Did Credit Rating Agencies Do Good Work - Essay Example

Did Credit Rating Agencies do good work? The topic of the project is “Did Credit Rating Agencies do good work?” The research report aims to make a statistical analysis of the performance of the economy of Qatar during the global financial crisis of 2008. The report also describes how the economy of Qatar absorbed the effects of the economic downturn through the strengthening of its major assets and the reasons underlying the last financial crisis of 2008 and its effect on the economy of Qatar. The report goes on to evaluate the role that the Credit rating Agencies played in the GCC countries as well as the significant effects of the activities of the Credit rating Agencies in the Qatar economy during the global downturn. Data is collected from secondary sources considering the importance of statistical data for reaching a conclusion. A proper analysis and evaluation is done to understand the findings of the study and indicate the key factors underlying the report. Introduction-Background The essential role of the Credit Rating Agencies have been particularly highlighted during the period of global economic crisis in 2008 which affected even the strongest economies in the world. The Credit Rating Agencies essentially served the main purposes of mitigating the asymmetrical information system existing in the markets between the investors and the businesses in requirement of financing modes, bringing a solution for the collective action issues existing in the market and solving the major agency problems existing in the economies. After the global financial crisis of 2007-2009 affecting all the economies of the world, it was stated by many researchers that the financial system followed in the GCC countries were much more equipped to cope with the economies following the conventional financing systems. The financial crisis of 2008 proved that the Credit Rating Agencies are not full proof in predicting the defaults that may occur in the market in future and the over dependence on the credit rating Agencies can be considered as one of the primary reasons underlying the cause of the global financial disruption. The Credit Rating Agencies, though regarded as powerful institutions have several drawbacks like information asymmetry and conflict of interest which often have negative impacts on the businesses and the economy has a whole. The effect that the global financial crisis had on the creditworthiness of the various economies throughout the world is depicted below: (Source: International Monetary Fund 2) Literature Review Credit Rating Agencies are regarded as influential institutions which can impact the market and the survivor of the companies and economies by influencing the direction and working of the market through their effective rating mechanisms. But there exist debatable views on the actual effect of the Credit Rating Agencies on the market where some researchers have pointed out the Credit Rating Agencies more effectively react to the occurring of the events in the market than anticipate the events. The role of the Credit rating Agencies is critical for an economy which was especially reflected during the global financial crisis in 2008. The anticipatory or follower roles of Credit Rating Agencies are critical from the viewpoint of financial stability of a country or an economy. If the Credit Rating Agencies play an anticipatory role in the market, the ratings given by them are critical for influencing the financial stability and the policies in the economy. Conversely, if the Credit rating Agencies are only followers of the events in the market, then their ratings and actions do not have major impact and only end up reflecting the condition of the market and the information gathered from the market events (Kiff, Nowak and Schumacher 159). There are many theories proposed over time relating to the role of the Credit rating Agencies as influential institutions in the normal as well as crisis situations prevailing in the economies. The major theories presented with the objective of explaining how the Credit Rating Agencies use their power to add to the value of the markets are related to certification services, information provisions and monitoring services provided by the Credit Rating Agencies. The certification services provided by the Credit rating Agencies are used to segregate the securities into investment and non-investment classes. The grading of the securities as investment and non-investment assets play a critical role in driving the liquidity in the market and the institutional demands existing in the market. They also act as the drivers for taking important decisions regarding investment and regulatory gaps. The use of ratings for capital requirements in Basel II is another major role played by the Rating Agencies. The ratings and actions of the Credit Rating agencies also dictate the required margin levels and collaterals, the management of reserves and the behavior of the funds related to investment (Alam 2-21). The traditional services of the Rating Agencies are useful in adding value to the businesses by producing information regarding the risk factors associated with fixed income securities. This information is effectively used by the investors to determine the prices of the investment securities which are sensitive to the information available in the market (Boot and Schmeits 81-118). These activities result in the reduction of information costs and the promotion of increased liquidity in the markets. According to the information theories of Credit rating agencies as proposed by Millon and Thakor (1985), the Credit rating Agencies produce high quality and costly information which may result in effective pay-offs in the market. The information provided also help the agencies to diversify their risks by being able to screen the agents for information sharing. According to Boot, Milbourn and Schmeits (2006), the Credit Rating Agencies have high monitoring powers and they act as important institutions to create smooth coordination of the different situations in which a balanced equilibrium can be achieved. The Rating Agencies do not provide informational services