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is the extent to which the ratings agencies had

models appropriate for rating structured finance

products. The modeling exercises involved are

formidable but even taking this into account,

Giovanni and Spaventa (2008) note that the

models for structured finance products were

calibrated using short spans of data over a benign

period of moderation in financial markets and

rising house prices. 39 They simply had not experienced

turbulence or falling house prices to

evaluate whether the models might prove unreliable.

These problems were compounded when

rating CDOs and CDOs-squared because these

products were given too much benefit for combining

lower tranche residential MBSs, when in

fact the default risks were more highly correlated

than the models assumed and were prone to a

common shock—a fall in house prices. Fundamentally,

is a rating metric suitable for sovereign

bonds, investment, and sub–investment-grade corporate

bonds, or project finance also suitable for

structured financial products? The International

Organization of Securities Commissions (IOSCO)

has suggested that agencies should introduce

new ratings for mortgage-backed or structured

finance products because of the perception that

they behave differently than other financial

instruments in times of stress.

Whether regulation should be extended to

ratings agencies is not a new topic of debate, but

the recent experience will mean it has a new lease

of life. With its influence through the presidency

of the European Union in 2008, France has encouraged

the European Commission to propose that

ratings agencies be registered and subject to

greater regulation if they wish to operate in Europe.

This follows the recommendation of IOSCO and

the Financial Stability Forum. Ratings agencies

have long argued that they publish their opinions,

underpinned by their reputations, and the use to

which they are put is not something for which

39 In simple terms the ratings agencies assessed the probabilities of

default for individual mortgages, considered the correlations

between individual loans, used these to assess the probability of

default for the securitized products, and then rated the tranches

accordingly. Where they failed to calculate defaults correctly was

in assessing the proper weight to be attached to falling house prices

on the defaults of individual loans, the interdependence between

loan defaults, and the likelihood of falling house prices occurring.

they are answerable. In the United States the SEC

confers a “nationally recognized statistical rating

agency” status on certain qualifying ratings agencies,

allowing their ratings to be used for regulatory

purposes by others, but it stops short of

regulating their methodologies. This deters entry

into the ratings business because ratings have

value to the purchaser when they can be used to

reduce capital; conferring this status on some

agencies and not others creates barriers to entry.

Similarly, Basel II makes provision for credit ratings

agencies to be used to evaluate bank capital,

and the same argument applies. Whether regulation

should be extended to ratings agencies is a

question that needs to be addressed, since at

present there is no regulation of their procedures.

The Financial Stability Forum, through the IOSCO,

offers a code of conduct fundamentals for credit

rating agencies that it recommends but does not

require agencies to adopt.

Regulation and Stress Testing. A fourth issue

concerns the evaluations of risk by banks themselves.

A number of early warnings had signaled

difficulties ahead for financial institutions under

certain risk scenarios; for example, in London

the supervisory agency of the United Kingdom,

the Financial Services Authority, had been concerned

for some time about complexity and liquidity

of financial markets, stating in January

2007 that “Financial markets have become

increasingly complex since the last financial

stability crisis, which implies that transmission

mechanisms for shocks have also become more

complicated and possibly more rapid…It is still

important for market participants to consider

how they would operate in an environment

where liquidity is restricted (Financial Services

Authority, 2007). The Bank of England was even

more direct in its Financial Stability Report,

stating “Financial institutions can become more

dependent on sustained market liquidity both to

allow them to distribute the risks they originate

or securitise and to allow them to adjust their

portfolio and hedges in the face of movements

in market prices. If it becomes impossible or

expensive to find counterparties, financial institutions

could be left holding unplanned credit

risk exposures in their ‘warehouses’ awaiting

562 SEPTEMBER/OCTOBER 2008 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW

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