The imperfect nature of the financial market can be a cause of the crisis. In many economic models markets are assumed to be efficient, which is the demand and supply will match each other under the guidance of the price. Although there is nothing such as perfect market, the assumption of near perfect efficient market does stand for itself in some cases. For example, the food grain market and some raw material markets. However, the financial market may not be one of these near perfect markets for some reasons.
First of all, the flow of information is far from perfect in financial market compared to other markets. Asymmetric information can occur between credit suppliers and credit demanders. …show more content…
Investors can gain the relatively accurate and in-depth information without significant cost to do so.
Mistakes made by Credit Rating Agencies
The ratings provided by Credit Rating Agencies (CRA) can significantly influence the investors. Study shows many investors trust and view rating as the most important factor of making investment decision. On the other hand, ratings can also have a great influence on the pricing of securities. The wrong ratings that are over confident could be a wrong signal to the market and lead to an irrational “too hot” demand of the questionable securitie. (Legind, Nina Dietz, and Camilla Hørby Jensen. 2014. "The European Regulation of Credit Rating Agencies." Law In Context 30, no. 1: 114-145.)
During the crisis, the Credit Rating Agencies (CRA) generally failed to provide accurate assessment on the risks of subprime mortgage related securities. Actually, the CRA like Moody and S&P gave high rating on those securities. In 2007, the senior tranche of the CDO, which involved subprime mortgages, received the highest rating of …show more content…
One thing is that CRA can have conflict of interest when conduct rating on securities. CRAs used to be paid by issuers of the securities to perform the rating. The rating results can sometime be affected by the interest of issuers, investor or other stakeholders. Also CRAs should be prohibited to provide other consultant and advisory services. It can lead to unjustifiable internal utilize of rating results. Finally, CRAs may not settle compensation for employees based on quality, accuracy and integrity of the work. Then a conflict of interest of employee can arise since employees may not work at their best effort to ensure the accurate rating results. Besides conflict of interest, free rider problem is also noticeable. It happens when CRAs fail to keep independent from each other. One agency may relay on the studies and researches conducted by another agency and fail to provide independent result due to the incentive of being a free rider. (Legind, Nina Dietz, and Camilla Hørby Jensen. 2014. "The European Regulation of Credit Rating Agencies." Law In Context 30, no. 1: 114-145.)
It is understandable that inaccurate rating can be simply due to the complexity of the CDO securities. The individual risk of each tranche can be overwhelmingly complex when too much different assets were added to the CDO fund pool. CRAs might underestimate this complexity and rate roughly. For example the safest tranche was rated as AAA, medium tranche as