Introduction

In the midst of the financial crisis, ratings agencies have come under intense scrutiny and fire. They are now under even closer scrutiny from the regulators following the global credit collapse as the sector is partly blamed for the demise of the economy.

Key findings

• Current state of the market – The financial crisis has made the headlines of every broadsheet newspaper over the past year. While initial focus was on Freddie Mac and Fannie Mae in the US, the rating agencies associated with them became the focus of much media attention. Critics blame the agencies whose job was to assess the credit-worthiness of issuers of debt in financial markets, for failing to spot the dangers inherent in the toxic structured financial products at the heat of the crisis.
• The importance of credit ratings – Credit ratings are important to the financial industry because many investors such as pension funds, insurance companies and banks, use them as a yardstick either to restrict the kinds of products they buy, or to decide how much capital they need to hold against them.
• Conflicting interests – Credit rating agencies were fully aware that their conflicts of interest were giving unduly high scores to risky assets, threatening the stability of the entire financial system. The “issuer-pay” model has been roundly criticised for leading the agencies to cosy up to the firms creating financial products – especially the complex one by assigning ratings that are more favourable than justified in order to hold on to the business.
• Change is afoot – The European Parliament and Council of Ministers has approved the European Commission’s framework for the regulation of the credit rating agencies in the European Union. The move has been largely welcomed by the financial services industry.

Conclusion

Rating agencies have done a lot of damage to the global financial crisis. The manner in which they are paid for rating a firm stinks of bad practice and the exposure over how it has favourably rated firms in trouble has damaged its fragile reputation once again. The sector appears to have learned little from its previous troubles when it failed to spot the demise of Enron and the crisis in the Asian markets in the late 90s. Its behaviour in the current economic climate has done nothing to garner favour with the industry and the general shareholder. This is why it is now time for change. The ruling from the European Parliament and Council of Ministers that has approved the European Commission’s framework for regulation of the credit rating agencies in the European Union, will hopefully go some way to improve its beleaguered reputation.

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Tagged with: 2009, ratings agencies, risk, Risk Research Report