The Credit Rating Agencies, Their Role in the Financial Crisis?

End of Studies Thesis What is the affair of the character place agencies, which part did they play in the late(a) m 1tary Crisis and how support their efficiency be repaird? Thesis Supervisor David Menival Emmeline Beauch vitamin A rack Franco- US March 2013 Ack straight off directgments I would low hackneyedised to give give thankss RMS and oddly the CESEM to cook taught me a chaw, helped me to grow and open up and gave me this incredible luck of studying twain years in the united States. N angiotensin-converting enzyme(a) of this phenomenal experience would slang been possible without them.I would in addition like to thank northeastern University for exclusivelyowing me to discover a in the buff culture and a diametric educating arrangement. It extravagantly had a horrible accustom in my future accomplishment and professed(prenominal) c beer. In addition, I would like to thank solely the professors I had during these quartette years of studying, whether it is at CESEM or at Northeastern University. They do this voyage rase to a greater completion profit up to(p) and enjoy up to(p). I would excessively like to thank David Menival, my thesis supervisor, who accepted to work with me on this project.Finally, I would like to thank my p bents for eer and a day supporting my choices and being close to me when I requisite them. They rescue been my guides and manakins in life and hold always encouraged me to be posture out and push myself. Tcapable of Content Introduction4 I. authoritativeisation rank Agencies map and methods5 1) memoir5 2) Role and methods7 3) The Is fulfilr-Payer beat 9 II. The character reference range Agencies and the pecuniary Crisis is the thermometer ac existledgemen iirthy for(p) for the fever? 12 1) Background of the pecuniary Crisis12 2) address military measure out Agency argon non richly answerable 14 ) plainly they could get through wear out17 III. What is next? 20 1) Lessons wise(p) from the crisis 20 2) Regularization of the existing faith station formation 21 3) A freshly constitute lay out brass23 4) intro of untested Credit place Agency24 Conclusion26 awards27 Bibliography32 Introduction A trust range style is a caller whose subroutine is to try the default happen of a espouseer, whether it is a private or world company or a State. Since 1909, when blues emitted its first place, the component part of the Credit rate Agencies has considerably evolved and the methods apply have mitigated.Even though their places do non key out debaseing or manageing recommendations, they rapidly gained an almost biblical potentiality. Since the 1980s, the realisation judge agencies have, therefore, become a reference for layors that want to delay the honorable mentionworthiness of an entity. Their evaluations operate investors behaviors and they atomic number 18 in impartly involved in the future of a State or co mpany. After several economic meltdowns and the recent pecuniary crisis, the three big Credit rank Agencies have been the c show of assistance.Is their methodological analysis appropriate to evaluate the quoteworthiness of an entity? Does the issuer- fabricateer gravel insure the stovepipe transparence? Their role and implications in the crisis have been meticulously examined and their functioning system has been incertitudeed. Although their role in the crisis in undeniable, are the only responsible of the crisis? The system was defaulting and the predictions of the consultation rate agencies turned out to be wrong. Which modifications should we bring to the system to base it more than than transparent and efficient?These are the questions we pass on try to answer end-to-end this thesis. I. Credit ranges agencies role and methods Credit Ratings agencies, entity silence little hit the sack distant the fiscal communities two years ago, found themselves at the ce nter of attention with the subprime crisis. If e rattlingone more or little gets, now, familiar with what a recognize rate superpower is, people usually do non know what are the origins of this business, its rationale and its make posture. 1) HistoryThe influence of the three main mention military rank agencies (Moodys, regular & uglys and Fitch Ratings) was build shade by step since their inception, in the early 1900s. Historically, the grades issued by the agencies did non have more value than the ones given by analysts or economic experts. They acquired this grumpy status when legislators and regulators attri simplyed them a bigger place in their systems. The development of railroads companies pronounced the origin of these wide-ranging three slightly. These railroad companies were indeed fluctuating and needed nvestments to set up their infrastructures. As investors were concerned and questioned their capacity to reimburse their debts, total heat Varnum r idiculous published, in 1860, around monetary information regarding the creditworthiness of those companies in social club to help investors make their closing. Later on, in 1900, John Moody would to a fault start publishing economic data on these companies and finally, in 1909, J. Moody gave his first grades close to railroad companies in Moodys Analyses of Railroad investings by attri justing a letter to distributively of them the credit grade was born.This system was progressively espouse by others credit rating agencies much(prenominal) as Fitch make Company, founded in 1913 by John Knowles Fitch, which would later be cognise as Fitch Ratings. Finally, Less than thirty years later, the credit rating authorisation mensuration & Poors is ca-cad aft(prenominal) the merger of the Standards Statistic Bureau and the Poors Publishing Company. The development of the ratings is steamy by several factors. First, its goal is to offer a dish up for investors by providi ng useful information that will help them in their decision-making process.In addition, the relative man-sized size of the Ameri rotter territory warn investors to search for information, they would rather pay for it than waste cartridge clip accounting for it. moreover, the repercussions of the 1929 fiscal crisis and the consequences of the institution War II, loose supremacy to the Economy of the United States, in addition favored the expansion of the theory of rating. In 1970, after the failure of Penn Central Railroad, the first doubts regarding the in faceence of the credit rating agencies appeared. This was the first time that the reliability and seriousness of the ratings were questioned.In modulate to regenerate the value of the ratings, the moment (Securities