Future Regulation of Credit Rating Companies
The paper discusses risk management as part of the lending business of banks and the regulations pertaining the same as well as risk management in relation to the credit crisis, the alleged role played by Goldman Sachs in causing the crisis and the defense forwarded by the company is also discussed. Outlining the fundamental essentials of risk management in relation to bank-wide capital allocation and defining the central legal and regulatory requirements on effective risk management. Due to the heterogeneous character of the credit industry, some concepts require extensive consideration of history and the past, in order to effectively and accurately give an informed opinion as regards to the prospective future regulatory measures. Contemporary risk management methods which have been advancing and the augmented utilization of inventive financial products such as securitization and credit derivatives have caused considerable transformation to the business environment.
Several schools of though have offered varying definitions of Credit risk, it is however commonly accepted that credit risk is the possibility of a bank borrower or counterparty absconding and do not honor its obligations as per the agreed terms and conditions.
A credit rating company is a company that is charged with responsibility of assigning credit scores for issuers of given types of debt requirement and at the same time evaluate the debt instruments themselves, Credit rating agencies offer independent evaluation and objective analyses about securities to investors about companies and countries that issue such securities.
The credibility of credit ratings have however been adversely been put to doubt after the 20072009 financial crisis, earlier in 2003 the in a submission to Congress the Securities and Exchange Commission elaborated plans to initiate an investigation into the anti-competitive operations of credit rating agencies in diverse issues such as ratings use by bond issuers and conflicts of interest, the step is seen as a beginning to intended extensive regulation laws and rules governing Credit rating agencies.
Emergence of Nationally Recognized Statistical Rating Organizations (NRSRO) Significant and substantial changes on the regulation of credit agencies started in 1970, when the field adopted imperative revolution and innovations. This saw the beginning of paradigm shift to issuers of securities having to pay in order to be rated. This is contrast to the past, where investors paid for publications from the ratings companies. This was occasioned by the recognition that objective credit ratings considerably increased the value to issuers in terms, coupled with the adoption of advanced statistical and analytical tools. An attempt by financial institutions led by banks reduced considerably the capital and liquidity requirements earlier agreed approved by the Securities and Exchange Commission. This led to the creation of nationally-recognized statistical ratings organizations (NRSRO). This allowed financial institutions to meet capital requirements by investing in securities positively rated by any Nationally Recognized Statistical Rating Organization, in effect leading to growth and expansion in the industry.Credit ratings, bond ratings also referred to debt ratings are issued to financial institutions as regards preferred stock, corporate bonds and government bonds. The duration of the obligation affects the rating levels. Moreover issuers take credit ratings as an independent verification and validation of their credit-worthiness and the accuracy and efficiency of the instruments they issue.
However, there has been widespread criticism as regards the regulation of credit rating agencies, in that existences of weak regulations have given credit agencies much freedom, there are several criticisms which are bound to affect any decision made in regards to regulating credit rating companies, in the present and in future, these criticisms include-
Credit rating agencies are reluctant and take time to downgrade companies punctually. Banks which have been declared bankrupt, have at times enjoyed favourable credit ratings up to the collapse stage, which whereas credit agencies have sufficient information pertaining the companys financial woes. Past research has revealed that the market leads a downgrade, therefore invalidating the need for rating since it is a product of the market. Regulatory measures have been proposed for the financial regulators to adopt and rely on credit spreads, when calculating the risk in the portfolio of banks.
Moreover, credit rating agencies been accused of undue influence by relating closely with the rated companys management, personal interests if feared to supersede the independence of rating. It is not lost that the corporations being rated are the ones who pay the credit agencies, conflicts of interests are therefore bound to occur, which may result to biased rating positions and the rating companies may not provide honest ratings. In addition, credit agencies usually offer what they belief to be the best alternative to positively affect credit score, in case companies desire to take actions. This is seen as serving and limiting the rated companies to achieving a better score, which may be in conflict or may not be in agreement with the companys goals, vision and objectives and strategic actions.
