Introduction
Various regions have institutions with Securities and Exchange Commissions, which help in controlling the rating agencies in order to protect investors and businesses. Also, it has the responsibility of regulating the rating agencies to conform to the set standards. The main function of credit rating agencies is to give the investor a well-versed study of the risk related to debt securities (Zingales 5). The securities include mortgage-backed securities, preferred stock, corporate bonds and government bonds. The riskiness of investing in the securities mentioned above is determined by the probability that the debt issuer, which can either be a bank-developed entity or corporation, can fail to generate interest payment on the debt in the given period. It is important to note that the rater’s judgment is based on the highest and safest grade, which is Authentication, Authorization and Accounting (AAA), with the lowest grade being AA or A. These ratings are always available for investors and the public.
Banks should always have several systems that improve the measurement of their financial risks linked with their business actions. Specifically, banks should always have the interest to capture the possibility that borrowers cannot gather for their financial responsibilities. The capability of borrowers to repay the principal and interest in the given period indicate the credit quality of the borrower. Credit risks indicate the reduction in the significance of debt mechanism and other credit-linked securities owed to unforeseen changes in the fundamental credit quality of the borrowers and counterparties in a given time. It is crucial for banks to develop their capacity to measure credit risks that stem from their high exposure to prospective losses that are likely to arise in the event of ratings default (TrĂĽck 10).
Unprecedented downgrade
Due to the financial crisis that started in 2008, most banks have been subjected to downgrading from AAA to AA+. The move was mainly done to cut the deficit to permit the rise in the country’s debt and liquidations of some assets. During that period the rating agencies failed to calculate the risks linked to mortgage securities. This showed that rating agencies created sophisticated models to estimate the likelihood of default for individual mortgages and other related securitized products. This led to the downgrading of some of the grade AAA institutions to below investment-grade status, especially when the housing market failed (Higham and Lin 4).
The raters were not efficient enough to foresee the possibility of the decline in housing values and their impact on loan defaults. The overstated ratings also failed to predict the greater systematic risks linked with downgrading planned products, as opposed to easier securities such as sovereign and corporate bonds. The difference between the above-investment-grade and below-investment-grade is very crucial; it affects the value at which issuers may borrow and downgrading also influence the amount of the supply of funds. Particularly, regulations and statutes usually bar institutional investors from investing in assets with ratings below a given level (Higham and Lin 4). These assets are always called speculative assets and it is important to note that when an issuer gets such grading the number of prospective investors greatly reduces. In such conditions, if the authorized restriction becomes binding for institutional investors, speculative issuer will only depend on small part of investors to which such restriction do not apply.
It is also clear that sovereign downgrading, may lead to changes in the way regions are perceived by the market and also, changes can influence investors’ attitudes towards the affected nations. The affected banks can also face higher weighting of interbank exposure from institutions lending money to them. This led to stepping up of capital asset requirements (CARs), making downgraded banks to experience a worse cost of interbank credit. However, it is clear that sovereign downgrading has no great impact on bank CARs especially in established nations getting high-income because it stimulates ample swings for bank CARs. This shows that the volatility of bank CARs in developing countries is much worse (Trück 10).
The direct impact of improved bank CARs and the extra institutional issues shows that developing nations’ banks are likely to tap less developed financial market places in order to accumulate the required capital, therefore, worsening the cost and the availability of credit to nations’ private sector. It is crucial to note that provisional worsening in bank credit has a negative impact on business sector in developing countries leading to business bankruptcies and production held below potential. This shows that there is reduction in business capability in developing economies’ corporate sector with prospective long-term negative consequences for those developing economies (Higham and Lin 4).
According to Basel Proposal, it is important to increase the volatility of capital needs of banks in non-high-income countries against high-income countries, because corporate ratings and banks in non-high-income countries are strongly linked and in an asymmetric methods to changes to any rating. A sudden downgrading alters the capital allocation and this calls for larger capital when it is not available. Therefore, it is important for banks to use widespread ratings in order to have more sound risk assessment. Banks in high-income countries are able to monitor their capital needs reducing due to discreet lending behavior, while the banks in non-high-income countries cannot use a similar method to evaluate their capital requirements. Therefore, it is important for banks to have integrated approaches to monitor their capital requirements (Zingales 5).
Conclusion
It is clear that a weak banking system can lead to draining of public finances and reduction of economic development which in turn leads to downgrading. Central banks should use supple operational structures that provide continuous supply of funds to ease bank’s liquidity pressure. Banks should build a strong capital base to reduce the effects of downgrading. The financial crisis has led to a stiff deterioration in public resources all over the world. The fiscal deficit has become very big, showing the necessity of discretionary stimulus and automated stabilizers to ease the severity of the downgrading and strengthen the financial sector. Since 2009 the composition of bank funding has not changed much, therefore, banks have continued to use more stable funding institutions like equity and retail deposits. Banks have also reduced the use of interbank deposits and other related institutions like central bank financing. Banks need to implement the Basel Capital accord (Basel II) to assess their credit risks because it provides the operational framework used for modeling credit risks and creating internal credit risks. The framework is important in establishing a system that ensures continuous flow of capital for investors.
Works Cited
Higham, Nicholas & Lin, Lijing, On pth Roots of Stochastic Matrices, Manchester Institute for Mathematical Sciences, School of Mathematics, 2009. Print.
TrĂĽck, Mugele. Measures for Comparing Transition Matrices from a Value-at-Risk Perspective, University of Karlsruhe, 2004. Print.
Zingales, Luigi. Causes and Effects of the Lehman Brothers Bankruptcy, University of Chicago Graduate School of Business, 2008. Print.