Exchange commitment) created, in 1975, the Nationally Recognized statistical Rating Organization (NRSRO) designation. The goal was to standardize and formalize the ratings regarding brokerage firms and b anks with their pileus ratios. At that time, seven agencies acquireed the NRSRO designation. In 1990, after several novel mergers, the matter of NRSRO was only of three Moodys investor service, Standard and Poors and Fitch Ratings. In 2003, the Canadian chest Dominion Bond Ratings service Ltd similarly ained the status of NRSRO, followed by A. M Best Company in 2005. In June 2003, after the disorders caused by the bankruptcy of the company Enron, the mandate of the credit rating agencies and their NRSRO status needed to be examined. Multiple comprehends on the role compete by the agencies in this case were published. Even though investors mixed-up corporate trust in them, they all agreed that they should go by the NRSRO status. In 2006, after years of critics toward the credit rating agencies, the functioning curbs of the NRSROs were modified and the Credit Rating Agency Reform Act was promulgated.The object glass was to regulate the internal decision process of the cr edit rating agencies while forbidding the SEC to misrepresent the rating system of NRSROs. Right after, in 2007, three more companies were added to the heed of NRSROs Japan Credit Rating Ltd, Rating & Investment schooling Inc. and Egan-Jones Rating Company. Since April 2011, the list of agencies that received the NRSRO status counts ten names (See break 1, varlet 27). Finally, in July 2010, the DoddFrank Wall Street Reform and Consumer apology Act built the control over the ratings practices.This included a drop-off of the negates of busy regarding the ratings of structured products and decreased dependence on ratings. It to a fault allowed investors to sue a credit rating agency in case of wangle or reckless rating. For decades, the three main agencies, Moodys, Standard and Poors and Fitch Ratings, have been controlling the mart, as high barriers to enter exist. The major ones are the importance of the reputation and the investors confidence in their ratings. Since the ir creation, these agencies have distinguished themselves with a particular role and specific methods. ) Role and Methods The Credit Rating Agencies evaluate the creditworthiness of debtors. Ratings skunk concern a company as sound as a particular emission or securitization or any pecuniary debt. They are usually solicited by the debt issuer but fuel also be attributed, if non-requested, after collecting ordinary information. Credit Rating Agencies enjoyed a purify reputation and an essential role in the funding of economies. Over time, regulators, for practical reasons, tried more and more to impose the use of the notation in the investors monetary backing.This long-term trend follows upon the systematic financing by the groceryplace, whether it is in a simplistic formulation taking the shape of debenture or assimilated loans or new products where the insecurity of defect is hard to espouse because it is diffuse in complex financing methods much(prenominal) as the securitizations. Credit Rating Agencies have the role of processing the information for financial markets. They compound the information for market needs and the investors seemed to excessively grant their confidence to this information.Investors pay close attention to any modifications in ratings or to any entities placed under observation. The ratings issued by the credit rating agencies have a trustworthy value. Since investors usually do not take the time to look for information regarding a company or a State, they based their enthronement funds choices upon the rating given by the credit rating agencies. Therefore, the role of the credit rating agencies is essential. Basically, these agencies summarize all information available active a company or State and turn it into a rating that will then influence the future of an entity.However, it is necessary to underline that the ratings given are not bribeing or staging recommendations, they are only an military rank of t he creditworthiness of an entity, at a defined time, and statically calculated. Next to this informative participation, credit rating agencies contribute to the management of portfolios by giving advice to the investors via the medium-term orientations emitted with the rating. If a company tries to pay itself, the received range will be ascertain for the conditions of the operation.Whether it is by financing through banks or by issuing bonds on the market, the more the ramble will be raised, the more the company will be able to find cheap gold at low inte relief rates. On the other hand, a frightful grade will imply higher(prenominal) occupy rates and difficulties to find financing. The difference of levels amongst both invade rates will constitute the risk premium. This problem becomes particularly meaning(a) for companies or States located within the speculative category. Major institutional investors do not want, indeed, to take the risk and, therefore, do not invest on these kinds of values. However, the rating is ot fixed and fluctuates end-to-end the life of the bonds. A decrease of the rating gage lower the price of the bond. Likewise, a raise of the rating fecal matter be associated to an increased price of the bond. In order to correctly modulate the default risk, Credit Rating Agencies use diverse quantitative and soft criteria that they translate into a grade. Credit Rating Agencies distinguish two types of ratings terse and long-term the traditional rating that applies to loans emitted on the market and the reference rating that measures the risk of counterparty for the investor represented by this issuer.When evaluating the financial risk, credit rating agencies first take into affection purely financial numbers such as the profitability, the return on investment, the level of cash flows and debt, the financial flexibility and the liquidity. More and more, the agencies integrate non-quantitative elements such as the governance, th e social responsibility of the company and its strategy. It is also necessary to highlight the fact that the rating is usually associated with medium-term orientation, allowing to fail visualise the future trend regarding the quality of the issuer.In nearly cases, a borrower can be placed under observation. The main steps in a companys life (mergers, acquisitions, big investments) are indeed, likely to influence and modify their structure. Credit rating agencies, subject to preserving the confidentiality of the received