Credit Rating Agencies Regulation Across Countries: A ...

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Credit Rating Agencies Regulation Across Countries: A ...

  1. 1. Credit Rating Agencies Regulation Across Countries: A Critical Assessment of Reform Initiatives The Future of Credit Rating Agencies: Regulation and Accountability Capital Markets Institute - Toronto JUNE 25th, 2009 STÉPHANE ROUSSEAU
  2. 2. Context <ul><li>American subprime crisis having profound consequences </li></ul><ul><li>Subprime loans made their way into asset-backed securities (ABS) through securitization: ABS experienced tremendous growth </li></ul><ul><li>Structured finance products widely held and incorporated into other securities: ABCP is a case in point </li></ul>
  3. 3. Context <ul><li>Credit market turmoil : a « perfect storm » with all safeguards failing </li></ul><ul><ul><li>Central role of credit rating agencies (CRAs) </li></ul></ul><ul><ul><li>Spectacular downgrading of ABS </li></ul></ul><ul><li>Critiques of CRAs : calls for reforms </li></ul><ul><ul><li>Regulatory interventions in the U.S., the EU, and Canada; </li></ul></ul><ul><li>How to regulate CRAs? </li></ul>
  4. 4. Asset-Backed Commercial Paper <ul><li>Introduced in Canada in the 1980s </li></ul><ul><li>Traditionnally backed by conventional debt: credit cards and trade receivables, leases, mortgages… </li></ul><ul><li>In the 2000s, synthetic assets such as RMBS and CDOs incorporated </li></ul><ul><li>2000-2007: ABCP market doubles to $120 billion </li></ul>
  5. 5. ABCP Structure <ul><li>Wason (2008) </li></ul>Seller ABCP Conduit Investors assets asset cash securities cash Asset return Bank liquidity Rating Agency
  6. 6. ABCP and the Credit Crisis: The Domino Effect <ul><li>Delinquencies and foreclosures rates rise in the US </li></ul><ul><li>Property values plummet </li></ul><ul><li>Uncertainty about CDOs and RMBS losses </li></ul><ul><li>Liquidity crisis </li></ul><ul><li>Impact on ABCP: </li></ul><ul><ul><li>Uncertainty with respect to underlying assets </li></ul></ul><ul><ul><li>Demand dries out </li></ul></ul><ul><ul><li>Liquidity facilities inoperative </li></ul></ul>
  7. 7. ABCP Issues <ul><li>Transparency </li></ul><ul><ul><li>Lack of information on underlying assets </li></ul></ul><ul><ul><li>Ratings: primary source of information </li></ul></ul><ul><li>Asset/liability </li></ul><ul><ul><li>Long-term assets becoming predominant </li></ul></ul><ul><ul><li>Short-term notes </li></ul></ul><ul><li>Liquidity facilities </li></ul><ul><ul><li>Global style: banks acting as liquidity provider </li></ul></ul><ul><ul><li>Canadian style: general market disruption </li></ul></ul><ul><ul><li>Only DBRS rates ABCP with Canadian style liquidity facilities </li></ul></ul>
  8. 8. Rating Agencies: Salient Facts <ul><li>Concentrated industry: S&P, Moody’s, Fitch, DBRS </li></ul><ul><li>Ratings: assessment of creditworthiness/probability of default </li></ul><ul><ul><li>Efficiency dimension: </li></ul></ul><ul><ul><ul><li>Assist investors in their assessment of the risk and uncertainties associated with asset-backed securities. </li></ul></ul></ul><ul><ul><ul><li>ABCP: rating apply to the notes issued by the conduits </li></ul></ul></ul><ul><ul><li>Regulatory dimension </li></ul></ul><ul><ul><ul><li>Prospectus exemption for ABCP (short-term debt) </li></ul></ul></ul><ul><ul><ul><li>Investment grade vs speculative securities </li></ul></ul></ul>
