Ratings Users Beware

Using Information from the Credit Default Swap Market to Validate Credit Assessments

James M. Cataldo, PhD, and Alex C. Yen, PhD, CPA

Credit risk assessment ranks among the most important tasks faced by accountants and other financial professionals, and it is made ever more difficult by the growing complexity of the financial markets. Despite questions raised during the recent financial crisis about the process and output of credit ratings agencies, financial professionals and the U.S. financial system in general continue to heavily rely on ratings in the credit assessment process. For example, company and mutual fund investment policies often use agency ratings as their primary criterion for credit risk. Regulatory requirements in the banking industry still use agency ratings to determine the amount of capital needed to protect against risks of different kinds of investments (see, for example, the Basel Committee on Banking Supervision, “International Convergence of Capital Measurement and Capital Standards: A Revised Framework,” November 2005). The recent financial crisis raised significant concerns about the role of credit ratings agencies in capital markets. Ratings agencies attracted a considerable amount of criticism for giving inflated ratings and for being slow to revise ratings following “downgradable” events. Financial conflicts of interest with clients, a long-standing concern of market observers and policy makers, were once again raised as a fundamental weakness of the ratings agency business model.