American International Journal of Social Science Vol. 4, No. 4; August 2015 103 Rating Models Mistakes and Implications for the Basel Committee on Banking Regulation Ángel Vilariño Sanz Doctor of Economics Complutense University of Madrid Spain Nuria Alonso Gallo David Trillo del Pozo Doctor of Economics Rey Juan Carlos University of Madrid Madrid, Spain Abstract Rating agencies have been key players in various financial crisis not just the current one but also in previous episodes such as the Asian crisis. In this paper we address the following issues: (i) the methodological errors in the agencies rating systems regarding corporate and sovereign debt (ii) Basel Committee banking regulation proposal regarding the agencies’ role in establishing the minimum capital requirements. We have analyzed the relationship between ratings and default frequencies for corporate and sovereign bonds in the pre-crisis period and we have identified inconsistencies in the rating system. Another interesting result is that it is not possible to discriminate between issuers with such a large number of rating scales. We concluded that the actual credit risk regulation gravitate around models based on rating systems that cannot be estimated or validated with the guarantees of rigour and allows regulatory arbitrage by banks Keywords: rating agencies, rating, bonds, credit risk, banking regulation 1. The Importance of Rating Agencies Credit rating agencies have gained great momentum in the financial markets which has been reinforced in the outbreak and unfolding of the financial crisis. The ratings they assign to issuers and financial instruments are considered relevant information by a majority of investors and have an impact on the behaviour of investors, issuers and governments. There are groups of investors who are prohibited from acquiring financial instruments not rated in the investment grade4; also, the rating is a decisive factor to assess the securities’ eligibility as collateral in central banks’ open market operations with the financial institutions or for liquidity support. What is more, changes in ratings have a strong impact on investors’ portfolio preferences. In the presence of any sign, or the evidence of a future possible rating downgrading of an issuer, the holders of those securities engage in sales that can generate a strong downward pressure on prices as well as an increase in spreads. These pro-cyclical movements reinforce bouts of financial instability and constitute the breeding grounds for speculative operations. The reports that agencies draw up on the corporate and sovereign issuers’ creditworthiness have a high-impact due to their often self- interested amplification carried out both by the media and the advisory reports of banks, securities firms and hedge funds. Agencies’ reports on issuers are riddled with strongly conservative recommendations which in the case of governments point out to the standard neoliberal guidance towards strong fiscal adjustments and public spending cuts. Rating agencies are private companies which elude all public control, regulation and supervision. It is an industry with a strong oligopolistic structure where three US companies, Standard & Poor's, Moody's and Fitch dominate the world market. Their business has spiralled up due to the increased presence of corporate and sovereign issuers in the capital markets but especially due to the unprecedented boom in structured products issuance. These include products originated through asset securitization and structured products linked to financial variables. 2. Agencies’ Rating Methodologies Discriminatory Capacity