  9. 9. Rating Agencies and ABCP <ul><li>Canada: CRAs unregulated </li></ul><ul><li>U.S.: Nationally Recognized Statistical Rating Organization (NRSRO) </li></ul><ul><ul><li>Prior to 2006, SEC No-Action Letter procedure </li></ul></ul><ul><ul><li>Credit Rating Agency Reform Act of 2006 </li></ul></ul><ul><li>IOSCO Code of Conduct </li></ul><ul><li>European Union: CRAs unregulated </li></ul>
  10. 10. Concerns: Quality of Ratings <ul><li>Resources </li></ul><ul><ul><li>Growth in the volume and complexity of structured finance products not matched by increase in CRAs staff </li></ul></ul><ul><ul><li>Impact on monitoring of ratings and timeliness of downgrading </li></ul></ul><ul><li>Due diligence </li></ul><ul><ul><li>Information provided by issuers taken at face value </li></ul></ul><ul><ul><li>Disclosure of lack of due diligence </li></ul></ul><ul><li>Effectiveness of methodologies questioned </li></ul>
  11. 11. Concerns: Conflicts of Interest <ul><li>Issuer pays model </li></ul><ul><ul><li>CRAs paid only if retained to rate the product </li></ul></ul><ul><ul><li>Incentive to downplay risk/inflate rating </li></ul></ul><ul><ul><li>Particular problems with respect to structured finance products </li></ul></ul><ul><ul><ul><li>Concentration in the underwriting business </li></ul></ul></ul><ul><ul><ul><li>Ratings structured finance products highly profitable </li></ul></ul></ul><ul><ul><ul><li>Unsolicited ratings difficult </li></ul></ul></ul><ul><li>Consulting services </li></ul><ul><ul><li>CRAs advise issuers as to how to design the SPV in order to obtain the rating contemplated </li></ul></ul>
  12. 12. Concerns: Transparency <ul><li>Deficiencies in the disclosure of rating process, methodologies and criteria </li></ul><ul><li>Lack of verifiable and easily comparable performance data </li></ul><ul><li>Use of same symbols to rate traditional debt (corporate and municipal bonds) and structured finance products </li></ul>
  13. 13. Reform Proposals <ul><li>Need for reform: strong consensus </li></ul><ul><ul><li>“ We have agreed on more effective oversight of the activities of Credit Rating Agencies, as they are essential market participants”. </li></ul></ul><ul><li>G20 Communiqué, April 2009 </li></ul><ul><li>Wave of reform initiatives across countries </li></ul><ul><ul><li>Securities and Exchange Commission </li></ul></ul><ul><ul><ul><li>Amendments to rules governing NRSROs </li></ul></ul></ul><ul><ul><li>International Organization of Securities Commissions (IOSCO) </li></ul></ul><ul><ul><ul><li>Amendments to the Code of Condut </li></ul></ul></ul><ul><ul><li>European Parliament: </li></ul></ul><ul><ul><ul><li>Regulation on Credit Rating Agencies </li></ul></ul></ul><ul><ul><li>Canadian Securities Administrators Concept Paper 11-405 </li></ul></ul>
  14. 14. Reform Proposals: Key Initiatives <ul><li>Rating Process </li></ul><ul><ul><li>CRAs should adopt reasonable measures so that the information it uses is of sufficient quality </li></ul></ul><ul><ul><li>Review periodically methodologies and models </li></ul></ul><ul><ul><li>Monitoring and updating of ratings: objectivity </li></ul></ul><ul><ul><li>Appropriate knowledge & experience: rating committees’ members </li></ul></ul><ul><ul><li>IOSCO Code of Conduct </li></ul></ul><ul><ul><li>EU Regulation </li></ul></ul>
