Credit Rating Agencies Regulation Across Countries: A Critical Assessment of Reform Initiatives

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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

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Context

• American subprime crisis having profound
  consequences
• Subprime loans made their way into asset-backed
  securities (ABS) through securitization ABS
  experienced tremendous growth
• Structured finance products widely held and
  incorporated into other securities ABCP is a
  case in point

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Context

• Credit market turmoil a  perfect storm  with
  all safeguards failing
• Central role of credit rating agencies (CRAs)
• Spectacular downgrading of ABS
• Critiques of CRAs calls for reforms
• Regulatory interventions in the U.S., the EU, and
  Canada
• How to regulate CRAs?

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Asset-Backed Commercial Paper

• Introduced in Canada in the 1980s
• Traditionnally backed by conventional debt
  credit cards and trade receivables, leases,
  mortgages
• In the 2000s, synthetic assets such as RMBS and
  CDOs incorporated
• 2000-2007 ABCP market doubles to 120 billion

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ABCP Structure
Rating Agency

• Wason (2008)

asset
Seller
ABCP Conduit
securities
Investors
cash
cash
Asset return
liquidity
assets
Bank
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ABCP and the Credit Crisis The Domino Effect

• Delinquencies and foreclosures rates rise in the
  US
• Property values plummet
• Uncertainty about CDOs and RMBS losses
• Liquidity crisis
• Impact on ABCP
• Uncertainty with respect to underlying assets
• Demand dries out
• Liquidity facilities inoperative

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ABCP Issues

• Transparency
• Lack of information on underlying assets
• Ratings primary source of information
• Asset/liability
• Long-term assets becoming predominant
• Short-term notes
• Liquidity facilities
• Global style banks acting as liquidity provider
• Canadian style general market disruption
• Only DBRS rates ABCP with Canadian style
  liquidity facilities

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Rating Agencies Salient Facts

• Concentrated industry SP, Moodys, Fitch, DBRS
• Ratings assessment of creditworthiness/probabilit
  y of default
• Efficiency dimension
• Assist investors in their assessment of the risk
  and uncertainties associated with asset-backed
  securities.
• ABCP rating apply to the notes issued by the
  conduits
• Regulatory dimension
• Prospectus exemption for ABCP (short-term debt)
• Investment grade vs speculative securities

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Rating Agencies and ABCP

• Canada CRAs unregulated
• U.S. Nationally Recognized Statistical Rating
  Organization (NRSRO)
• Prior to 2006, SEC No-Action Letter procedure
• Credit Rating Agency Reform Act of 2006
• IOSCO Code of Conduct
• European Union CRAs unregulated

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Concerns Quality of Ratings

• Resources
• Growth in the volume and complexity of structured
  finance products not matched by increase in CRAs
  staff
• Impact on monitoring of ratings and timeliness of
  downgrading
• Due diligence
• Information provided by issuers taken at face
  value
• Disclosure of lack of due diligence
• Effectiveness of methodologies questioned

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Concerns Conflicts of Interest

• Issuer pays model
• CRAs paid only if retained to rate the product
• Incentive to downplay risk/inflate rating
• Particular problems with respect to structured
  finance products
• Concentration in the underwriting business
• Ratings structured finance products highly
  profitable
• Unsolicited ratings difficult
• Consulting services
• CRAs advise issuers as to how to design the SPV
  in order to obtain the rating contemplated

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Concerns Transparency

• Deficiencies in the disclosure of rating
  process, methodologies and criteria
• Lack of verifiable and easily comparable
  performance data
• Use of same symbols to rate traditional debt
  (corporate and municipal bonds) and structured
  finance products

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Reform Proposals

• Need for reform strong consensus
• We have agreed on more effective oversight of
  the activities of Credit Rating Agencies, as they
  are essential market participants.
• G20 Communiqué, April 2009
• Wave of reform initiatives across countries
• Securities and Exchange Commission
• Amendments to rules governing NRSROs
• International Organization of Securities
  Commissions (IOSCO)
• Amendments to the Code of Condut
• European Parliament
• Regulation on Credit Rating Agencies
• Canadian Securities Administrators Concept Paper
  11-405

