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Stress before Consumption: A Proposal to Reform Agency Ratings

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Abstract

The financial turmoil starting in late 2007 has engendered serious criticisms of major credit rating agencies (CRAs), crystallising in a groundbreaking Regulation on CRAs in the EU. This article considers that the Regulation might have failed to take into account a fundamental problem relating to credit ratings—the single, through‐the‐cycle rating system—which probably contributed to the ratings of entities highly sensitive to changes in overall market conditions, including banks and financial institutions, to be vulnerable to cascading ratings downgrades during downturns. The first part of the article analyses the performance of such credit ratings to support the above argument, while the second part explores a proposed solution of moving away from the single rating system to one where ‘standard’ ratings are supplemented by ‘stressed ratings.’ This solution can be based on a public–private partnership where CRAs produce stressed ratings based on scenarios set by regulators—an idea that entails recognition that regulatory efforts in this area ultimately entails a complex balancing of the roles of both the CRAs and regulators as gatekeepers in making safety‐and‐soundness judgements together for global financial markets.
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Document Type: Research Article

Affiliations: New York University

Publication date: January 1, 2012

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