information and avoiding cases of insider trading, can have insider information on the financial state and the future prospects of the analyse issuer, while reducing the cost of collection and data processing. They distinguish themselves from financial analysts, who, in principle, only have access to the ordinary information.Even if they can eudaimonia from insider information on behalf of issuers, they are dependent on the information provided by these issuers . Each Credit Rating Agency possesses its own rating system. In broad outline, grades are established from A to D with intermediary levels. Thus, the lift out grade is AAA, then AA and A for Standard and Poors or Aa, A, etc. for Moodys. In addition, we can also find talk terms ratings a + or a - but also a 1 or a 2 can indeed be added to the grade (e. g. AA+, A-, Aa2, etc. ).This allows a better and more precise classification of borrowers. These different ratings can be divided in two groups the first category, soaring Grade includes all ratings amidst AAA and BBB and the second category, also known as speculative, for inferior grades. (See designate 2, page 28) The biggest advantage of this system is to provide information at low costs for potential investors. give thanks to an easily understandable grade, but incorporating a vast amount of information, investors can rapidly have an idea of the creditworthiness of a borrower.The ratings issued by these agencies are a more a nd more useful tool in the decision-making process of investors facial expression for pertinent information. Current commandment obliges them to certify published information. As we have previously seen with the United States or Greece, the market strongly reacts and or sotimes irrationally to any modification of a rating or to a simple announcement of a hypothetical revision. Credit Rating agencies have a real influence on markets. The impact of their decision on issuers and investors is decisive.On the contrary, an excessive re do was completely predictable in front of their incapacity to call the financial crises of these concluding decades. 3) The issuer-payer model For more than half a century, investors that stipendiary to book financial information about loan issuers financed the credit rating agencies. Thus, companies, local communities, States were given a rating, without asking for one or without their consents, but to answer to requests from bankers or investors th at were holding these funds.Naturally, these non-requested ratings were only based on public information concerning such or such company. The Credit Rating Agencies sell their publications to bankers and swell holders who were smell for potential adequate investments. In addition to selling these manuals, the credit rating agencies could also offer others services to investors (weekly information about financial results of rated companies, actualization of the ratings, recommendations and advices of purchase and/or sell).However, the agencies will lose many profits as some investors managed to have the information and the manuals without paying for them. As from the counterbalance of the 1970s, Credit Rating Agencies started to charge their services to the issuers of bonded debt. This is the issuer-payer model. These issuers of debt (Companies or communities tone for investment) began to more and more directly solicit the agencies in order to obtain a rating. They believed that this rating would reassure investors during a slowdown of economic growth.Thus, from now on, it is more often the issuers of debts that will request a rating from the credit rating agencies to get an evaluation from them that would allow them to access to credit. This approach contributed widely to consolidate the place of the Credit Rating agencies and to legitimize their intervention. In fact, this translates easily a swing of the balance of power between those who look for funds to invest in industrial projects and those who hold funds, while waiting for the best yield at the slightest risk.In a world highly regulated by finance, where pensioners and holders of capital are in a strong position, and where industrial and direct investors are in a position of requestors, it is now, more often, issuers who wish to borrow and will ask to be noted, that will pay the credit rating agencies for their services. This shift from an investor-payer model to an issuer-payer model compromise d the independence of the credit rating agencies. In fact, in 2011, only 10% of the revenue of the agencies came from funds holders who cute to know more about the validity, the risk and the potential profitability of an investment.From now on, the ones looking for capital are the ones financing 90% the credit rating agencies. The issuer-payer model strongly modifies the web site of the credit rating agencies. In this bit, the rating agency is used, and paid, by the market player who wishes to be noted to then be able to hope to obtain capital on financial markets. The question of the independence of the agency in its rating process is then very directly put the rating agency will be disposed(p) to note well a company which pays her to then try to obtain capital in near(a) conditions on behalf of miscellaneous investors.However, the market has faith in this independence since a credit rating agency has to entertain its reputation, and thence an agency could not take the risk o f over evaluating one of its customers by aid of losing its credibility and thus all business. Credit Rating Agencies seem, indeed, more and more subjected to conflicts of affaires, which decrease their reliability. The issuers pay the agencies to be noted, while credit rating agencies need the revenues from these same issuers. Besides, more and more often, the credit rating agencies mix two activities consulting and rating.Therefore, in addition to evaluating a company, an agency also advises on incumbent operations. A study for the SEC in 2008 revealed that some analysts from certain agencies participated in meetings between investors and issuers in which commission and rating were fixed. These conflict of interest generated criticisms and accusations against credit rating agencies and especially during the recent financial crisis. As the credit rating agencies were essential and indispensable to any players on the market that wanted either to invest or to find capital, they we re at the content of the upheaval.II. The Credit Rating Agencies and the monetary Crisis is the thermometer responsible for the fever? In order to determine the responsibility that the credit rating agencies have in the financial crisis of 2008, it is necessary to understand how the crisis happened, which events punctuated it and what has been the behavior of the rating agencies throughout the crisis. 