The fact that companies operate in an interdependent manner, creates a major challenge for credit scoring. An action taken by one company is bound to have adverse or otherwise effects in collaborating companies such as creditors and debtors. Any action, which may affect the credit score by a CRA can have a net result of creating a vicious cycle, to the rated company and affect the interest rate, this affects the existing contracts with collaborating institutions, this results to addition in expenses hence lowering credit worthiness, causing an increase in expenses and ensuing decrease in credit worthiness. The collapse of Enron due to rating triggers has it has been pointed out by Salter (220), is an exemplar, of resonating effects of reducing in CRA score reduction. When a rating falls below a trigger rating, some creditors demand to be paid in full, since the rated company may not be in position to honour the debt, creditors may seek to acquire the companys assets, this results to collapse of the firm. This should therefore be considered by the regulating authorities, since CRA ratings are influential accelerant in a downfall of a weak firm.
Oligopoly market behaviours is also observable in credit rating companies, in the rating market there is a domination of a few companies that deal with the rating business, the principal rating companies are recognized and entry of a new player is very restrictive. The existing credit rating firms therefore enjoy huge percentages of the market as can be attested of the very insignificant number of new rating firms, the fact that most credit rating companies rarely disclose their financial earnings, while ensuring that restrictive conditions offer a disadvantage to potential entrants.
The need for regulation of Credit Rating Agencies has been further catapulted by apparent misjudgements made by the rating companies, this is more apparent in cases were the rating companies have awarded high scores to structured products such as structured debt, which fail to reveal their true status, till a later time when the rating is reversed downwards. The rating of Goldman Sachs Abacus CBOs is an example of such a case, where the true value of Abacus could not be ascertained by the investors, since it had been rated highly by a respectable firm, Moodys. According to Carmichael et al (155 - 65), very limited legislations and regulations exist to address such shortcomings. Quality and inconsistence in rating standards is also apparent when different firms rate the same organization. In addition, there is no clear distinctive clear difference of corporate or government bonds and structured finance by the rating agencies. In addition, banks which have overly relied on the credit ratings and failed to do complementary internal risk assessment, have suffered from insufficient capital reserves.
Some rating agencies have been given a preferential treatment by the government as they play a quasi-regulatory role these are Moodys, Fitch, and Standard and Poors. However, the fact that they profit seeking entities is bound to generate conflict of interest. The rating agencies are supposed to be impartial and neutral in their ratings without being compromised, however, the fact that they are paid by the companies issuing securities means that they may work for the benefit of the hand that feeds them, hence being insensitive to the concerns of the investors. This has resulted to market stakeholders using credit rating scores it as regulatory requirement of the Federal Reserve, but use Treasuries and index to benchmark.
Credit rating agencies share a symbiosis relationship with the government in terms of regulation. Whereas governments are expected to regulation all organizations operating within its area of jurisdiction, Credit rating agencies assign credit scores to the government. The score is very important for the government, the government may therefore fail to acutely apply regulatory procedures on the rating agencies, on a political perspective, the rating agencies may manipulate the government score ratings, to win government confidence and avoid regulatory measures.
Credit Risk Management definition
Credit risk is defined as the extent of value fluctuations in debt instruments and derivatives due to alteration in the fundamental credit quality of borrowers and counterparties.
There are several components and functions of risk management, this includes
identification, where banks risks have to be recognized before they can be measured and managed, this is paramount in categorizing risk, since they fall into different classes such as operational risks, market risks and credit risks, these risks have quantifiable metrics that can be used to measure them, however strategic risks, or reputation risks, do not have a consistent methods of quantification, therefore are seldom included in risk measurement. Apart from the risks above, credit risks is also affected by other risks such as measurement risks and aggregation risks , it is therefore imperative that risk management is a process which involves planning, management and monitoring aimed increase transparency and to control risks. Risks once identified have to assessed, unswerving assessment of the aforementioned risks is an indispensable precondition for triumphant risk management. There have been advances in risk assessment methodologies however the metrics for credit risk measurement have failed to keep phase due to limitation in accessibility of past data and information. Most institutions calculate Credit risk on the foundation of probable losses from the credit portfolio this can either be expected losses and unexpected losses. The sum of individual risks may differ from overall risks, the cause should therefore be considered when aggregating risks. Risk management in addition has the purpose of planning the banks cumulative risk situation and controlling the effects of the risks. There are management tools that are used in credit risks, these measures are trading in assets, risk-considered costing of every loan transaction, insuring risks and setting loan ceilings and utilizing collaterals in loan awarding. In order to keep limits within manageable boundaries, to avoid surpassing ceilings that can be controlled by a bank, Risk monitoring is important, this also is relevant in case risk can be managed and has to be responded to.
