Credit Rating Agencies’ Decisions and I.S.D.A.’s Credit Events: Effects on Banking Liquidity and Legal Contracts

Abstract

This paper aims the research whether involving Credit Ratings Agencies (CRAs), regarding the provision of credit risk rating for the banking structured products, as well as the credit clauses of ISDA (International Swaps and Derivatives Association) agreements between banks, could affect the banking liquidity. The research work focuses on the existing regulation and the literature for CRAs and on whether a proposed set of regulation reforms could aim in manipulating future crisis in the finance environment. The ISDA operation, the legal framework of its proposed contracts (for banking products transactions) and the decisions of its committees are factors, which can also influence the operation of these products and the banking liquidity. The paper reviews the current European legislation of CRAs, as well as the policy of ISDA through its contracts. We examine the procedure with which the activation of hedging instruments is decided, when a “credit event” takes place. The research effort is based on the study of ISDA contracts as legal tool protecting the banks, bilaterally, from credit event risks. Under this reasoning, we have examined the liquidity effects concerning banks and how this is involved with the changes of the credit ratings. Among our conclusions and results, we present a clear explanation of how an ISDA credit event affects banking liquidity and we suggest specific legislative interferences and changes in ISDA agreement clauses wording, to preserve the banking liquidity. Under these changes, EU-certified CRAs, certainly, have to interfere in circumstances of downgrading the credit ability of banking institutions.