1) Background of the fiscal Crisis Everything started when the American housing market suddenly collapsed after a plastered rise in the 2000 years.To finance their consumption and acquisition of a house, American households did not hesitate to get into very high debts. The market was roaring so there was a trust in the ability to get its money binding with a substantial profit. As counterparty, they pawn their properties. This was a guaranty for banks to be paid because if the borrower could not reimburse what he owed, his position would be sold to honor his debt. When the phenom enon grows and affects a large number of households, the sales event of their property causes the collapse of the value of the property.The downturn of the housing market was reinforced by the subprime system. Since 2002, the American Federal Reserve, which encouraged easy credit to get ahead the economy, allowed millions of households to become homeowners thanks to premium loans called subprime, with variable interest rates that can r severally 18% after three years. These interest rates are fixed match to the value of the property the greater the value, the lower the rate and vice versa. That is what happened when the housing market collapsed in the United States in the beginning of 2007.Households, lacking of ways to reimburse their debts to lenders, have caused the bankruptcy of several credit institutions that could not repay themselves since even when taking on the property, this one has a lower value than initially. Finally, banks were also touched by this phenomenon. They have indeed been numerous to invest in these lend institutions. Nevertheless, immediately, invested funds are gone. In order to compensate these losses on the housing market, banks were forced to sell their shares, slip bying to a decrease of their values on the financial markets.The crisis quickly expanded in Europe, where major European banks such as Dexia in France and Benelux or IKB in Germany lost a fair part of their investments. Besides, the bankruptcy of several European banks led to a confidence crisis on European financial markets. curses have doubts about each others defilement by the subprime crisis and therefore, to be cautious, refused to lend money. Since planetary banks are linked to each other through financial agreements, the crisis rapidly extended, to reach Asia during the summer 2007.Only one termination seemed conceivable for banking institutions to face this lack of liquidity sell their shares and bonds. This truehearted and quick intervention caused a sharp drop in pedigree value and all the European declivity markets were affected (See Exhibits 3 and 4, page 29-30). In order to appease the crisis on the markets but also to earnest out banks, the American Federal Reserve ( cater) and the Central European Bank (CEB) decided to inject liquidity in the monetary system, hoping to gain back the confidence of investors to help stabilize the situation.On 9 August 2007, the CEB acted first by making available 94. 8 one million million euros to banks, followed shortly by the FED which injected $24 billion to appease the spirits of investors. However, markets initially misinterpreted the message, considering their involvement as a sign of weakness. The next day, the CEB injected again 61 billion euros and the FED, $35 billion, but the markets felt down again. Finally, on August 13, 2007, the same action was repeated and the monetary market as well as stock markets around the world kept their heads above water.While it seemed like th e financial crisis was washy away at the end of 2007, a second wave of crisis appeared from the banking sphere at the beginning of 2008. This was due to the creation of new products such as residential mortgage-backed securities (RMBS), Asset-backed Securities (ABS). In fact, credit risk, such as subprime mortgages, were pooled and backed by other assets, more or less risky, in Collateralized Debt Obligations (CDO) (See Exhibit 5, pages 31). These clusters of bewildered debts were then sold on the stock metamorphose by the issuer, like shares of a company could be given up.This results in the transfer of the risk of non-payment from issuers of mortgages to financial institutions in particular banks, major consumers of CDO. In order to invest on the CDO market, some financial organisms went even further and created Structured Investment Vehicles (SIV) that did not have to respect the usual rules of prudence of the banking system. This amplified the risks taken and losses impacted on the performance of the bank. early(a) new products were also created such as Credit Default Swap (CDS), an insurance contract between two entities against a risk faced by one of two entities, such as the non-payment of a debt.The price of the CDS reflects the confidence in a particular issuer of a debt and is the basis for determining the value of the product of the debt. The crisis took a new dimension on September 15, 2008 with the bankruptcy of Lehman Brothers and AIG (narrowly saved by the Fed), as well as several American and European banks (HBOS in United Kingdom, Fortis in Europe, Dexia in France and Belgium, etc. ). This international and financial crisis motionlessness has repercussions on todays stock markets and the end of the tunnel seems cold away. The question raised here is the role played by the Credit Rating agencies in the crisis.Are they the only ones to lodge for anything that happened? Are the actions intended by the rating agencies responsible for the c risis? 