in this approach and maintain privacy regarding the credit quality of the issuer so that it can’t be observed by every participant in the market. Instead, the rating Agencies create value through the monitoring services mostly implemented in their procedures of watching the credit levels of the issuer. Boot, Milbourn and Schmeits (2006) have proposed that the credit monitoring approach is a process involving both the dissemination of information as well as monitoring activities based on the information. The credit monitoring approach accounts for the establishment of an implicit agreement between the Rating Agencies and the issuer. The procedure of credit watching is economically important as it plays a major role in achieving the desired balance by creating a contract with the issuer regarding the maintenance of specific standards for the credit standings. Other empirical studies like the study proposed by Ederington, Yawitz, and Roberts (1987) and Liu and Thakor (1984) establishes the role of Credit Rating Agencies for maintaining the corporate ratings as a critical variable influencing the cross-sectional margins between the yield spreads. These theories correlate the ratings given by the agencies with the credit risks of based on a regression analysis. According to the works of Hand, Holthausen, and Leftwich (1992), there is an empirical impact of the rating variations on the pricing of the equities and commercial papers of the business. According to the studies of Dichev and Piotroski (2001) the changes in ratings as given by the agencies are incorporated into the pricing decisions of the securities of the firm. According to the work of Hull, Predescu, and White (2004), the changes in ratings are influenced by the anticipations in the market regarding the fluctuations in the credit quality of the issuer. The study designed by Micu, Remolona, and Wooldridge (2006) suggests that the individual rating actions or a combination of them impact the financial stability of the firms in a significant way. According to the model proposed by Cantor and Packer (1996), the Credit Rating Agencies play a critical role in influencing the economic activities of the market especially during an economic downturn in the market. The model also indicates the importance of the interpretation of the accessible information in the market for the Credit Rating Agencies as well as the participants in the market. According to Ismailescu and Kazemi (2010), proposed that ion the background of the global financial crisis in 2008, though the GCC countries including Qatar were seen as better equipped to face the economic downturn particularly due to the soaring prices of crude oil. The economies of the GCC countries practicing Islamic financing modes were identified as more strong to absorb the financial shocks than the conventional financing systems (Bauer, Koedijk and Otten 1751-1759). According to Norden (2008), the countries practicing Islamic financing were more immune to the effects of the global financial crisis due to certain major strengths in the economy that helped them absorb the downturn shocks. Research Objectives and Research Questions The main objective of the research is to find out the role of the Credit Rating Agencies, especially during the financial crisis that hit the world in 2008. Other objectives include analyzing the credibility of the Credit Rating Agencies on the background of the financial crisis of 2008. The consequence of the asymmetrical information prevailing in the financial markets is also studied. The reasons driving the financial downturn and the effects of the crisis on the economy of Qatar is extensively studied. Research Design The analysis done for preparing the report is done through the traditional research techniques and methodologies. The initial phase of the report presents an extensive literature review used to support the objectives and analysis of the study. The literature review is presented with the aim of discussing the different works presented by researchers, scholars and academicians to discuss similar studies and concepts related to the study. The literature review accounts for a major portion of the secondary research done for preparing the report. Also relevant academic sources like articles, journals and books are consulted related to the studies and works done towards this particular area. Also, various websites related to the study like Standard and Poor’s official website and working papers of the International Monetary Fund have been referred to for preparing the report (Sadeghi 15-26). The report is prepared by following a proper research approach and the set objectives are attained through a detailed analysis of the data collected. Data collection An effective and data sufficient research work is required to determine the exact role of the Credit rating Agencies in relation with the global economic crisis and the various economies of the world including the economy of Qatar. Proper data are collected and sourced from reliable sources and analyzed by using appropriate methodologies to create a systematic and extensive report. The research methods can be broadly categorized into two different types: Qualitative Research methods and Quantitative Research methods. The qualitative research procedures are used to understand and study the behavior and feelings of the people whereas the quantitative research method is aimed at the proper analysis and evaluation of the statistical data collected for the report. Both the research methods are collectively used to implement the various approaches of research to analyze the collected information. Due to the nature of the study under consideration, the statistical data and information is considered more critical for attaining the objectives. Hence, the quantitative research is given more importance than the qualitative research to conduct the study efficiently. The secondary data is collected extensively from reliable academic sources and the websites of international institutions. Also data is taken from the past statistical data used by the different researchers for their work. The secondary data collection procedure has been adopted to conduct this research. Analysis