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Reform Proposals Key Initiatives

• Rating Process
• CRAs should adopt reasonable measures so that the
  information it uses is of sufficient quality
• Review periodically methodologies and models
• Monitoring and updating of ratings objectivity
• Appropriate knowledge experience rating
  committees members
• IOSCO Code of Conduct
• EU Regulation

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Reform Proposals Key Initiatives

• Independence and Conflicts of Interest
• Compensation
• Issuer pays model prohibited unless disclosure of
  information received by CRAs
• Proposed SEC Rule
• Fees
• Prohibition to negotiate the issuer fees where
  rating the security.
• SEC Rule
• IOSCO Code
• Consulting
• Prohibition to issue a rating for a security
  where advice provided as to its structure
• EU Regulation
• SEC Rule
• IOSCO Code

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Reform Proposals Key Initiatives

• Transparency
• Information of substantially material sources
  obtained for ratings
• EU Regulation
• Differentiate ratings for structured products
• EU Regulation
• IOSCO Code of Conduct
• Ratings, and subsequent rating actions
• Methodologies, models, and key rating assumptions
• Verifications performed on the underlying assets?
• Verifications of the quality of originators of
  assets?
• Performance statistics
• IOSCO Code of Conduct
• EU Regulation
• SEC Rules

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Reform Proposals Key Initiatives

• Competition
• Disclosure of information on asset-backed
  securities
• IOSCO Code of Conduct
• Proposed SEC Rule
• Regulatory use of ratings
• Remove reference to ratings in regulation
• Proposed SEC Rule
• 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
• CSA Concept Paper

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Enhancing CRA Accountability and Effectiveness
Between State and Markets

• Limited Effectiveness of Market-Based Instruments
• Competition
• Concentration market- and regulatory-based
  barriers
• Impact
• Ineffective check on quality integrity of
  ratings
• Hampers reputational pressures
• Solutions
• Remove regulatory barriers
• Natural barriers to entry will remain
• Reputation impact of market concentration

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Enhancing CRA Accountability and Effectiveness
Between State and Markets

• Restore Investor-Pays Model
• Public good problem
• Impact on information efficiency
• Narrower dissemination
• Limited public scrutiny
• Uneven level playing field
• Insufficient coverage of issuers
• Self-regulation
• Self-regulation has been tested since 2006 and
  the outcome is far from acceptable
• European Commission Staff, 2008

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Enhancing CRA Accountability and Effectiveness
Between State and Markets

• Uncertain Promise of the Regulatory Path
• Government Utility Model
• Attractions
• Solves the public good problem
• Ensures wide dissemination of ratings
• Alleviates conflicts of interests
• Issues
• Scope of ratings services
• Funding
• Conflicts of interests government bonds policy
  objectives
• Investor over-reliance
• Accountability

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Enhancing CRA Accountability and Effectiveness
Between State and Markets

• Registration Model
• Wide support G20, US EU Models
• Attractions
• Competition facilitate entry by smaller agencies
• Accountability regulatory oversight
• Issues
• Competition registration requirements as
  barriers to entry
• Accountability rules of conduct
• Expertise?
• Impact on innovation
• Over-reliance on ratings

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Enhancing CRA Accountability and Effectiveness
Between State and Markets

• Disclosure-Based Model
• Weak form of registration system
• Attractions
• Competition
• No substantive registration requirements
• Clarify recognition criteria
• Accountability
• Market disclosure
• Regulatory oversight
• Issues
• Natural barriers to entry remain
• Reputational pressures

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Closing Comments

• CRAs, Credit Crisis and ABCP
• What role for regulation?
• Strong consensus for regulatory intervention
• CRAs failings
• Limited effectiveness of market instruments
• G20 favors registration system
• Caution avoid Nirvana fallacy
• CRA regulation in Canada disclosure-based
  approach
• Supports complements market-based mechanisms
• Ensures regulatory coordination
• US ABS market dwarfs the Canadian market 2,480
  billion vs 157 billion

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Comments? Questions?

• stephane.rousseau_at_umontreal.ca