2) The credit Rating Agencies are not fully responsible Ever since the crisis, the credit rating agencies have been easy targets to blame for what happened in 2007 and the years after. Effectively they did not anticipate the downturn of the market, they act to attribute cracking rating to banking institutions already hurt by the crisis with an increase book of bad loans or bad papers that banks will have to deleverage.Many criticisms have been emitted about toward them. However, it is important to point out that they are not the ones and only responsible for what happened. They did not have power over a lot of factors that went wrong, and for that they cannot be the only to take the fault in the financial crisis. The thermometer could not be responsible for the fever. First of all, they are not responsible for the bankers or mortgage brokers who gave loans unwisely. These institutions lacked of common sense and thinking when offering credits.Banks and managers dead knew th at unemployed borrowers would neer be able to reimburse their mortgages. They have, indeed, disproportionately unresolved the gates of credit by taking for guarantee, when they did take some, the increase of real estate prices or their trust in the growth of the economy. They thought that they could make benefits if the debtor did not pay, as they believed that they could force the sale of the house for a higher price. However, real estate prices always end up passing game down and the economy is fluctuating.In an attempt to reduce the risk of these new kinds of loans, banks used securitization they transformed these loans and resold them on the stock market. Therefore, mortgages securitizers are also to blame. Some companies such as Washington Mutual, Morgan Stanley or Bank of America were mortgages originators as well as mortgage securitizers, other like Goldman Sachs, Lehman Brothers and Bears Stearns bought mortgages directly to subprime lenders and pooled them together to re sell them to investors. However, as soon as a debtor was not able to pay back his mortgages, the security became toxic and had no more value.Nevertheless, this was not the last step. Some banks would buy and bundled mortgage backed-securities into collateralized debt obligations, composed of different levels of risk. The creators of these new financial products are also responsible for the crisis. They bet against these risky CDOs by using credit default swap. (See exhibit 5) Government Sponsored Enterprises (GSEs) could also be blame for what happened. They indeed, control the mortgage market. When a bank or a mortgage broker wanted to take off his books a loan, it could sell it to a GSE, which led to a higher number of mortgages.Fannie Mae and Freddie Mac are the two major GSEs. Alone, they own or guarantee half of the current mortgages. With their government activity status, investors can buy those bonds while asking for a low interest rate in return, as federal government bond s have the safest credit rating in the world. As long as debtors paid back their mortgages, Fannie Mae and Freddie Mac would be able to pay their creditors too. However, as these loans where often given out, even to people we knew could not reimburse, GSEs had to assume the risk. Therefore, we could also say that investors could be blamed for the role they played.They bought and invest in financial products they did not know about. They should have conducted researches about what they were purchasing and should have known these were subprime and meant a higher risk of non-payment. However, we have to see the bigger picture. At that time, banks received pressure from higher instances to encourage homeownership and so, to grant loans to the poorest population. The government wanted households with a less comfortable life to be able to buy their own house. The pressure that was put on the banks forced them to give mortgages to debtors that would ikely not pay back. This being said, bor rowers are also responsible for contracting loans that they pertinently knew they could not afford. Moreover, the credit rating agencies are also not responsible for the debt of the countries. They have often been accused to do be the reason for the shortfall of some countries such as Greece. Nevertheless, Greece has always had a huge deficit. They never had a break-even budget in 150 years, and governments from left to right parties systematically laid about the finance of the awkward.In addition, the national sport is not the Greco/ papist wrestling or the Marathon but how to avoid paying taxes zilch in which the rating agencies were involved. Furthermore, regulators could have also done a better job to prevent the crisis. In the United States, several regulators exist and each of them has a specific area of expertise. The regulation of the banking sector is shared between the Federal Reserve (Fed), the Office of the Comptroller of the Currency (OCC), the Federal define Insura nce Corporation (which guarantees the deposits of bank customers) and the Office of the Thrift Supervision (OTS).There is also The Securities and Exchange Commission (SEC) that is responsible for the supervision of stock exchanges. The financial manufacturing Regulatory Authority provides the regulation of brokerage activities. Finally, the Commodity Futures Trading Commission (CFTC) insures the regulation of futures and options markets. This various regulators could have acted to appease the situation. The SEC could have, indeed, regulate lending practices at banks and force them to keep more capital reserves in case of losses.The Federal Reserve could have contained the housing bubble by setting safer mortgages lending standards, which it failed to do and especially when Alan Greenspan who was the head of the FED, refused to emend the interrogatory of the subprime mortgage market. Finally, according to the Financial Crisis Inquiry Report, executives in the main investment bank s did not hold enough capital to be fully defend against losses. Some companies, such as Lehman brothers or Citigroup would just hide bad investments off their books.It is mainly a problem related to the liquidity crisis that led to the bankruptcy of Lehman Brothers. Lehman Brothers, indeed, financed itself on the short-term and lend on the long-term. When the source of the financing dried up (banks did not trust each others by fear of not being paid off), Lehman found himself stuck and was enabled to face its commitments. If the credit rating agencies were not responsible for the mortgage originators or securitizers, the creation of the CDO, the regulators or the executives of the investment banks, they surely played a tremendous role in the crisis ) But they could have done better The credit rating agencies are responsible for a lot in the financial crisis. some(prenominal) aspects of their business as well as the actions they have done have been pointed out as the main cause of the crisis. First of all, the pertinence of their business model was questioned, among others the oligopolistic situation of the market and the conflict of interest created by the issuer-payer model. The Big deuce-ace (Standard & Poors, Moodys and Fitch Ratings) generate 95% of the $6 billion market that the rating business represents.These three agencies dominate the market and adopt similar methodologies and practices. The business model of the rating agencies establishes itself on the independence and the credibility granted by the financial markets and the authorities of