This can be graphically represented as
Figure 1. Risk Management Process
Rating Companies regulation
Regulation of rating companies can effectively execute if the prerequisites for Efficient Risk Management are understood. These prerequisites are sound and dependable methods, organizational processes and structures as well as Information Communication Technology infrastructure. The methods are utilised to reveal means in which risks are captured, measured, and aggregated into a risk position by risk rating companies. Processes and organizational structures are utilised to guarantee risks being measured within a viably relevant time span, that the ceilings are defined and adhered to for every risk position and that mitigation steps are immediately implemented in the ceilings are exceeded. There should be a reporting methodology which considers the organizational structure and attempt to define the boundaries of risk causing areas from areas that measure, plan, manage, and control the risks. With advancement in technology and computerization, Information and Communications technology systems are infrastructure play a crucial role in risk management. These involves the use of effective enterprise resource planning tools and decisions support systems, which provide required data and information, and when needed, and to provide a means of informing the decision makers, when critical risk levels are approached.
Rating companies Calculation of Risks
There are several methods that can be employed to measure unforeseen lose however Value-at-Risk analyses and scenario techniques are adversely utilized to effectively and adequately measure a banks risk.
The methods however have different calculation means and precisions. However, they differ strongly in their calculation methods and their precision. Value-at-Risk analyses are used in complex environments while scenario analysis is a simpler alternative. Under scenario analysis, the obtainable information concerning past transactions are exercised to reconstruct probable scenario as regards the potential occurrence of default rates. Optimal conditions are called normal case, while worst case scenarios are the occurrence of extreme losses. Scenario analysis however suffers from lack of extensive presentation and explanatory capabilities due to consideration of fewer parameters. This therefore gives limited accuracy results and output. The
Value-at-Risk Concept states the ceiling of a loss that will not be surpassed with a specified probability at a given horizon. This gives better precision output with a confidence level of higher accuracy.
The Goldman Sachs Group
There have been several accusations, lawsuits and defences concerning the role played by Goldman Sachs in the credit crisis as a principal and as a player. It is therefore imperative to understand the history Goldman Sachs Group.
Founded in 1869 and headquartered in New York, The Goldman Sachs Group, Inc. is a worldwide investment banking and securities firm which is concerned with offering diverse financial services to a wide customer base especially institutional clients, these services include underwriting, securities, investment banking, prime brokerage, investment management mergers and acquisition guidance, services, and has branches located in several parts of the world.
Goldman Sachs Group has survived several past financial crises, for example the 1970 bankruptcy of Penn Central Transportation Company threatened the existence of the firm Stitch (45 - 54). This however had immense effect in the market has it resulted to creating rating services, creating credit ratings for issuers of commercial paper. The organizations image was however improved in 1974, when it invented the white knight strategy to save Electric Storage Battery from an intended takeover. Goldman Sachs Asset Management was created in 1986, several years later, it was to introduce paperless trading to the New York Stock exchange and Goldman Sachs Commodity Index (GSCI).
The firm offered an Initial Public Offer (IPO) in 1999, in which 12 percent of ownership was offered to the public, this resulted to change in management. In 2007 when there was a subprime mortgage crisis, Goldman profited in the summer of the same year, of the collapse in subprime mortgage bonds by short-selling subprime mortgage-backed securities, this lead to positive reputation of the company as portrayed by reports appearing in newspapers and financial journals then.
The downward trend, which eventually led to collapse of Lehman brothers, played a role in creating a crisis. By 2007 November however, the crisis had spiralled, occasioned by loans offered without proper analysis by the lenders and speculators keen to make handsome profits in housing markets, this caused housing bubble and bust. In 2008, Goldman Sachs converted to a bank holding company this helped to cool fears which had send Lehman Brothers into bankruptcy, then an investment services firm.
