The article analyses the rationale of credit ratings in financial market regulation with a specific focus on bank capital regulation. Specifically, it traces the development of external credit ratings in bank capital regulation and in particular how they became a major component of Basel II. In doing so, it reviews how ratings were used in the structured finance markets before the global financial crisis began in 2007 and how their misuse contributed to the crisis. Because ratings had become an integrated feature in banking and securities market regulation, risk management in financial firms became excessively dependent on their use thereby creating agency problems and increased systemic risks in financial markets. The paper also considers the implications of the use of credit ratings in bank capital regulation for macro-prudential supervision and the control of systemic risks. It highlights the different approaches to the use of credit ratings in bank capital regulation between the European Union and the United States and suggests that the lack of harmonisation in this area could lead to market distortions and systemic risks. Finally the article concludes that credit ratings are inappropriate in prudential bank regulation especially in determining bank regulatory capital and their use should be reconsidered in the Basel III agreement.
European Business Law Review