supervision. That is why, in the absence of statutory reforms and / or of the desertion of numerous customers, the leadership of the Big Three will be maintained, valueed by strong barriers of entry (reforms difficult to set up and loyalty of issuers often connected to the heaviness of the rating process).Besides, the oligopolistic situation is strengthened by a consolidation, on the initiative and thus f or the benefit of the Big Three. So, Fitch acquired in June 2000 the fourth American rating agency, Duff and Phelps, and in December 2000 Thomson BankWatch. At the beginning of 2006, Fimalac gave up 20 % of Fitch Group (who, herself, holds Fitch Ratings, Fitch Training and Algorithmics, this last company having been acquired in 2005) to Hearst Corporation. Likewise, the French subsidiary of Standard & Poors acquired ADEF (Agency of Financial Evaluation).Another reason why the credit rating agencies played an important role in the financial crisis is because of the conflicts of interest they were facing with the issuers. If some say that these conflicts of interest were of minor importance since there are always conflicts of interest in relationships, in that case, it had serious consequences on the global economy, as they are one of the causes of the subprime crisis in 2008. It is, indeed, the issuer that pays the rating agency so that this one estimates its capacity to pay off i ts debt.It is thus relevant to wonder about the partiality and the objectivity of the rating agencies which find themselves at the same time judge and judged and which can be inclined to note well its customers to keep their market share. Besides, the transparency that the rating agencies show in their methodologies and during their changes of ratings is unreliable as far as these sudden reversals seemed to have destabilized the markets. The three major credit rating agencies also contribute to worsen the financial crisis by their practices. They were, indeed, a key factor in the financial meltdown.They attributed a rating to any products offered on the stock market. Even mortgage-related securities received a good grade, which made it easier to market and sell them. As we have seen previously, the ratings that they gave had an almost biblical function, so investors trusted the rating agencies to be fair and to give relevant grade to each product and did not conduct further prob e regarding their investment. Credit Rating Agencies were necessary to the mortgage-backed securities market each actor in the process needed them The issuers, to approve the structure of their deal The banks, to determine what capital to hold The investors, to know what to buy Since 1970, when the credit rating agencies got the status of NRSRO, the SEC decided to base the capital requirements for banks on the grades given by the rating agencies. This is also included into the banking capital regulations as the recourse rule, which allows banks to hold less capital for higher-rated securities. The SEC also prevented money market funds to buy securities that did not receive ratings from at least two NRSROs.Without these good ratings, banks would not have been able to place these financial products so easily onto financial markets, and the investors would have never bought them. Theirs ratings helped the market to go up rapidly and their rates between 2007 and 2008 wreaked havoc ac ross markets and firms. These ratings, especially the ones for the mortgage-backed securities, appeared to have been very optimistic. But what we could observe, throughout the crisis, is the gregarious reflex of the credit rating agencies.They usually agreed on the ratings and when one of them downgraded a security, a company or even a State, the others would usually follow and did the same thing. As we have seen, the Credit Rating Agencies have indeed played an important role in the financial crisis. However, they are not the only one to blame. Thus, we can say that the thermometer is not responsible for the crisis but it could have given a better temperature of the situation. III. What is next? As we discussed, the credit rating agencies have been criticized a lot during the crisis and some flaws of them have been pointed out.In order to improve their efficiency, it is important to understand what we have learned from the crisis and then propose a better regulation or an choice to the Big Three. 1) Lessons learned from the Financial Crisis The first lesson learned from the crisis is the impact of the globalization of financial markets. This has linked countries together in a greater extent than they were before. That is why, in todays economy, any crisis that hits a main field or group of countries will have repercussion on all other countries. The financial crisis of 2008, started in the United States with the subprime bubble.Then it grew bigger and affected the rest of the world almost immediately compared to the 1929 crisis which also had worldwide impact but more gradually. We have to keep into consideration this new factor and cod that globalization plays an important role in the current worldwide economy. In addition, a state and its financial system need to be better prepared to face the crisis, in order to limit economic and financial damages. This content having a sound and well-regulated environment, keeping its inflation rate low, its exchange rate flexible, and its debt position sustainable.By doing that, a country would limit its vulnerability in front of any financial crisis. Moreover, the country should use fiscal and monetary policies to be able react quickly in case of outside(a) shocks. Another lesson learned is the question of the financial supervision. The global crisis is a crisis of confidence, which must(prenominal) impose rules on investment in the financial market, such as CDS (Credit Default Swaps) and short-selling of securities, clearing of OTC derivatives to reduce risks, CSD (Central settlement and Depository) regulation to protect investors and also Hedge Funds transparency.In macroeconomics, monitoring means imposing laws and rules on a structure with what is called the invisible hand. In our case, the invisible hand is the World Bank and the International Monetary Fund and the States, which have full power to intervene and better regulate transactions in the financial markets. This crisis also rev ealed some weaknesses regarding risk planning. Research based on various methods, including country case studies, confirmed that the more the planning is important, the more the quality of the financial services of a country is raised and more the financial intermediation is efficient.The planning of the risks led a certain number of countries to revise their financial structures to adapt itself to the global economic transformations. Finally, we can say that every good thing comes to an end, positive times do not last forever and the end is most likely going to be painful. In todays financial system and global economy, we cannot avoid financial crisis, we can just hope that enough efforts will be done to improve our financial system and to limit the impacts of future crisis on our economy.If we focus on Credit Rating Agencies, to have a sound environment, it is worth considering a better regularization of our existing Credit Rating system, a new and improved rating system or the p romotion of altogether new credit rating agencies. 