Assignment Writing Help on The 2008 Financial Crisis

To

From

Subject: Alternative policy formulations to mitigate the role that failure to regulate the credit rating agencies had in the 2008 financial crisis

Date

The 2008 Financial Crisis

            In January, you posited a request for a memorandum that detailed the alternative policy formulations that could be used to mitigate the risk of a recurrence of the 2008 financial crisis. The following is a report that delineates the alternative policy formulations towards the same. There are many alternate causes of the financial crisis that have been articulated, and many proposals that have also been proffered for examination. However, it is the considered judgment of this author that the chief cause of the crisis was a lack of adequate regulation of the credit rating institutions. As a result of the overreliance on these unregulated agencies, the consequence was the detrimental financial crisis. The report thus focuses primarily on affording alternative solutions that can be used to remedy the issue of non-regulation of the credit rating agencies.

EXECUTIVE SUMMARY

            Credit ratings issued by the Nationally Recognized Statistical Rating Organizations (NRSROs) are deemed the chief cause of the 2008 financial crisis. The regulatory agencies suffered from a conflict of interest from relying on the ‘Issuer Pays Model’, which meant that those benefitting from favorable ratings were the ones paying the rating agencies. The failure to regulate the activities of these rating agencies led to their notoriety and consequently the financial crisis.

One of the proffered policy formulations is the strict regulation of the rating agencies. Under this approach, the SEC is given more oversight authority over the rating agencies. The agencies are required to reveal their methodologies and assumptions, as well as rating histories. Besides instituting a liability clause for the agencies, the SEC also has the authority to deregister the agencies.

The benefits of this approach encompass the reluctance by agencies to use inflated ratings and engage in activities that can be termed as a conflict of interest. The strict restrictions will also gloat investors to perform independent ratings. The investors also have a legal recourse if they suffer financial losses as a result of relying on faulty assessments. There are numerous adversative effects of this approach, however. First, the SEC definition of what it considers a significant error may conflict with that of rating agencies, leading to political scuffles. Second, the requirement for greater transparency may erode the intellectual property of the rating agencies. The government is also availed greater occasion to intervene in the undertakings of the agencies.

The second alternative is the change in the business model from the ‘Issuer Pays Model’ to either the ‘Regulator Pays Model’ or the ‘Insurer Pays Model.’ The benefit is the reduction in the incidences of conflict of interest. The downturn is that the ‘Exchange Pays Model’ can only be used for traded securities. In the ‘Regulator Pays Model’, there are potential opportunities for bias. The two approaches also erode the profits of the rating institutions.

The third alternative is that of regulating the rating institutions less followed by a prudential regulation of monetary institutions’ bond portfolios. The approach entails placing the burden for safe bond holdings on the regulated financial institutions. One significant benefit is the propensity to reduce conflict of interest. It also increases openness, innovation, and efficiency in the bond information process. The drawback is that a reduction in regulation may lead to crisis if the financial institutions prove incapable of handling the credit rating agencies. Since the financial institutions are responsible for their non-traded bonds and manage them efficiently, the likelihood of this happening is minimal.

Reducing the overreliance on credit rating agencies by widening the source of creditworthiness information comes as the last approach. Under this approach, regulations mandating financial institutions to rely primarily on NRSRO ratings are eradicated. The benefits of this policy include the elimination of the need to certify and regulate credit rating bodies. The numerous sources of information reduce the systemic risk of relying on wrong assessments. The bonds market is also opened up to novel ideas, methodologies, and technologies. There are, however, many adverse consequences of this framework. The lack of extensive knowledge on the new sources of info may occasion unintended outcomes, or increase the risks. The use of many sources of information, while being cumbersome in analysis, may lead to conflicting assessments.