  15. 15. Reform Proposals: Key Initiatives <ul><li>Independence and Conflicts of Interest </li></ul><ul><ul><li>Compensation </li></ul></ul><ul><ul><ul><li>Issuer pays model prohibited unless disclosure of information received by CRAs </li></ul></ul></ul><ul><ul><ul><li>Proposed SEC Rule </li></ul></ul></ul><ul><ul><li>Fees </li></ul></ul><ul><ul><ul><li>Prohibition to negotiate the issuer fees where rating the security. </li></ul></ul></ul><ul><ul><ul><li>SEC Rule </li></ul></ul></ul><ul><ul><ul><li>IOSCO Code </li></ul></ul></ul><ul><ul><li>Consulting </li></ul></ul><ul><ul><ul><li>Prohibition to issue a rating for a security where advice provided as to its structure </li></ul></ul></ul><ul><ul><ul><li>EU Regulation </li></ul></ul></ul><ul><ul><ul><li>SEC Rule </li></ul></ul></ul><ul><ul><ul><li>IOSCO Code </li></ul></ul></ul>
  16. 16. Reform Proposals: Key Initiatives <ul><li>Transparency </li></ul><ul><ul><li>Information of substantially material sources obtained for ratings </li></ul></ul><ul><ul><li>EU Regulation </li></ul></ul><ul><ul><li>Differentiate ratings for structured products </li></ul></ul><ul><ul><li>EU Regulation </li></ul></ul><ul><ul><li>IOSCO Code of Conduct </li></ul></ul><ul><ul><li>Ratings, and subsequent rating actions </li></ul></ul><ul><ul><li>Methodologies, models, and key rating assumptions </li></ul></ul><ul><ul><ul><ul><li>Verifications performed on the underlying assets? </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Verifications of the quality of originators of assets? </li></ul></ul></ul></ul><ul><ul><li>Performance statistics </li></ul></ul><ul><ul><li>IOSCO Code of Conduct </li></ul></ul><ul><ul><ul><li>EU Regulation </li></ul></ul></ul><ul><ul><ul><li>SEC Rules </li></ul></ul></ul>
  17. 17. Reform Proposals: Key Initiatives <ul><li>Competition </li></ul><ul><ul><li>Disclosure of information on asset-backed securities </li></ul></ul><ul><ul><ul><li>IOSCO Code of Conduct </li></ul></ul></ul><ul><ul><ul><li>Proposed SEC Rule </li></ul></ul></ul><ul><ul><li>Regulatory use of ratings </li></ul></ul><ul><ul><ul><li>Remove reference to ratings in regulation </li></ul></ul></ul><ul><ul><ul><li>Proposed SEC Rule </li></ul></ul></ul><ul><ul><ul><li>Analyzing whether the approach taken by the SEC could inform its proposals to maintain, modify or delete references to credit ratings in Canadian securities legislation </li></ul></ul></ul><ul><ul><ul><li>CSA Concept Paper </li></ul></ul></ul>
  18. 18. Enhancing CRA Accountability and Effectiveness: Between State and Markets <ul><li>Limited Effectiveness of Market-Based Instruments </li></ul><ul><ul><li>Competition </li></ul></ul><ul><ul><ul><li>Concentration: market- and regulatory-based barriers </li></ul></ul></ul><ul><ul><ul><li>Impact </li></ul></ul></ul><ul><ul><ul><ul><li>Ineffective check on quality & integrity of ratings </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Hampers reputational pressures </li></ul></ul></ul></ul><ul><ul><ul><li>Solutions </li></ul></ul></ul><ul><ul><ul><ul><li>Remove regulatory barriers </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Natural barriers to entry will remain </li></ul></ul></ul></ul><ul><ul><li>Reputation: impact of market concentration </li></ul></ul>
  19. 19. Enhancing CRA Accountability and Effectiveness: Between State and Markets <ul><ul><li>Restore Investor-Pays Model </li></ul></ul><ul><ul><ul><li>Public good problem </li></ul></ul></ul><ul><ul><ul><li>Impact on information efficiency </li></ul></ul></ul><ul><ul><ul><ul><li>Narrower dissemination </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Limited public scrutiny </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Uneven level playing field </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Insufficient coverage of issuers </li></ul></ul></ul></ul><ul><ul><li>Self-regulation </li></ul></ul><ul><ul><ul><li>“ Self-regulation has been tested since 2006 and the outcome is far from acceptable” </li></ul></ul></ul><ul><ul><ul><li>European Commission Staff, 2008 </li></ul></ul></ul>
