Loic sarton (2)


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Loic sarton (2)

  1. 1. Risk Management of Financial Institutions (Part II) LSMS 2020 Professor: L. Henrard – R. Olieslagers Année académique 2011-2012 Groupe 1 : BRIDOUX Jonathan DAKE MENSAH Augustin PERCY Cédric Final Report on Credit Rating Agencies The role of external ratings in regulation? Are rating agencies independent and transparent? Do they have an oligopolistic position? Date : 21 avril 2012
  2. 2. Introduction The credit rating agencies (CRAs)are private companies which assess the creditworthiness of companies, banks,sovereigns, institutions, securities,...CRAs estimate the ability and capacity of these organizations to meet effectively and in time their debt obligations1 .There are about 150 local and international CRAs around the world2 . However, only three of them are recognized such as significant CRAs: Standard & Poor’s (≈40% of market share), Moody’s (≈40%) and an actor with French capital, Fitch Ratings (≈15%)3 (see appendix 1). Throughout this paper, we will be studying the current situation in the rating industry. In an ever-changing world, more and more elements are required for CRAs in order to gain the trust of investors and issuers. Indeed, CRAs must be credible, objective, independent, transparent and have a sufficient level of resources.Moreover, some regulations and institutions have played an important role in the evolution of the rating industry. We will structure our paper like this: First, we will analyze the role of external ratings in regulation. Then, we will examinethe transparency and the independence of CRAs. Finally, we will describe the oligopolistic situation of the “big three”. 1 IYENGAR, S. (2010).Are Sovereign Credit Ratings Objective and Transparent.Journal of Financial Economics, 8(3), p 7. 2 GARCIA ALCUBILLA, R. & RUIZ DEL POZO, J. (2012). Credit Rating Agencies on the Watch List: Analysis of European Regulation. 1th Edition, Oxford UniversityPress, 7-8. 3 RUF, M. (2011). Agences de notation: Les indispensables mal-aimées. http://www.hebdo.ch/les_indispensables_malaimees_101677_.html (accessed 04/04/2012). L’Hebdo is a weekly French language magazine.
  3. 3. ROLE OF EXTERNAL RATINGS IN REGULATION First of all, we have noticed that the implication of external ratings in regulation has evolved with the evolution of the Basel Accords since 1988. These Accords were set up by the Basel Committee on Banking Supervision in order to regulate the finance and banking internationally4 . This Committee has elaborated three complementary Accords: Basel I (1988- 2004) – Basel II (2004-2011) –Basel III (2013-…). The importance of external ratings in regulation has really appeared with the introduction of Basel II.Therefore, we believe that a little introduction on Basel II is necessary. This Accord revised Basel I’s framework by establishing three pillars. The first pillar aims to reinforce the stability of the banking system on an international scale by setting a minimum capital requirement.The second pillar improves the supervision as well as the risk management practices. Finally, the third pillar’s goal is to allow market actors to evaluate the capital adequacy and risks of banks by increasing the disclosure requirements.5 For this part of the paper, we will focus on the first pillar of Basel II because CRAs play an important role in it. In this pillar, there are two approaches for the regulatory determination of capital for credit risk (the standardized approach and the internal ratings based approach). According to Van Roy P. (2005) : “The standardized approach uses external ratings such as those provided by “external credit assessment institutions” (ECAIs) to determine risk-weights for capital charges,(…) the IRB allows banks to develop their own internal ratings for risk- weighting purposes subject to the meeting of specific criteria and supervisory approval”6 .Therefore, we can easily understand that the CRAs have a huge role when banks choose to use the standardized approach. By this regulation, CRAs have gained kind of a “regulatory role” in determining the capital requirements for banks. Basel II gave a real boost to the role plaid by CRAs in regulation. Under the Basel II framework, the main role of external ratings in regulation has been to determine capital requirements of banks and investment firms.7 Nevertheless, as Van Roy P. (2005) has pointed out, the standardized approach has brought an issue. First of all, Basel II makes national supervisors in charge of defining which CRAs can 4 INVESTOPEDIA. http://www.investopedia.com/terms/b/baselii.asp (accessed 05/04/2012). 5 PPT DU COURS 6 VAN ROY, P. (2005). Credit ratings and the standardised approach to credit risk in Basel II. European Central Bank, N°517, p.7. 7 GARCIA ALCUBILLA, R. & RUIZ DEL POZO, J. (2012). Credit Rating Agencies on the Watch List: Analysis of European Regulation. 1th Edition, Oxford University Press, p.16.