POLICY FRAMEWORKS

Below are some of the proposed policy formulations that can be employed in addressing the detrimental role that credit rating organizations had in the 2008 financial crunch:

Strict Regulation of the Rating Agencies

The politically obvious solution is the strict regulation of the rating institutions. In this measure, the agencies are required to reveal their methodologies and assumptions as well as providing a detailed history of their records of accomplishment and rating histories. There are already measures that have been instituted towards this direction. The Dodd-Frank legislation that creates the Office of Credit Ratings at the SEC has helped afford more regulatory authority over the agencies. The new law obligates rating agencies to release an annual report. The law also calls for agencies to disclose their methodologies, which minimizes the dependence on ratings by investors. By so doing, investors conduct reviews that are more independent for themselves.

To eliminate the issue of conflict of interest, compliance officers have been banned from working on ratings, methodologies, and sales. Furthermore, the law has instituted a liability clause for whatever may be deemed as a ‘reckless failure to conduct a reasonable investigation.’ The SEC has also been granted the authority to deregister a rating agency if it opines that the agency has flouted the law.

There are obvious benefits to this model. First, by requiring the rating agencies to disclose the methodologies and assumptions they use in conducting ratings, it bars the agencies from using mediocre ratings that give false readings. The inflated ratings that depicted some financial instruments as secure had been doctored using bloated methodologies (Ashcraft). Mandating agencies to supply the method they utilize in the analysis thus reduces the incidences of collusion.

The second benefit that strict restrictions will occasion is the gloating of investors to perform independent ratings (Chung). Since the methodologies for conducting the ratings will be freely available, private investors will be in a position to perform independent ratings. The investors can then augment and countercheck their ratings using data from the rating agencies. By so doing, the opportunity to lie to investors will be drastically reduced.

The legislation laying liability on rating agencies for any reckless failure to conduct a reasonable investigation provides investors with recourse. If investors can prove that their financial losses are as a result of reliance on credit ratings that were not done satisfactorily, then the rating agencies will be required to recompense them. One of the main reasons that the rating agencies were so reckless about their investigations was because they suffered no legal repercussions in case of a financial meltdown. The liability clause will necessitate rating agencies to be more careful with their investigations.

Rating agencies are also bound to be more careful and avoid conflict of interest if they can be deregistered if the SEC deems their operations fraudulent or malicious. The deregulation of rating agencies gave leeway to the agencies to operate fraudulently. That coupled with the lack of any legal repercussions meant that ratings could collude with financial institutions to give them favorable ratings. By giving the SEC authority to deregister them, the rating agencies are bound to behave more ethically.

However, the move may, occasion several adverse effects. First, there is the obvious conflict in the SEC definition of a significant error with that of the rating agencies. S&P president Deven Sharma argues that while defining what a statistical error is; credit rating agencies incorporate qualitative and quantitative factors. It would beproblematic for the Commission to establish a principled definition (Utzig). Using their definition of significant error, the Treasury Department claimed that S&P made a$2 trillion error in the valuation of American debts and budgets, something that S&P vehemently denies.

The requirement for greater transparency may also erode the intellectual property of the rating agencies. If the investors can perform their independent evaluations, then the rating agencies will have nothing to compete with and may go out of business. Moreover, the requirement for greater transparency increases operational costs for agencies, which also raises the barriers to entry and thereby discouraging entry. The consequence of such lack of entry is the discouragement of the development of future intellectual property. By inhibiting entry, the stringent regulatory efforts will be making the incumbent rating agencies more significant, instead of less.

Third, the increased government regulation will not solve the inherent problem rife in rating agencies, especially that of sovereign debt. By instituting more opportunities for government to meddle with rating agencies, the government will have more power to force them into offering generous ratings to the sovereign. The result will be a change in a conflict of interest from private companies to government.

