In addition, both companies have a solid reputation in the financial markets and the usage of smaller agencies could be interpreted as suspicious. Another significant change for the rating industry occurred in the beginning of the s. In the original business idea, the investors needed to know the default probability and therefore they were charged for the service. However, when the prices for photocopy machines dropped, the issued rating reports could be copied easily and be accessible to all investors free of charge.
Rating agencies had to change the payment model: bond issuers became the ones that had to pay, as they were required by law to have issuer ratings. Regulators tried to change this payment model, whose problems become even more prominent in times of stress, such as financial crises.
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Especially when the asset is complex to evaluate and ratings differ, the issuer has an incentive to choose only the best rating. This happened, for example, with CDOs Collateralized Debt Obligations tranches and triggered the financial crisis in Agencies rated risky bonds with good ratings in an attempt to gain more business. For example, the rating agency Egan-Jones, founded in , entered the market and is increasing its market share continuously thanks to this concept. Another concern on CRAs consists of the rating analysts.
What’s (Still) Wrong with Credit Ratings
The credit risk is evaluated through the application of quantitative and qualitative factors. Research recently found subjectivity in ratings issued by the same firm. Analysts can be optimistic or pessimistic and this can be reflected in their decision. This consequently leads to a rating bias that can have serious consequences. As an example, during the financial crisis analysts were often too optimistic while analysing default risk and the market followed their advices.
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The last and probably the main challenge for CRAs lies in the changes of regulations which are due to the arising scepticism on their regards. In the last decade, several regulatory changes affected the rating industry. The most important one was the Dodd-Frank Act, signed into US law in in response to the financial crisis. The Dodd-Frank Act increased the liability for issuing inaccurate ratings and made it easier to sanction CRAs in case of material misstatements or fraud. Currently, CRAs are backed by the need of the financial markets because companies need to have at least one credit rating issued by a NRSRO in the case they want to issue a bond.
CRAs indicate the opinion of the creditworthiness of firms, in particular of bond issuers.
What happens if this would no longer be the case? In the past 20 years, alternative market instruments have provided similar information. Several researchers show that credit default swaps CDS spreads can be used to extract implied credit ratings. Financial institutions could satisfy their capital requirements by investing in securities that received favorable ratings by one or more of the NRSROs.
This allowance is the result of registration requirements coupled with greater regulation and oversight of the credit ratings industry by the SEC.
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The increased demand for ratings services by investors and securities issuers, combined with increased regulatory oversight, has led to growth and expansion in the credit ratings industry. Since large CRAs operate on an international scale, regulation occurs at several different levels. The U. The European Union has never produced a specific or systematic legislation or created a singular agency responsible for the regulation of CRAs. There are several EU directives, such as the Capital Requirements Directive of , that affect rating agencies, their business practices and their disclosure requirements.
Most directives and regulations are the responsibility of the European Securities and Markets Authority. Ever since the financial crisis and Great Recession of to , credit rating agencies have come under increased scrutiny and regulatory pressure. It was believed that CRAs provided ratings that were too positive, leading to malinvestment. New rules in the EU have made CRAs liable for improper or negligent ratings that cause damage to an investor.
Some have argued that regulators have helped to prop up an oligopoly in the credit rating industry, providing rules that act as barriers to entry for small- or mid-sized agencies. Investors may utilize information from a single agency or from multiple rating agencies. Investors expect credit rating agencies to provide objective information based on sound analytical methods and accurate statistical measurements.
Investors also expect issuers of securities to comply with rules and regulations set forth by governing bodies, in the same respect that credit rating agencies comply with reporting procedures developed by securities industry governing agencies. The analyses and assessments provided by various credit rating agencies provide investors with information and insight that facilitates their ability to examine and understand the risks and opportunities associated with various investment environments.
With this insight, investors can make informed decisions as to the countries, industries and classes of securities in which they choose to invest.
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