays business model, companies that are issuing or raising the debt pay credit rating agencies for rating the debt. In investor pays model, investors who invest in the debt securities pay credit rating agencies for rating the debt. The investor pays business model will remove the conflict of interest that is inherent in the existing business model of these agencies. In this model the company whose debt security is being rated also pays credit rating agencies for doing so.  The public and investors access the credit ratings given to a debt security for free, without paying anything for it.

The investor or subscriber pays model was popular before the decade of 70s. But after that, the issuer pays model continued to grow in popularity (Sun, Stewart, & Pollard, 2011). Today all the three biggest credit rating agencies use the issuer pays model. A few credit rating agencies such as Egan-Jones rating agency still work on the investor pays model. 

The reason for popularity of issuer pays model is that it has been found that issuers are more willing to pay for getting their debt rated than investors who are thinking of investing in a debt security. The model is also more convenient for credit rating agencies. They can get the entire revenue from rating a debt issue from just one issuer rather than collecting it from many different investors. But as long as the issuer pays model is there, conflict of interest will be there and credit rating agencies will find it difficult to do their job objectively.

Another suggestion is tighter regulation of credit rating agencies. Currently, in most countries, credit rating agencies are regulated by the capital markets regulator, such as the Securities and Exchange Commission (SEC) in US. Credit rating agencies play a very important role in the global financial system (Baldwin & Cave, 1999). There should be a separate regulator for regulating these agencies. This will improve the quality of regulation of these agencies. It will make them more accountable. 

Credit rating agencies should not be held in unnecessary suspicion where there is no basis for suspecting them for wrongdoing. Credit rating agencies have a limited role to play when it comes to risk management of a debt security. Their role is that of risk assessment and then of informing stakeholders and public about the risk of that security. In many instances, such as the downgrade of Thomas Cook’s debt to non-investment grade by these agencies way back in 2012, the agencies did rightly and gave accurate risk assessment. 

Credit rating agencies’ performance in risk assessment will improve if corporate governance and corporate social responsibility of companies improve. With better corporate governance and more corporate social responsibility, companies provide more accurate financial data and more extensive data to these credit rating agencies. This data is used in the credit risk assessment models by these agencies. Better the quality of financial data more accurate is the risk assessment.

Credit rating agencies should be made more accountable. They should maintain records of the basis on which they have given credit rating to a debt issue. They should disclose these records when they are asked to do so. Investors should also become more willing to pay for using the services of a credit rating agency. This will lay the ground work for a shift to investor pays model from issuer pays model in future.

Conclusion

The issuer pays model has created a conflict of interest in the business models of credit rating agencies. This is a major reason why these agencies are often failing in fulfilling their function of objective and accurate risk assessment. They also need to upgrade their credit models to include ESG risks, besides the usual financial risks. A shift to investor pays model from issuer pays model will make credit rating agencies more efficient and effective in performing their functions.