Last, stringent regulations do not address the tardiness by rating agencies to change their ratings. Rating agencies have the tendency to base their ratings on a long- term perspective instead of affording an up-to-the-minute evaluation. The trend is unlikely to change since the agencies will lag in perceiving whether a given change is an exhibition of the beginning of a reversible cycle, that of a sustained decline or improvement. Furthermore, the tendency has helped prevent the angering of investors and the reduction of evaluation costs, which also aid to benefit investors. The trend that has been a target for criticism is thus not likely to be negated by increased regulation. Due to these difficulties, a second policy formulation was proffered

Change in Business Model

            It has been suggested that the business model be changed from an ‘Issuer Pays Model’ to a ‘Regulator Pays Model’ or an ‘Exchange Pays Model.’ The main issue with the ‘Issuer Pays Model’ was the apparent conflict of interest it occasioned. Even though rating agencies were required to provide accurate ratings, they were dependent on the firms selling the assets for payment. As a result, the agencies ignored several signs that included the high-risk nature of the loans and the evidence of fraudulent mortgages (Krantz). Since giving low ratings to products would be bad for business, the agencies continued to assign quality ratings to these financial packages.

            Under the ‘Regulator Pays Model’, the government will fund the expenses of ratings. Firms will conduct evaluations that are then availed to the public. The regulator then pays the agencies for the provision of the score grades. Another method that can be used is the ‘Exchange Pays Model.’ Under this method, the securities exchange contract the rating agencies to perform the assessments. The securities exchanges then avail the information to traders, pay the rating agencies, and recover their costs through additional trading fees.

            One of the benefits of a change in the model is the reduction in the incidences of conflict of interest since there is an elimination of those reaping the benefit of favorable assessments being the ones paying for the rating services. The elimination of the structural incentive for bias means that rating companies have no incentive to collude with financial institutions. The benefit relates to both the regulator and exchange pays model.

            One of the major downturns of the ‘Exchange Pays Model’ is that it can only be used for traded entities. Securities exchanges will only pay for the rating of securities that are within their portfolio. For non-traded securities, the financial institutions would have to pay for ratings themselves, or have their investors use other means of valuing securities. The model cannot be used alone; it necessitates the incorporation of an additional model. The model also does not encompass all the securities in the market, which makes it a hard sell to policy formulators.

            The ‘Regulator Pays Model’, despite reducing the structural incentives for bias, however, does have opportunities for bias itself. Since the government will be the sole ‘employer’ of rating agencies, it may force the agencies to provide favorable ratings for government debts. Moreover, there is potential risk for public outcry where the government uses public funds where the issuers can afford. The model thus necessitates the unnecessary utilization of public funds.

            Another adverse effect would be the erosion of profits for the credit rating agencies. These agencies are competitive and rely on contracts by financial institutions to generate revenues. The financial institutions have to pay a competitive rate hence either enacting any of the two proposed models will lead to lower pay by the sovereign or the exchanges. Moreover, the rate will be balanced for all the regulators, which reduces the incentive to innovate. The ratings will thus be done using old methodologies, something that is detrimental to sustainability and growth.

Less Regulation of Rating Agencies, followed by a Prudential Regulation of Financial Institutions’ Bond Portfolios

            Contrary to the first alternative is the call to regulate rating agencies less, but at the same time require a significant revision of the prudential regulation of a bond’s portfolio. In this proposal, the Prudential investors place the burden for safe bond holdings not on the rating agencies but the regulated financial institutions (L. White). There will be no need for stringent regulation since, after all, the credit rating agencies are not liable for any unsafe information they provide.

            A significant advantage of the measure is the tendency to reduce conflict of interest. In the past, conflict of interest has exhibited itself where financial institutions collude with credit rating agencies to offer them favorable ratings. The decision to confer the liability for unsafe bonds on the financial institutions eradicates the incentive to collude. These institutional investors are prudential and sophisticated, and will demand the highest quality ratings from the rating agencies (F. Partnoy). Where before the financial institutions required agencies to afford doctored results that favored their securities, they will now necessitate the agencies to provide quality and true ratings to avoid litigation.

Another benefit is the increased openness in the bond information process. Since the financial institutions are liable to suffer financial losses and are the ones who pay the rating agencies, they will necessitate the agencies to avail more information on the methodologies and assumptions they use in assessments. The companies will also require the rating agencies to use more qualitative and quantitative data in performing the analysis. The result is that the bond information process will be more open, which also provides opportunities for some investors to conduct ratings for themselves. For banks, the liability is the typical burden that they bear for non-bond loan portfolios and as such, they have experience on how to mitigate the burden.

