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

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. 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

3. 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?

4. 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 Asset-Backed Commercial Paper

5. ABCP Structure Wason (2008) Rating Agency asset Seller ABCP Conduit securities Investors cash cash Asset return liquidity assets Bank

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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 Concerns: Conflicts of Interest

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. Comments? Questions? stephane.rousseau@umontreal.ca