Credit Rating Agencies Regulation Across Countries: A

Credit Rating Agencies Regulation Across Countries:

A Critical Assessment of Reform Initiatives

The Future of Credit Rating Agencies: Regulation and

Accountability

Capital Markets Institute - TorontoJUNE 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

Wason (2008)

Seller

ABCP

Conduit

Investors

assets

asset

cash

securities

cash

Ass

et

retu

rn

Bank

liquid

it

y

Rating Agency

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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: S&P, Moody’s, Fitch, DBRS

Ratings: assessment of creditworthiness/probability 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 ConductEU Regulation

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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 RuleIOSCO Code

Consulting Prohibition to issue a rating for a security where advice

provided as to its structureEU Regulation

SEC RuleIOSCO Code

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Transparency Information of substantially material sources obtained for

ratingsEU Regulation

Differentiate ratings for structured productsEU 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 RegulationSEC Rules

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Competition Disclosure of information on asset-backed securities

IOSCO Code of ConductProposed 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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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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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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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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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?

[email protected]

Documents

Credit Rating Agencies Regulation Across Countries: A