  4. 4. be considered as ECAIs.Then, banks can choose only among the different ECAIs validated by their supervisor to determine their capital requirement. The possibility for banks to choose between different ECAIs has raised the question of objectivity8 . Indeed, ECAIs uses different methodologies, procedures, practices and processes that are not always really clear. This brings the question of transparency in the rating industry The transparency and the independence of CRAs In recent years, some official institutions (IOSCO, SEC, ESMA …) as well as most of financial market participants have asked for more transparence from CRAs in their methodologies, practices, processes and procedures. To better understand the measures put in place by the official institutions to improve the transparency of CRAs, we will introduce these two institutions and afterward, enunciatebriefly one of their measures. First, the United States Securities and Exchange Commission (SEC) is a federal agency of the U.S created in 1934 by the Congress in order to regulate the securities markets and protect investors9 .The SEC has released several recent regulatory initiatives such as the “Proposed Rule” (2005) in order to enhance the transparency10 . Then, the International Organization of Securities Commissions (IOSCO) is “a global cooperative of securities regulatory agencies that aims to establish and maintain worldwide standards for efficient, orderly and fair markets”11 . In 2004, IOSCO tried to improve the transparency within the CRAs industry by implementing the Code Fundamentals. By this Code, the IOSCO has set up rules that CRAs have to consider. This regulatory initiative aims to improve three aspects of CRAs: - “The quality and integrity of the rating process – CRA independence and the avoidance of conflicts of interest – CRA responsibilities to the investing public and issuers”12 . In spite of the efforts of the official institutions to better regulate the opaque situation of the rating industry, no real evolution regarding the transparence has been shown. 8 VAN ROY, P. (2005).Credit ratings and the standardised approach to credit risk in Basel II. European Central Bank, N°517, p.8. 9 INVESTOPEDIA.http://www.investopedia.com/terms/s/sec.asp (accessed 07/04/2012). 10 ELKOURY, M. (2008). Credit rating agencies and their potential impact on developing countries. UNCTAD, N°186, p.12. 11 INVESTOPEDIA.http://www.investopedia.com/terms/i/iosco.asp#axzz1sg06GbPT(accessed 07/04/2012). 12 IOSCO.(2008). Code of conduct fundamentals for credit rating agencies.http://www.fsa.go.jp/inter/ios/f- 20041224-3/04.pdf(accessed 07/04/2012).