and Findings The major reason driving the financial crisis across the globe in 2008 was the excess subprime lending activities and the creation of the financial instability that reshaped the structure of the investment portfolios instead of focusing on the basic investment concerns to generate profit from the investment portfolios (Ederington, Yawitz and Roberts 211-226). Almost every economy of the world was affected by this global crisis but the economies of the GCC, especially the economy of Qatar showed impressive ways to absorb the negative effects of the downturn. Though the economy was affected to some extent, yet the financial structure of Qatar being based on Islamic financing deferred the payment instruments and prevented the flow of capital into every part of the market. These factors created a certain level of immunity for the economy of Qatar. The GCC countries, including Oman, Qatar, Saudi Arabia and Bahrain were not immune to the financial dislocations and the domestic financial industry were majorly threatened by the rapid credit growth with the bank lending in the private sector being most accelerated in the economy of Qatar as shown below. (Source: International Monetary Fund 5) The Qatar economy was able to absorb the economic downturn primarily because of the lesser exposure of the economy to the sub-prime asset investments, the implementation of prompt policy formulation in the economy to offset the impact of the financial crisis, the focus on the mobilization of the traditional saving procedures and lesser integration of the economy into the global financial markets (Nilsson 307-325). The economies of Qatar as well as the other GCC countries were affected by the financial contraction through the declining prices of the assets and impactful financial leveraging processes. But the price of crude oil continued to soar thereby creating a major immunity for the economy as shown in the figure below. (Source: International Monetary Fund 9) The economy of Qatar was also saved due to a boom in the real estate and construction industries which was in complete contrast with the other economies of the world where these sectors were rapidly going down. The increasing leverage of the bank and the non-financial corporate sectors existing in the OPEC countries was one another major factor that saved the economy from going down along with the global economic downturn. The GCC countries faced the financial downturn with much strength and succeeded in stabilizing the financial sector through the effective use of their resources such as the crude oil sector and the real estate sector and effective support of the banks in the economy. Of all the GCC countries, Qatar was one of the economies that absorbed the financial crisis with most strength and effectiveness as indicated in the figure below (Khamis 13). (Source: International Monetary Fund 13) Though the economy of Qatar faced a number of shocks, yet a major loss on the banks’ performance was not noted as there was no sign of a complete economic and financial breakdown (Barnett and Salomon 1101-1122). But the domestic credit position and the modes of bringing in external credit tom the economy were much affected due to the crisis. Conclusion The report uses sufficient data from secondary sources and the analysis of these data to find out the impact of the global financial crisis on the economy of Qatar. Though the outlook for the economy remains positive, yet many parts of the economy have seen to be dislocated by the global financial crisis. The study shows that the Credit Rating Agencies play a major role in monitoring the performances of the businesses and to an extent that of the various economies. But the Credit rating Agencies cannot always anticipate the events in the market as the case was during the financial crisis that hit the world in 2008. Qatar as an economy has sound fiscal policies being implemented in the system but seems to need more relevant global regulatory practices, risk management systems and more effective liquidity standards. The economy should also concentrate on improving the domestic debt markets and improve on the policy actions and better integration with the global economic sector. The economy of Qatar is found to be asset rich but need to improve on the macroeconomic perspectives at the financial level. The research has a scope of future work in the direction of detailed analysis of the GCC economies and the effect of the global financial crisis on these economies by taking the different key parameters to design a detailed multivariate analysis of the topic under study. References Alam, Nafisa. Resilience of Islamic Finance during Credit Crunch – Empirical Evidence Barnett Manor and Ruthold Salomon. Beyond Dichotomy: The Curvilinear Relationship between CRA s and Financial Performance. Strategic Management Journal. Vol. 27(11). 2006. Print. Bauer, Rauben., Kajo Koedijk and Rusfeld Otten. International evidence on ethical mutual fund performance and investment style. Journal of Banking and Finance. Vol. 29(7). 2005 Boot, Arnoud and Anjolein Schmeits. Credit Ratings as Coordination Mechanisms. Review of Financial Studies. Vol. 19(2). 2006. Print. Ederington, Louis., Jess Yawitz. and Brian Roberts. The Informational Content of Bond Ratings. Journal of Financial Research. Vol. 10(4) 2009. Print. from European Market. Journal of Banking and Finance. Vol. 14(2). 2009. Print. Khamis, May. The Impact of the Global Financial Crisis on the GCC Region: Lessons and Reform Priorities. Working paper of International Monetary Fund. 2010. Print. Kiff, John., Sylwia Nowak and Liliana Schumacher. Are Rating Agencies Powerful? An Investigation into the Impact and Accuracy of Sovereign Ratings. Working paper of International Monetary Fund. 2012. Print. Nilsson, James. Investment with a Conscience: Examining the Impact of pro-Social Attitude and Perceived Financial Performance on Socially Responsible Investment Behavior. Journal of Business Ethics. Vol. 83(2). 2008. Print. Sadeghi, Morteza. Financial Performance of Shariah Compliant Investment: Evidence from GCC Stock Market. International Research Journal of Finance and Economics. Vol.2 (20). 2008. Print. Read More