On the Origin of Financial Crises and the Survival of the Unfittest

Abstract

The risk of financial crisis fuelled by 'inflated ratings' is recognised but underestimated. Firstly, the manufacturing of inflated ratings is not fully within the control of credit rating agencies and is linked to arbitrage, which operates unless all avenues are sealed off. Secondly, the arbitrage is poorly understood for inside certain well-known but fake arbitrages there is a `hidden' real one. Ratings arbitrage (investing in credits with `inflated' ratings) is not an economic arbitrage but with Basel II-type capital requirements linked to credit ratings it became one for e.g. banks, because it creates higher financial leverage, a shareholder wealth arbitrage due to the government put, provided market inconsistent ratings exist, which is bound to be the case and of which inflated ratings is a subset. Thus, a Trojan horse was drafted into solvency regulation. Arbitrage emanating from this regulatory design-flaw is prone to spiral into financial crises and was plausibly the ultimate cause of the 2008 Financial Crisis.