  5. 5. Indeed, even though CRAs give information regarding some factors that are used to compute ratings, they don’t publish the relative weights that are assigned to the factors exposed in their publications13 . According to Elkhoury Marwan (2008): “CRAs’ methodologies, variables and weights which they employ, and the criteria used in the deliberations of rating committees remain opaque to both investors and borrowers”14 . Thanks to the different readings, we deeply believe that there is still a big issue regarding the transparence within the rating industry. An effort must be made by both the CRAs to improve their transparency and by the authorities that can be stricter and bring more discipline. Another current question concerns the independency of CRAs. The rating agencies have, by nature, conflict of interests because issuers on the one hand have to pay in order to receive a rating and on the other hand, issuers are dependent to their ratings which put them in a weak position compared to CRAs15 .It is as if a pupil paid his professor to obtain a grade that he absolutely needs. It is highly problematic because there is an obvious risk of conflict of interest. The agency becomes judge and part. Judge because it has to give ratings and part because it is financed by the issuerthat received the rating. Therefore, we could think that CRAs could be influenced to give a better rating than the deserved one in order to gain or keep their clients (issuers). We have noticed that this conflict of interest is due to the fact that issuers can choose by their own their CRAs (as we have seen previously). A recent measure from the European Securities and Market Authoritiesthat goes against the problematic of independence: In the European Union, after a review of CRA practices by the European Securities and Markets Authority (ESMA), the supervisor recommends that CRAs reinforce the internal control functions (Internal Audit, Compliance and Internal Review functions) and expects the Independent Directors to continue developing their role and involvement in CRA’s activities and their interaction with internal control functions. This would help to strengthen the CRA’s accountability and independence16 . 13 MILAS, C., PANAGIOTIDIS, T. (2011).Rating agencies must be « more transparent ».Public service europe. http://www.publicserviceeurope.com/article/648/rating-agencies-must-be-more-transparent#ixzz1scOxwdVx (accessed 07/04/2012) 14 ELKOURY, M. (2008).Credit rating agencies and their potential impact on developing countries.UNCTAD, N°186, p.14. 15 ELKOURY, M. (2008).Credit rating agencies and their potential impact on developing countries.UNCTAD, N°186, p.14. 16 ESMA (2012).Report on the Supervision of Credit Rating Agencies.ESMA/2012/207.P.10.
  6. 6. A defended thesis is that the “Big Three” would like toincrease their political power and therefore avoid that regulators reduce their autonomy. For example, few years earlier, the SEC explored the possibility of establishing an independent company that would have to rate asset-backed securities (ABS) such as CDOs. The rating agencies have directly put pressure on these authorities by threatening to freeze these markets and the SEC kindly accepted to stop its projects17 . We can easily understand that those three CRAs are aware about their influence on regulators thanks to their positioning in the rating industry. Through our readings, we have also found another possible conflict of interest between Moody’s andBerkshire Hathaway. Indeed, the empire of Warren Buffet (Berkshire) has approximately 12,5% of Moody’s shares18 and many authors as we do believe that this could have brought insider trading. As Berkshire Hathaway’s mission is to invest in financial markets, Moody’s could give internal information and they also could upgrade or at least, avoid downgrading the securities owned by Berkshire as well as the company itself. The oligopolistic position: The “Big Three” Throughout the last century, the big three (S&P, Moody’s and Fitch)have accumulated a strong notoriety in the financial world, an essential quality in this sector. Indeed, most ofthe investors and issuers prefer ratings provided by agencies with better credibilityand reputation. This fact hasput in light the oligopolistic situation of this market which is characterized by high barriers to entry. Indeed, new entrants have fewer resources (staff, analytical tools…), which limits the quality of ratings and the number of issuers analyzed. Costs to entry in this market are very high to get reputation and economy of scale. Furthermore,price competition is not a solution for new entrants because the quality of their ratings may decrease19 ... Another point that enhancesthe oligopolistic situation is the fact that independent organizations such as the SEC reduce competition into the rating market and strengthen the dominant position of the actors already in place. According to the author LAWRENCE 17 MANNS, J. (2011). The Revenge of the Rating Agencies.http://www.nytimes.com/2011/08/10/opinion/the- revenge-of-the-rating-agencies.html?_r=1 (accessed 08/04/2012). The New York Times 18 VERON, N. (2011). What can and cannot be done about rating agencies. http://www.iie.com/publications/pb/pb11-21.pdf (accessed 08/04/2012). Peterson Institute for International Economics.P.1. 19 GARCIA ALCUBILLA, R. & RUIZ DEL POZO, J. (2012).Credit Rating Agencies on the Watch List: Analysis of European Regulation. 1th Edition, Oxford University Press, 6-7.