The main accusation against Goldman Sachs is that it created collateralized debt obligations (CDOs), then offered them to customers, after which it bet short against them. A CDO is a collateralized debt obligation, a security where cash flows generated by a portfolio of assets are used to repay the principal and interest. A case of Goldman Sachs CDO which has been given a lot of media coverage is the Abacus 2007-AC1.
According to Reuters, partial proceeds from the sale of Abacus 2007-AC1 notes went into the purchase of Greywolf CLO 1, while Abacus prospectus failed to disclose whom the 192 million tranche of the Greywolf deal was being purchased from, Greywolf Capital Management was related to Goldman Sachs has it had been formed by a faction of ex- Goldman upset bond traders, this therefore created a conflict of interest between investors and underwriters who were putting their own deals into CDOs.
According to the U.S. Securities and Exchange Commission (SEC), investors in the Abacus 2007-AC1 were misled since Goldman Sachs did not reveal the clear cut operations of the hedge fund manager John Paulson. John Paulson had participated in picking the underlying portfolio of mortgage-backed securities and was shorting the synthetic collateralized debt obligation as Blumberg (12-24) argues.
The Greywolf invested in a 1 billion CDO backed by mostly subprime assets called Timberwolf 1, which was underwritten by Goldman Sachs. Whereas by the summer of 2008, according to Securities and Exchange Commission, institutional investors lost 1 billion on the deal and the Abacus deal was no more, in contrast Paulson Co which was shorting the transactions made the same amount in profits. Moodys Investors Service had given it Triple A rating in February 2007, however regulators have absolved Paulson Co from any wrongdoing in the Abacus transaction.
Figure 2. Bond Rating of Moodys and Standard Poors
The collateralized debt obligations (CDOs), therefore performed very poorly, therefore the investors lost colossal amounts of money, in addition there are claims that CDO regulations appertaining CDO-default pay outs were altered in 2005to favour short sellers.
It is alleged that Goldman distorted facts presented to potential investors that an autonomous selection agent, ACA, had made an assessment of the mortgage package, Goldman is also accused of failing to reveal to ACA that Paulson Co, which had sought to short the package, had conflicting and competing objectives with ACA, which was made to believe that Paulson Co.s interests were aligned with ACAs.
Figure 3. Rankings of Abacus
The accusation against Goldman is that one of its employees, Mr. Egol was a prime mover of CDO, occasioned by sky rocketing housing prices soaring and obsession with mortgage, this was when Abacus was created. It is alleged that in a four year period, Abacus deals worth over 10.9 billion were issued. In the scheme, investors were allowed to bet for or against the mortgage securities related to the deal, since the C.D.O.s were made up credit-default swaps and not actual mortgages, which is a sort of insurance, where payments are made when a borrower defaults, this was the driving force behind the 2007 and 2008 soaring in C.D.O value when the mortgage market collapsed
In addition, Goldman is accused to have attempted to distort actual value of assets that were concerned in Abacus transactions. In the allegation, analysts at Moodys Investors Service, a Credit rating agency, were requested to assign a higher rating Abacus C.D.O. related assets. However, the performance of the C.D.Os was instrumental in the downgrading of the rating of the C.D.Os,
Figure 4, Goldman Sachs Credit rating as at 5th May, 2010.
Earlier, there had been alterations to the regulations governing CDOs, this was to the favour of banks as it made it feasible for C.D.O.s to expand faster, the developed system was referred to as Pay as You Go, in that quick payments would be made for insurance for those betting against mortgages, as was adopted by the International Swaps and Derivatives Association, the regulating organization. The new regulations also resulted to situations were investors took loses in case of mortgage market tank, in that investors were obliged to make payments to short sellers under any relegation on a bond.
Goldman which has been on the defence stated that the firm it had provided extensive disclosure to the long investors in the CDO, and that Golman Sachs incurred loses Whereas Goldman and other Wall Street firms preserve synthetic C.D.O.s, has no undue shortcomings it is apparent that the trading in synthetic C.D.O.s aggravated the financial crisis since it, in actual fact reproducing losses by providing more securities to bet against., this is occasioned by the fact that synthetic C.D.O.s and related bespoke trades are not effectively regulated and seldom reported to any financial exchange or market, as presented by Lewis (156), the importance and effectiveness of rating system is therefore put to question since Both Moodys Investors Service and Standard Poors Ratings Service rated the Abacus deal as triple-A ratings.