  20. 20. Enhancing CRA Accountability and Effectiveness: Between State and Markets <ul><li>Uncertain Promise of the Regulatory Path </li></ul><ul><ul><li>Government Utility Model </li></ul></ul><ul><ul><ul><li>Attractions </li></ul></ul></ul><ul><ul><ul><ul><li>Solves the public good problem </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Ensures wide dissemination of ratings </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Alleviates conflicts of interests </li></ul></ul></ul></ul><ul><ul><ul><li>Issues </li></ul></ul></ul><ul><ul><ul><ul><li>Scope of ratings services </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Funding </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Conflicts of interests: government bonds & policy objectives </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Investor over-reliance </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Accountability </li></ul></ul></ul></ul>
  21. 21. Enhancing CRA Accountability and Effectiveness: Between State and Markets <ul><li>Registration Model </li></ul><ul><ul><li>Wide support: G20, US & EU Models </li></ul></ul><ul><ul><li>Attractions </li></ul></ul><ul><ul><ul><li>Competition: facilitate entry by smaller agencies </li></ul></ul></ul><ul><ul><ul><li>Accountability: regulatory oversight </li></ul></ul></ul><ul><ul><li>Issues </li></ul></ul><ul><ul><ul><li>Competition: registration requirements as barriers to entry </li></ul></ul></ul><ul><ul><ul><li>Accountability: rules of conduct </li></ul></ul></ul><ul><ul><ul><ul><li>Expertise? </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Impact on innovation </li></ul></ul></ul></ul><ul><ul><ul><li>Over-reliance on ratings </li></ul></ul></ul>
  22. 22. Enhancing CRA Accountability and Effectiveness: Between State and Markets <ul><li>Disclosure-Based Model </li></ul><ul><ul><li>Weak form of registration system </li></ul></ul><ul><ul><li>Attractions </li></ul></ul><ul><ul><ul><li>Competition: </li></ul></ul></ul><ul><ul><ul><ul><li>No substantive registration requirements </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Clarify recognition criteria </li></ul></ul></ul></ul><ul><ul><ul><li>Accountability: </li></ul></ul></ul><ul><ul><ul><ul><li>Market: disclosure </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Regulatory oversight </li></ul></ul></ul></ul><ul><ul><li>Issues </li></ul></ul><ul><ul><ul><li>Natural barriers to entry remain </li></ul></ul></ul><ul><ul><ul><li>Reputational pressures </li></ul></ul></ul>
  23. 23. Closing Comments <ul><li>CRAs, Credit Crisis and ABCP </li></ul><ul><li>What role for regulation? </li></ul><ul><ul><li>Strong consensus for regulatory intervention: </li></ul></ul><ul><ul><ul><li>CRAs failings </li></ul></ul></ul><ul><ul><ul><li>Limited effectiveness of market instruments </li></ul></ul></ul><ul><ul><li>G20 favors registration system </li></ul></ul><ul><ul><li>Caution: avoid Nirvana fallacy </li></ul></ul><ul><li>CRA regulation in Canada: disclosure-based approach </li></ul><ul><ul><li>Supports & complements market-based mechanisms </li></ul></ul><ul><ul><li>Ensures regulatory coordination </li></ul></ul><ul><ul><ul><ul><li>US ABS market dwarfs the Canadian market: $2,480 billion vs $157 billion </li></ul></ul></ul></ul>
  24. 24. Comments? Questions? [email_address]

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