Investors are not sufficiently protected against financial risks

In the aftermath of the 2008 global financial crisis, criticism of credit rating agencies was widespread. It was fueled by a general consensus that they did not play their role, to protect investors against unwanted financial risks, well enough. Since then, international laws and regulations pertaining to credit rating agencies have been tightened considerably. However, the new rules do not always increase the risk-related transparency that investors so desire. Credit rating agencies are lumped together as though they are all the same, but the quality appears to vary significantly from one agency to the other. The value of the ratings is greatly overestimated, especially when it comes to financial products that are relatively complex to understand. These are the conclusions drawn in the study titled “Security design and credit rating risk in the CLO market” by Prof Dr Dennis Vink, Dr Mike Nawas and Vivian van Breemen. Vink and Nawas work at Nyenrode Business University, and Van Breemen began Nyenrode’s part-time PhD program after previously completing the financial management track. Alongside her studies, she works as a supervisor at De Nederlandsche Bank (DNB).

Credit rating risk

A credit rating is an independent assessment of the creditworthiness of a financial product, such as a bond. This is typically expressed in letters, ranging from AAA (the highest creditworthiness) to D (the lowest). These credit ratings are provided by credit rating agencies such as Moody’s and Standard & Poor’s (S&P) at the request of the firm that issues the bond. Issuers are free to choose which of the requested credit ratings they publish. This results in credit rating risk: the risk that the selected rating does not fully or accurately represent the credit risk associated with a financial product.

Impact on investors

The study is important because the complexity of these financial products makes it difficult for many investors to assess the risks themselves. For this reason, investors often rely on the opinions of credit rating agencies– despite the large sums of money they invest in these structured finance products. “The data set that we used in the study represents $1.8 trillion of investments,” van Breemen says. “Our research helps to shed light on the risks and can serve as input for the potential optimization of laws and regulations. In the current legislative framework for structured finance products, issuers must disclose at least two credit ratings per product, irrespective of the complexity of the product. We think that it actually is quite important to take the degree of complexity into account.” Van Breemen explains: “Imagine you’re looking at two cars: a Suzuki Swift and a Ferrari. You want to be certain that the engine won’t fail, so ask for an inspection to be conducted prior to your purchase. The Ferrari obviously has a more complex engine than the Suzuki, so it’s logical for you to require multiple inspectors to better understand the potential consequences of the complexity of the Ferrari engine. That may not be needed for the Suzuki. Both cars currently require two inspectors, which in our opinion doesn’t make sense.”

Another key finding is that investors differentiate between credit rating agencies in their willingness to rely on the quality of their credit ratings. Vink explains: “We show that investors perceive more credit rating risks with Moody’s than with S&P. In other words: the quality between the ratings appears to differ, and investors are concerned about getting stuck with unwanted risks when issuers only disclose credit ratings from Moody’s.”

International conferences and further research

Van Breemen: “We presented our study at the 2019 Financial Management Conference in Paris in December 2019, followed by the prestigious American Finance Association conference in San Diego in January 2020.” Now the paper is under review for publication in an international journal. Vink, Nawas and Van Breemen have since also launched a follow-up study. Nawas: “In that study we compare and contrast the markets for these products in the United States and the European Union. We aim to understand the extent to which investors in these markets rely on credit ratings, and whether any differences can be explained by the increasing discrepancy in laws and regulations in both markets.”