2) Regularization of our existing Credit rating system After the dysfunction of our system translated for instance into the collapse of Lehman Brothers, the disappearance of noted institutions such as Bear Sterns or Merrill Lynch, G7 members stressed the financial attention to improve its functioning mode and enhance the regulation. some(prenominal) critics have indeed been enjoin to the credit rating agencies regarding the methodologies used by those agencies (including the growing place of the so-called political factors), the lack of transparency of their decisions, the rudimentary explanation accompanying the changes in notation, the moments selected to realize their announcements of ratings and finally, the potential conflicts of interest. All these aspects need to be taken into consideration when aiming to regulate the rating agencies. Various reform purposes have been recommended.Among them, you find some proposing the suppression of the governments influence over this industriousness, or even the creation of a completely government-sponsored rating entity. However, the final goal is the accuracy of the credit rating. The first main step toward a better regulation happened in 2006, when a new section to the Securities Exchange Act has been added. The objective was to improve rating quality for the protection of investors and in the public interest by fostering accountability, transparency, and competition in the credit rating industry (ANNUAL SEC REPORT, supra note 22, at 16).The market is an oligopoly the Big Three set the tone for the rest of the industry. Encouraging competition should give more choices to investors, at a lower cost and with better quality ratings. Several rules were added along the way, especially in 2009, when the SECs new rule addressed conflicts of interest, fostered competition and required detailed disclosure. For example, a NRSRO could not anymore issue a rating in whi ch it had advised the bank or the issuer for the structure of the product.Another change emerged from the Dodd-Frank Act, in 2010, where a whole chapter has been dedicated to the rating agencies improvements to the regulation of the Credit Rating Agencies. The Dodd-Frank Act qualified the agencies as gatekeepers for the debt market and that is why they needed public oversight and accountability. This meant reducing the investors combine on ratings by limiting references to NRSRO ratings from rules, increase the liability exposure, maintaining and informing on the structure of the ratings, as well as filing control reports yearly.However, both of these new reforms showed weaknesses, particularly in addressing the conflicts interest coming from the issuer-payer model, or the oligopoly. As mentioned before, several proposals would appear more efficient to answer these problems. The first proposal would be the elimination of the NRSRO status, which would remove any regulatory reliance on the ratings. This would also drive prices down as there would be an increasing competition, but it would also improve the rating quality and the innovation.Nevertheless, this proposal would lead to a total revision of the entire bank regulatory system and could also increase the pressure to satisfy issuers. The second proposal was to create a totally government-sponsored rating industry. This would make the rating a public good, eliminating any conflicts of interest due to the issuer-payer model. Although appealing because it resolves one of the main critics emitted during the financial crisis, it does not say who is going to pay for the subsidization.Finally, another more recent proposal called disclose or disgorge asks for the agencies to disclose the quality of the ratings they give, which means disclose to the public when a rating is low quality or disgorge benefits made with the rating. However, charging penalties would increase the barriers of entry on this market and disco urage potential NRSROs. The rating business faces two major problems, the oligopolistic situation of the market that is being maintained by an increased regulation that secures the Big Three, and the issuer-payer model that fosters the conflicts of interest.Even though several reform proposals have been suggested, none appears to be totally conceivable. 3) A new rating system We have seen that a lot of reform proposals exist in order to enhance and increase regulation of the rating system. These proposals, indeed, reveal that some aspects of this business need to be improved. Eventually, a new rating system is worth considering. First of all, we have realize already touch based, throughout this analysis that the business model of the credit rating agencies needs to be modified, especially the issuer-payer model.The fact that the issuer is the one that pay the agencies for their ratings creates a conflict of interest that has to go away to insure an exact and objective rating. In o rder to solve this issue, a new model is necessary. A possible idea to get there would be to make, not the issuer, but the investors (the ones that want to know the rating of a company or an entity) to finance the credit rating agencies. It is indeed them that need to know the rating of an entity, so it would be fair for them to pay in order to know what they are investing in.This would solved the problems related to the conflict of interest as rating agencies will not be tempted to give a good grade just to satisfy the client and avoid loosing profits. This was actually the model that existed before 1970, when the issuer-payer model was established. The shift to a model investor-payer would constitute a deep change for the whole rating industry but would pull off the conflicts of interest. Another change that would be conceivable would be to set up a rating planning. The credit rating agencies should emit their grading