What is the role of credit rating agencies in the financial system, and how did they fail during the crisis?
Answer (1)
Credit rating agencies (CRAs) are companies that give ratings or scores to financial products like bonds, loans, or CDOs (Collateralized Debt Obligations). These ratings tell investors how risky a financial product is. For example, an AAA rating means the investment is very safe, while a lower rating means higher risk.Investors use these ratings to decide where to put their money. Big institutions like pension funds or insurance companies are only allowed to invest in high-rated products. So, credit rating agencies play a very important role in the financial system—they influence where billions of dollars go.But during the 2008 financial crisis, these agencies made big mistakes. They gave high ratings (like AAA) to financial products that were actually full of risky subprime mortgages. Why did this happen? One reason is the principal-agent problem: the agencies were paid by the banks who created the products. This means they had a reason to give better ratings to keep getting business.Many investors believed the ratings and bought CDOs thinking they were safe. But when homeowners started defaulting on their loans, the value of these CDOs dropped fast. Investors lost money, and trust in the whole system collapsed.In the Philippines and other Asian countries, we also rely on credit ratings, especially when foreign investors decide to lend money or invest in our government bonds. If a rating is wrong, it can cause problems for the whole economy.
