RATING AGENCIES AND FINANCIAL INSTITUTIONS

Case Study

A rating agency is an institution whose work is to assess the financial capabilities of an organization or government institutes that uses the capital market to finance. The ratings give a range of an organization’s hardships, for example, their capacity to accomplish their financial activities (Sanjay, 2019). Credit rating agencies are controlled by the following agencies that dominate 95 percent of the rating business. The agencies include Moody’s Investor Services, Fitch Group, and Standard and Poor’s. Standard and Poor, as well as Moody’s Investor Services, controls 80 percent of the global market, and it is located in the U.S. Fitch dominates approximately 15 percent of the worldwide market, and it is situated in London and the United States. The above agencies came after massive criticism of the international financial crisis because of giving AAA ratings to bankrupt institutions (Deena, 2016).

The 2008 financial crisis was a result of the failure of rating agencies to acknowledge the risks associated with investments and giving high mortgage credit. However, the growth of the global financial markets would not have been achieved without the existence of rating agencies. Rating agencies played a significant role in the last financial crises as it reduced the understanding of credit risk by issuing AAA ratings to the massive portion of finance products. This is the same ratings accorded to government agencies and corporate organizations, resulting in systematically reduced yields. Errors in rating strategies applied were another factor that contributed to the financial crisis that culminated in wrongly approximating the credit risks of investments assured by small debts. The following factors contributed to the poor rating estimations of structured products.

• Lack of strength to take into consideration the sharp weakening of approving standards by individual financial institutions.
• Lack of enough data associated with the United States market.
• The perception of agreeing in the results which would occur in the case of a downtown.

The management of rating agencies did not deal with related to issues, which were a result of analytical independence and conflict of interest. Agencies that were competing for the rating business did not come up with new innovative structures to make sure that commercial goals did not decision making and judgments on whether finance institutes had the ability to be rated adequately. Rating purchases by supplies influenced sudden erosion on how standards of rating were conducted among structured finance products. The negative impact was a result of the right of lenders to conquer scores, which they considered to be hostile, thereby increasing pressure on the rating agencies (Utzig, 2010).

As discussed above, the financial crisis of 2008 was, as a result, the credit rating agency being optimistic in their rating of the subprime market. The credit rating agency’s excessive scores of the subprime market were an indicator of the borrowing institutions had very low-interest rates; therefore, the housing boom had to extend the stoke. Housing prices stopped to increase in 2006 and started to decline while mortgage failure to full fill the obligations increased rapidly. With the increase of meeting mortgage obligations, the assured opinions of the subprime market drastically changed. The credit rating agencies started to decrease the residential mortgage-backed securities, which they had given AAA ratings. As the debt defaulters increased and residential mortgage-backed securities decrease followed, the residential mortgage-backed securities lost its value. The financial companies which were in retaining the residential mortgage-backed securities suffered significant losses. Many big financial institutions did not have the capability to deal with the losses they got, and significant financial crises were experienced in 2008 (Lawrence, 2018).

Conflict of interest is a problem that is a result of an institution trying to achieve many objectives at once; therefore, the objectives conflict, and this can lead to prediction or giving misleading information. Dispute of interest in the conditions of the relationship among financial institutes and rating agencies are as a result of trustee duties by financial institutions to their customers. Trustee relation is a unique segment of the lawful relationship where an involved party agrees to follow the other party’s interests so as to achieve their own objectives. Banks acting as an intermediator between depositors and borrowers can be classified as involving themselves in two different principal-agent agreement. One with depositors where its role is to act as an agent and on the other side with borrows where its purpose is to serve as the principal. Investment banks have two functions, and at times it might be competitive and making a deal relationship (Harper, 2011).

Conflicts of interest other than being aa problem of ethics ad moral risk can as well significantly decrease information quality in financial institutions; thus, increase unbalanced information issues. Biased data prevent financial markets from distributing funds to the chances of the most effective investment and therefore resulting in financial institutions and the economy from being less productive. The following are areas that have high capability for creating conflicts of interest.

One of them is providing and researching in investment banking. The role of investment banks to undertake two activates, which are studying organizations issuing securities and guaranteeing the securities by releasing them to the public as a representative of the corporation providing protection. Conflict of interest emerges among research and security guarantees since the investment bank tries to satisfy the requirements of two different client groups. If the institute is unable to deal with conflict effectively, escalation policy is executed to make sure that conflict is appropriately evaluated and managed.

The other potential conflict of interest is credit evaluation and consulting services in rating agencies. Ratings are primarily used by investors as a lead to the creditworthiness of the debt issuer; therefore, they are significant in the pricing of debt securities and in the process of regulating. Conflict of interest can emerge from the truth that their many users of rating agencies, and in short periods of time, the importance of different borrowers can vary. Regulators’ and investors’ main interest is productive research, impartial evaluation of creditworthiness to be issued to borrowers in favorable ratings. Since lenders pay to have their securities rated, lenders fear that rating agencies might not be accurate in their ratings so as to acquire more businesses. Another issue is that rating agencies nowadays provide necessary consulting services. Rating agencies have increased their chances of being requested to give advice on the way to solve debt issues, generally to assist secure beneficial rating. If this is the case, rating agencies are capable of auditing their individual works resulting in conflicts of interest the same as those in accounting companies when they offer to review and consulting services (Linda, 2016).

Universal banking is another potential conflict of interest. Insurance companies, commercial banks, and investment banks were a result of transparent financial institutions where economics could greatly benefit as a result of their combination, thus leading to the creation of universal banking, which combined all of the activities into one institution. With the events being in one organization to serve a large number of clients, there are multiple conflicts of interest. If the expected revenues from one institution shift upwards or downwards, employees will be motivated to distort information, the advantage of their clients, and to profit their departments (Strier, 2008).

References

Deena Z. (2016). The Indisputable Role of Credit Rating Agencies in the 2008 Collapse, and Why Nothing Has Changed. Retrieved from: https://truthout.org/articles/the-indisputable-role-of-credit-ratings-agencies-in-the-2008-collapse-and-why-nothing-has-changed/

Harper, S. (2011). Credit rating agencies deserve credit for the 2007-2008 financial crisis: An analysis of CRA liability following the enactment of the Dodd-Frank Act. Wash. & Lee L. Rev., 68, 1925.

Lawrence, J. (2018). The Credit Rating Agencies and Their Role in the Financial System. Oxford Handbook on Institutions, International Economic Governance, and Market Regulation. Retrieved from: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3192475

Linda, G. (2016). What role did credit ratings play in the 2008 crisis? Retrieved from: https://www.weforum.org/agenda/2018/08/evaluating-the-role-of-credit-ratings-in-the-2008-crisis

Sanjay, B. (2019). Rating Agency. Retrieved from: https://efinancemanagement.com/sources-of-finance/rating-agency

Strier, F. (2008). Rating the Raters: Conflicts of Interest in the Credit Rating Firms. Business and Society Review. 113. 10.1111/j.1467-8594.2008.00331.x.

Utzig, S. (2010). The financial crisis and the regulation of credit rating agencies: A European banking perspective.