(This is an archived page, from the Patterns of Power Edition 3 book. Current versions are at book contents).
Banks, money-lenders, savers and investors are all lenders of money. They want to be repaid, but they have to take account of the risk that the borrower might default (i.e. not repay the loan). They mostly charge an interest rate, or ‘yield’, which is affected by the risk of default and by competition for the money available in the financial system. Lenders can, though, insure themselves against credit-default risks.
Savers and investors should take account of the robustness of the financial products (bonds, shares, savings accounts etc.) that they use. Provided that the risk in the product is clearly visible, they can choose to incur more risk in exchange for a higher rate of interest. Some sellers of financial products have been successfully prosecuted for misrepresenting risk – as when it was reported that Wells Fargo Agrees to Pay $2.09 Billion Penalty for Allegedly Misrepresenting Quality of Loans Used in Residential Mortgage-Backed Securities. That pay-out, though, was more than 10 years after the illegal activity.
Credit-rating agencies are responsible for assessing the risk of financial products and the risk-worthiness of individuals, companies and governments as borrowers; the credit ratings are used to determine the interest rates available to savers, investors and borrowers. Financial products are becoming increasingly complex, though, and some are so complex that they cannot be rated reliably – so neither buyers nor sellers can properly assess risk. There has also been a problem of ratings agencies having a conflict of interest when they are paid by clients who want favourable ratings; as Russ Roberts remarked in an EconTalk interview, Cathy O'Neil on Wall St and Occupy Wall Street:
“One of the strangest aspects of the financial crisis is the people who argue that it's the rating agencies' fault because they rated junk highly. That was what they were paid to do. Why would you expect them to do otherwise?” [about 20 mins into the interview]
The misrepresentation of risk and the lack of trustworthiness of credit-rating agencies were just two of the factors that made the financial markets unstable in the period leading up to the 2007-8 economic crisis. The need to tighten regulations on the industry is discussed below (3.3.4.4).