Credit Risk Management development principles
Banks and other financial institutions been faced with a myriad of challenges, these challenges have been attributed to poor portfolio risk management and failure to mitigate effects of changes occasioned by circumstances that can affect a banks credit rating as presented by Dell (125), this is due to some banks heavily relying on ratings offered by credit rating companies. Credit risk management is aimed at sustaining risk exposure within defined limits in order to maximize a banks risk-adjusted return rate. To effectively manage credit risks, it is prudent for banks to consider existing relationship between credit risk and other risks, the cumulative risks determination is vital for the survival of the banks.
There have emerged other sources of credit risks to banks, other than the clear-cut globally believed loans, this includes but not limited to foreign exchange transactions, interbank transactions, trade financing, bonds, equities, and guarantees. The credit rating organizations play an important role in determining the banks score, past experiences is therefore a critical factor in determining the best course of action for the present and in future.
Credit management procedures, differ from one banks to another, however, the underlying principles are the same, risk is considered when it has surpassed a stated limit, for example a credit rating point, there are therefore appropriate methods of defining Limits. The limits are a product of banks capital allocation method, strategy and business direction. To effectively measure, regulate and monitor the risk limits, a limit management system is a requisite. The system should be able to utilize existing parameters are utilized to determine limits and the indicators to be applied consistently throughout the bank. Risk measurement and management should be treated as a continuous process, where any deviation from the expected values should be dealt with immediately.
The future of regulation of rating companies
From the criticism presented on credit rating firms, there is need for policy response. There have been a range of regulation designed developments over the same, the Financial Stability Forum (FSF), standard setters, national authorities, and the Fund have joined forces to address the regulation shortcomings concerning credit rating firms, and there are therefore several policy issues which need to be considered, over the same.
There is need to expand the boundaries of financial segment supervision to gather for a more financial institutions and markets, with segregation to ensure that the credit rating institutions not only offer partial disclosure but there are upper levels of prudential oversight with increase in risks. There should also be apparatus to be used to assess and respond to, complete risks posed by unregulated or less regulated credit rating companies.
For future regulations to be effective there is need to increase the amount of information available to regulators about credit rating firms for example risks not reflected in the balance sheet, and risks which may occur due to relationship with other companies. There is also need for more transparency with investors, in that the investors can make objective judgments and offer their own perceptive rating, having enough information to allow them make informed decisions.
The regulation of credit rating companies should also consider political and legal obstacles in companies that operate in several countries, there may be disharmony in the legal requisites of several countries, it is therefore important that uniform regulations be adopted. Furthermore, the regulations should offer superior suppleness for central banks to grant liquidity and provide extensive coverage and attention on credit and asset booms. As from the credit crisis, the regulation should offer advanced crisis responses, where national governments are empowered to take drastic actions, both within the country and internationally in cases of crisis, not just wait for dictates of market forces. As regards the containment and restructuring process, the regulations should provide for economic support for restructuring firms, the regulations should also offer effectual supervision, of the activities, entities, and risks of credit rating firms. In addition, there is need for strengthening further the oversight of counterparty risk management in regulated institutions, to avoid immense effects caused by unregulated companies.
Regulations should in addition offer minimum quantitative funding liquidity buffer. These are premium assets that can be liquefied within short times this is envisioned to provide assurance and indemnity at times when the financial institutions are faced with liquidity challenges. From the credit crisis, it was apparent that financial institutions had underestimated the need to have high quality liquid collateral.
Conclusion
A success of every field requires the involvement of all stakeholders, for the regulation of Credit rating firms also to succeed it requires the involvement of all the concerned stakeholders. The laws concerning regulation should be altered to give investors a voice in the rating process, for example investors, should be allowed to seek customized professional advice from credit rating firms, at their expenditure. Or having Investor sponsored credit rating companies. Moreover, the trading companies should revel more about the product being sold to allow investors make objective judgments. Laws should be enacted to ensure that crisis effects are mitigated earlier, and that governments have the powers to offer independent audit of credit rating companies, and take in cases of crisis, the government is obliged by the regulations to take early corrective measures.
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