  7. 7. J.White (n.a): “It is clear that the three dominant credit rating firms have received a considerable boost from financial U.S regulators”20 . Since 1975, this institution has decided which CRAs can be considered such as “nationally recognized securities rating organization (NRSRO)”.At this time, the SEC designated the “big three”under the NRSRO denomination. The selection criteriato put CRAs under this denomination were never really disclosed (lack of transparency). During the next 25 years, only four additional agencies have received this status. Nevertheless, in 2000, the newagencies have been taken over by Fitch which led to the previous situation21 . The NRSRO status reinforces investors’ confidence in CRAs and so strengthens the barriers to entry for new entrants22 . Indeed, without the NRSO designation, issuers and investors prefer not to give their confidence in CRAs. In order to avoid this, in 2006, Congress passed the “Credit Rating Agency Reform Act”. This act has askedmore transparency and hasrequired that the SEC is no longer a barrier to entry to this market and have to provide information on selection criteria for new CRAs23 . As a result, the SEC has selected new NRSRO. Nevertheless,only a dozen CRAs havereceivedthe status of NRSRO so far24 . Here is a great quotation on the oligopolistic situation within the rating industry: According to SETTY G. & DODD R. (2003): “The ability of three firms to dominate a global market is not simply regulatory protection, but can more reasonably be attributed to the product of mergers and acquisitions, increasing economies of scale for the large firms and the high fixed costs of building a national, if not global, reputation”25 . After those readings, we tend to think that the current oligopolistic situation is due to the combination of regulations and of many other factors (reputation, M&A, costs to entry…). 20 WHITE, L.J. (n.a) The Credit Rating Agencies: How Did We Get Here? Where Should We Go?http://www.ftc.gov/be/seminardocs/091112crediratingagencies.pdf(accessed 05/04/2012),pp 12. 21 WHITE, L.J. The Credit Rating Agencies: How Did We Get Here? Where Should We Go?http://www.ftc.gov/be/seminardocs/091112crediratingagencies.pdf(accessed 05/04/2012),pp 7. 22 COCHRAN, J. (2005). An Economic Analysis of the SEC’s Nationally Recognized Statistical Rating Organization (NRSRO) Standard. http://mercatus.org/sites/default/files/publication/An_Economic_Analysis_of_the_SECs_NRSO_Standardv2.pd f (accessed 05/04/2012), 4-7.Mercatus Center: George mason University is the world’s premier university source for market-oriented ideas. 23 WHITE, L.J. (n.a) The Credit Rating Agencies: How Did We Get Here? Where Should We Go?http://www.ftc.gov/be/seminardocs/091112crediratingagencies.pdf(accessed 05/04/2012),pp 11. 24 U.S. SECURITIES and EXCHANGE COMMISSION.http://www.sec.gov/answers/nrsro.htm (accessed 05/04/2012). 25 GAUTAM, S. & DODD, R. (2003).Credit Rating Agencies: Their impact on Capital Flows to Developing Countries.http://www.financialpolicy.org/FPFSPR6.pdf(accessed 06/04/2012).
  8. 8. This has discouraged many (if not most) of entrants from entering into the market and has emphasized the dominant position of the “Big Three”. Conclusion The role of CRAs has changed in recent years. Because of the oligopolistic situation described previously, the “Big Three” have become three huge actors in the financial world. On the one hand, through the effects that their ratings do on financial markets. On the other hand, through the role of external ratings in the capital requirements of banks (Basel II). Because of the huge importance that these CRAs have gained, competent authorities must regulate this industry by improving regulations, transparency, independence and also by increasing the competition within CRAs. For this last point, the suggestion of Jean-Claude Juncker (Prime Minister of Luxembourg and chairman of the euro zone committee of finance ministers): “the agencies’influence had been "disastrous" and called for the setting up of a new, European rival " (…) we should intensify our efforts to create a European rating agency in order to be able to better judge the medium-term outlook for the European states”26 .Many other points of view exist but what is, for us, sure is that regulators have to cope with the obvious problem of: - Regulation (through Basel II) – Transparency (More discipline and stricter rules) – Independence (More control from authorities / Independent Rating agencies) – Oligopolistic situation (by reducing barriers to entry). 26 FOLEY, S. (2011).European leaders rail against ‘oligopoly’ of rating agencies.http://www.independent.co.uk/news/world/europe/european-leaders-rail-against- oligopoly-of-rating-agencies-2308884.html (consulted on 03/04/2012). The Independent is a British newspaper in London.