Conflicts of Interest in Credit Rating Agencies during Financial Crisis

RUNNING HEAD: RISK MANAGEMENT 0
RISK MANAGEMENT
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RISK MANAGEMENT 1
Risk management is an important tool for every business, which is to be taken care off. In the
following context, the discussion is made on the various conflicts of interest at the time of
financial crisis, which resulted in failures of credit rating agencies. Along with macroeconomic
situation at the time, the discussion is also reflects upon market and credit risk and, how they
influence each other.
RISK MANAGEMENT is a big business. It is the formal sector, which evaluate and forecast
the financial risk together with the recognition of the process to minimize or avoid their impact
on the business.
The fairness of credit ratings is critical for the normal operation of debt markets. The failures of
the credit rating agencies have reinforce the negative impact of global financial crisis, which
generates risk. From the past three years, the global financial crisis indicated that the issues
regarding the error of the credit rating could be due entirely because of their mistakes. There are
some cases, which are dealing with the bankruptcy of large corporations for example Lehman
brothers went bankrupt in the year 2008. In spite of the individual cases of poor ratings of the
agencies, the ratings of corporate bonds also reflect the high level of credit risk. In the period
1981-2009, the standard of Gini coefficient is used to examine the awarded ratings, which
resulted in more than 77% for the bonds for the next three-year time horizon. It has not fallen
below 75% and sometimes it exceeded 90% [16, 2010]. The major important failure of credit
rating agencies is the appraisal of the risk mortgage-backed securities. In the year 2007, the
rating of structured financial instruments (SFI) was reduced by Moody’s and standards and poor
up to USD 26 and continued reducing till the end of the year up to USD 69 [8, 2008, pp. 81-110].
Therefore, a substantial drop is noticed by the beginning of the global financial crisis: 67% in the
year 2008 and 44% in the year 2009. In 2009, the values of collateralized debt obligations were
lower up to 15% only [17, 2010]. (rafailov, 2011)
The conflicts of interest, which led to define such failures of credit rating agencies involves lack
of competition in the market that limit the opinions of the investors, lack of power to secure and
analyze the information, combining consulting and rating services, lack of alternative appraisal.
The use of improper mathematical models to examine the structured instruments can risk the
chances of insolvency. Inadequate and absent information and inefficient regulation of CRA’s
gave birth to the failures of the credit rating agencies. (Neate, 2011)