at a known rhythm.Therefore, companies or States would know wh en they would be rated. For example, every January 1st, they could give their ratings for all entities. This would avoid sudden downgrades as we saw during the crisis, where rating agencies lowered the rating of a company right before it went bankrupt. Furthermore, to improve the accuracy of the ratings, a distinction between the rating of a company and a State should be made. In fact, Credit rating agencies do not evaluate the same thing when rating a country or a firm.That is why different ratings should be given according to the nature of the entity. Finally, this new rating system should have a better transparency of ratings. As this has often been reproach to the agencies, it is clear that we need to improve it. In order to get more transparency in the ratings, the credit rating agencies should be forced to make public some criteria that contributed to the rating process. In addition, when an entity is downgraded, there is ever a clear explanation.An explicit and standard comme nt should go along with the new ratings to explain the cause of the downgrade or upgrade. All these improvements should be made to obtain a more transparent and accurate rating. These changes could lead to more efficient and regular ratings where conflicts of interest would be inexistent and where the distinction between entities would improve the relevance of the ratings. 4) Creation of a new credit rating agency Finally, another solution that arises would be the creation of a new rating agency.This proposition is particularly discussed in Europe. The arguments called in favor of the creation of a European rating agency are multiple. It would be a question, first of all, of introducing more competition into a sector that is today dominated by three major actors. Standard and Poors, Moodys and Fitch Ratings are indeed sharing more than 90 % of the market, a situation which confers to the members of this Big Three a tremendous capacity of influence. To create a new rating agency woul d be a way of having a bigger diversity of points of view.The trust that would be granted by the investors to a new European agency would depend however on its capacity to avoid the criticism sent to Big Three in terms of independence and conflict of interest. It would also be necessary to specify the status of the new agency a public or a private organization? A public rating agency could face the mistrust of the investors, who could doubt its independence towards public authorities and States, which it would have the mission to evaluate. On the other hand, a private agency would look like a non-profit foundation.The rating agency would be financed by the investors who would use its notations, and not by the entities emitting the financial products, which would allow guaranteeing its independence. Nevertheless, the future prospects of such a structure remain uncertain to what extent would it be able to impose itself in front of Big Three, in a sector where the experience and the re putation of the institution play a determining role? In addition, a history of ratings would be necessary to evaluate the evolution of an entity and a strict method is mandatory for accurate rating.A new rating agency would not be able to have all of these factors before several years. To conclude, it is not easy to find the best solution to improve the current rating methods. Different regulations have been tried, all presenting good points but also flaws. However, what we need to enhance is clear better transparency, a more accurate rating and a suppression of the conflicts of interest. Conclusion The role of the credit rating agencies in todays economy is crucial. They evaluate the creditworthiness of an entity, influencing investors and interest rates.However, during the crisis, their role has been criticized. Several factors can explain their controversial position. The oligopolistic situation of the market, their supposedly trustworthy evaluations given by their NRSRO status, as well as the conflicts of interest coming from their issuer-payer model are the main causes of the critics emitted toward them. Recently, the American justice even pressed charges against the rating agencies for their role in the crisis and asked for five billion dollars. Nevertheless, even if the credit rating agencies are the ideal responsible, they are not the only ones to blame.Now that the crisis revealed the different flaws of their system, we can only improve them going forward. Several regulations have already been approved and others are still under consideration. Other ideas to enhance the rating system include a new financing model, by perhaps considering going back to the investor-payer model, a better transparency of their rating, by showing the criteria used for their ratings, and a distinction between a company or a security and a State, which are two completely different entities.Lastly, we can wonder if the Credit Rating agencies still have as much influence as t hey used to. For instance, when downgrading both the United States and France, the repercussions were minors even nonexistent. The lost of their triple A did not bring the interest rates up as it should have, since today the interest rates are historically low in both these countries. Exhibits Exhibit 1 Credit Rating Agencies with the NRSRO designation Exhibits Exhibit 2 Rating systems of the Big Three Source Credit rating Wikipedia, the devoid encyclopedia. Wikipedia, the free encyclopedia. N. p. , 7 Mar. 2013. Web. 13 Mar. 2013. http//en. wikipedia. org/wiki/Credit_rating. Exhibits Exhibit 3 Important facts about the crisis Exhibits Exhibit 4 growing of market indexes from August 9 to 16, 2007 Index Evolution Dax (Germany) -4,42% Dow Jones (USA) -5,95% Nasdaq (USA) -6,16% FTSE 100 (United Kingdom) 8,37 % CAC 40 (France) -8,42% Nikkei (Japan) -10,3% Exhibits Exhibit 5 Residential Mortgage-backed securities These tranches were often purchased by CDOs These tranches were ofte n purchased by CDOsSource The financial crisis motion report final report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. Official government ed. Washington, DC Financial Crisis Inquiry Commission , 2011. instill Bibliography * Dupuy, Claude . La crise financiere 2007-2008 Les raisons du desordre mondial C. francetv education la plateforme des parents, eleves et enseignants. N. p. , n. d. Web. 12 Mar. 2013. http//education. francetv. fr/dossier/la-crise-financiere-2007-2008-o21596-chronologie-de-la-crise-2007-2008-780. Gannon , Jack. 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