Credit Rating Agencies


It's been a year since the meltdown of financial markets began, yet the media and politicians are still wielding pitchforks against City Bankers. In some cases this is understandable: even if their decisions were being driven by expansionary monetary policy, it is hard to deny that many bankers took extraordinary financial risks, pocketed their bonuses, and then passed the losses on to the taxpayer. That's not the way free markets should work. However, there is another set of financial institutions that seem to have evaded the limelight for now – the Credit Rating Agencies (CRAs).

These companies – such as Moody's, Standard & Poor and Fitch Ratings – were charged with assessing and attributing risk to financial derivatives created by banks. These ratings, ranging from AAA through to C, would then determine the risk involved with those securities and hence the price and demand for them. This seems a pretty trivial task for companies with vast resources and expertise until you realize that these companies gave securitized debt, containing toxic sub-prime loans, a AAA rating.

Naturally with such a seductive low-risk rating these securities were bought up by banks and in the end it was these, which caused the stagnation of inter bank lending. This kind of asymmetric information in the derivatives market added to the crisis. Yet little has been done to reform CRAs. President Obama has proposed 'reforms' which would basically be a slap on the wrist, but there has been no full-scale investigation as to why these debts were given such high ratings (apart from the companies blaming faulty models). The first major move was from a US pension fund which is attempting to sue three of these agencies for $1 billion.

More should be done. Evidence in the IEA's Verdict on the Crash: Causes and Policy implications points towards a systemic failure in CRA strategy, with too much emphasis placed on mathematical modeling, rather than economic reasoning. Interestingly, the solution may be the reverse of current government proposals: a reduction in regulation. Reducing regulation would increase competition in the credit ratings market (where market entry by new firms is currently nigh-on-impossible), increasing the number of different 'opinions' available and bringing an end to the all-too-cozy oligopoly of present-day CRAs.