            There is also the benefit of an upsurge in innovation as well as greater efficiency in the bonds market. The financial institutions will demand that rating agencies proffer better methodologies for carrying out assessments to increase their credibility. Credit rating agencies will also be forced to be more competitive since only the ones providing the best quality assessments will be contracted. Owing to this, rating agencies will continually engage in innovation efforts to offer the best ratings, and in so doing develop the eminence of ratings (Cinquegrana). Tied to this advantage is the increase in efficiency in the bonds markets. Traditionally, rating agencies have been sluggish in changing their ratings. Part of this sluggishness was driven by a response to the preference by financial institutions to avoid frequent costly adjustments to their portfolios by frequent changes. However, with the risk of litigation, these institutions will necessitate rating agencies to change ratings often to reflect current trends. The consequence will be an upsurge in the efficiency of the securities market.

The drawback of this policy framework, however, is the reduction regulation that while beneficial, may lead to more crises especially if the financial institutions prove incapable of handling the credit rating agencies. The dogma is grounded on the premise that the financial institutions have the willpower and resources to mandate and thoroughly analyze the assessments that the regulatory agencies present (Claessens and Kodres). Where those are lacking, the result is a confused securities market. This is, however, a less likely occurrence.

Reduce the overreliance on Credit Rating Agencies by widening the source of Creditworthiness Information.

            This policy route is bound to open up the bond information market to fresh, innovative ideas, technologies, methodologies, and business model. The SEC has already instigated measures towards achieving this policy by withdrawing some regulations that mandated SEC-regulated institutions to rely primarily on NRSRO ratings. There is a variety of sources of info regarding the creditworthiness of bonds and issuers in addition to the rating agencies. By reducing the overreliance on NRSRO ratings, financial institutions will have a wider choice of information options.

            The institutions might opt to conduct the assessments themselves or they may rely on the market info yielded by Credit Default Swaps (CDS) prices. Moreover, the institutions may rely on advisors who may be the incumbent rating agencies or fixed income analysts at investment banks. The financial institutions may also upstart their advisory firms to avail creditworthiness info. Since most of the investors are primarily institutional investors, they are expected to have value judgment based on prior experience of who is a reliable advisor (Calomiris).

            The advantages of this dogma are numerous. First, it eliminates the need to certify the NRSRO system and the regulation of credit rating bodies. By scrapping the control and certification, systems that were the chief cause of the financial crisis, the risk of a reprise of the crunch will be minimized (F. Partnoy). Moreover, regulation efforts are cumbersome and do not guarantee effectiveness since they are also prone to manipulation. Without their presence, the incidences of collusion and conflict of interest are also eliminated.

            By relying on various sources of information as to the creditworthiness of financial instruments, financial institutions will reduce the systemic risk of being wrong. Overreliance on one primary source of creditworthiness information meant that if the info were wrong or had been manipulated, then the investors would have a false image of the bond portfolios. By using many measures from different advisors and sources, investors can compare the information and consequently make an informed decision on the creditworthiness of the portfolios.

Another benefit that can be derived from this policy is the opening up of the bonds market to novel ideas, procedures, technologies, and methodologies. The reliance on credit ratings hindered the quest for new methods of carrying out creditworthiness assessments. With the elimination of this requirement, advisors, invested banks, and other interested parties will search for better ways of assessing creditworthiness. Some of these analysis measures include Co Var, MES, and SLR. Systems for analysis financial system stress will also provide vital information. As a result of the shift from overreliance on credit rating agencies, innovations are bound to occur.

