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Preventing bail out of Banks: What went wrong and role of Credit Rating Agencies in

the Crisis
Background/ Introduction:

The development of the global financial crisis put the credit rating agencies
(CRA) into the centre of discussions regarding the problems of the financial
system. They were considered an instrumental factor for the reduction of
information problems of the credit markets and for better investment decisions.
The crash of mortgage bonds that led to concussions on the other financial
markets and global recession became the reason to increase the criticism. The
agencies that were said to be one of the main culprits for the crisis were accused
of acting against the investors interests and of generating system risk in their
pursuit of greater profit.
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 participants.
Objective of the study:

The objective is to study the credit rating methodology adapted by rating


agencies and to determine extent to which the agencies were responsible for
global financial crisis. Further, we will study the reasons for failure of rating
agencies and possible approaches to avoid them.
Methodology:

Benchmarking agency ratings with relation between rating and default


rate
Rating migration practices and policies
Time horizon - short term vs long term focus of agencies
Agency issue - Conflict of interest
Regulation of rating activities to ensure a competitive rating industry
Reasons for mistakes of rating agencies
Possible approaches to improve the credit rating process

References:

1. Altman, E., H. Rijken, How rating agencies achieve rating stability, Journal
of Banking & Finance, Vol. 28 (11), November 2004
2. The Failures of Credit Rating Agencies during the Global Financial Crisis
Causes and Possible Solutions, Economic Alternatives, issue 1, 2011
3. Lawrence J. White, A Brief History of Credit Rating Agencies: How Financial
Regulation Entrenched this Industry's Role in the Subprime Mortgage
Debacle of 2007 2008
4. Credit Ratings in the Presence of Bailout, Economia, Vol. 10, No. 1 (Fall
2009), pp. 45-79
5. Rating Agencies: Is There an Agency Issue?, Roy C. Smith, Ingo Walter