            The policy is, however, not without its drawbacks. Firstly, there is a lack of extensive knowledge on new methodologies of carrying out credit risk assessments. The lack of knowledge even extends to what are perceived as the right incentives to advisors and other interested parties. The lack of knowledge may produce outcomes that were unintended. Ironically, the lack of knowledge may aid to upsurge the buildup of risks instead of mitigating them. Some of the novel sources of information have had analytical failings while many suffer from ‘in-sample’ bias, which renders them ineffective if not misleading.

            The use of many indicators may also lead to confusion especially if the results from various indicators are conflicting. Since most of these indicators use different methodologies, the results may also be conflicting, which brings the dilemma of which information source to use. The reliance on credit rating systems meant that in case of conflict, there was a guideline on which course of action to take, something that would be absent in the new system. Moreover, if careful attention is not paid to the structure and participants who avail the information, the data may be skewed, outdated, or downright wrong. The result is an increase in risks, which occasions a failure of the system.

            Lastly, the new system is cumbersome and tasking. It firstly is not well developed, which means that financial institutions will be critical of the assessments, leading to more problems. Secondly, the tools of analysis are full of flaws while some of them have proved ineffective in their use. Thirdly, the choice of the advisors to use presents another headache to financial institutions since these advisors are not regulated and thus the quality of their ratings cannot be ascertained. Moreover, the use of information from numerous different sources entails financial institutions to use a lot of time and resources in analyzing and sieving out non-reliable data. The system thus proves cumbersome and utilizes many resources of the financial institutions.

Decision

            In light of the adverse outcomes of the delineated alternatives, the best policy would be that of regulating the rating agencies less, followed by a prudential regulation of financial institutions’ bond portfolios. The decision has the most favorable outcomes, and also accords the minimum risk. The decision also allows the rating agencies to generate profits while minimizing the incidences of conflict of interest, which were the chief cause of the financial crisis.

Works Cited

Ashcraft, A., P. Goldsmith-Pinkham, and J. Vickery, The Role of Incentives in the Rating of Mortgage-Backed Securities. Working Paper. Federal Reserve Bank of New York. New York: Mimeo, 2009. Document.

Calomiris, Charles W. “A Recipe for Ratings Reform.” The Economist’s Voice 6.11 (2009): 1-4. Document.

Chung, Joanna. “SEC Aims to Curb Ratings Dependency.” 26 June 2008. FIN. TIMES. Document. 24 April 2015. <http://us.ft.com/ftgateway/superpage.ft?news_id=fto07072008201 8368832>.

Cinquegrana, Pietro. The Reform of the Credit rating Agencies: A Comparative Perspective. Policy Brief. New York: ECMI, 2009. Document.

Claessens, Stijn and and Laura Kodres. The Regulatory Responses to the Global Financial Crisis: Some Uncomfortable Questions. Working Paper. Institute for Capacity Development. Geneva: IMF, 2014. Document.

Krantz, Matt. “2008 crisis still hangs over credit-rating firms.” 13 September 2013. USA TODAY. Electronic. 24 April 2015. <http://www.usatoday.com/story/money/business/2013/09/13/credit-rating-agencies-2008-financial-crisis-lehman/2759025/>.

Partnoy, F. Overdependence on Credit Ratings was a Primary Cause of the Crisis. Research Paper No. 09–015. Legal Studies Research Paper Series. San Diego: University of California, San Diego, 2009. Document.

Partnoy, Frank. Rethinking Regulation of Credit Rating Agencies: An Institutional Investor Perspective. White Paper. San Diego: Council of Institutional Investors, 2009. Document.

Utzig, S. The Financial Crisis and the Regulation of Credit Rating Agencies: A European Banking Perspective. ADBI Working Paper 188. Asian Development Bank Institute. Tokyo: ADBI, 2010. Document. <http://www.adbi.org/working-paper/2010/01/26/3446.credit.rating.agencies.european.banking/>.

White, L.J. “Credit Rating Agencies and the Financial Crisis: Less Regulation of CRAs Is a Better Response.” International Banking Law and Regulation 25 (2010): 170-180. Document.

White, Lawrence J. The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation. New York: Oxford University Press, 1991. Document.