The role of external ratings in regulation? Are rating agencies independent and transparent?

Do they have an oligopolistic position?

BRIDOUX JonathanDAKE Mensah AugustinPERCY Cédric

LSMS2020- Risk Management of Financial Institutions (Part 2)Professors : HENRARD L. - OLIESLAGERS R.

25 avril 2012

Introduction▫Credit Rating Agencies (CRAs)

▫Structure

1) Role of external ratings in regulation

2) Transparency and independence of CRAs

3) Oligopolistic situation : The “Big three”

Since BASEL II (first pillar)

a) Important role of CRAs in banks’ capital requirements

IFthe standardized approach is chosen

NOT IFthe internal ratings based approach is chosen

Role of external ratings in regulation

« Regulatory role » in determining the capital requirement :

Boost for CRAs

Nevertheless, 1) “External Credit Assessment Institutions” (ECAIs) validated by national supervisors

2) Banks can choose among the different ECAIs for the Standardized approach

3) As banks have the choice… Is it objective ?

New role of CRAs…

• Some official institutions (IOSCO, SEC….) asked for more transparence

from CRAs in their methodologies

• First, the United states Securities and Exchange Commission (SEC)

• In 2005 , SEC released several recent regulatory initiatives

• Second, the International Organization of Securities Commissions (IOSCO)

• In 2004 , IOSCO implemented the code Fundamentals

• IOSCO set up three aspects of CRAs: -quality of rating -integrity of rating -CRA responsibilities to the investing public and issuers

The transparency and independence of CRAs

• No real evolution regarding the transparence has been shown

• CRAs give some factors that are used to compute ratings

• But don’t publish the relative weights that are assigned to factors exposed in their publications

• An effort must be made by both the CRAs to improve transparency and by the authorities that can be stricter and bring more discipline.

• The rating agencies have conflict of interest

• The Agency becomes judge and part

• CRAs could be influenced to give a better rating than the deserved one in order to gain or keep their clients

• This conflict of interest is due to the fact that issuers can choose their own CRAs

• In the European Union , the European Securities and Market Authorities (ESMA) goes against the problematic of independence

• The big three would like to increase their political power

• Another example of conflict of interest is between Moody’s and Verkshire Hathaway

Independency of CRAs

Drivers of the oligopoly in the rating industry

High barriers to entry

a) New entrants have a fewer capacity (resources and skills) lower quality of ratings and lower number of issuers analyzed

b) Price competition is not a solution for new entrants because quality of their ratings may decrease

c) Difficult to obtain a strong reputation and a great credibility difficult to attract issuers

The oligopolistic position : The « Big Three »

Regulatory protection

• In 1975, th SEC designated the « Big Three » under the NRSRO denomination

• During the next 25 years, only 4 additional agencies received this status

• In 2000, return to the previous situation

• The NRSRO denomination reinforces confidence

• Lack of transparence about the selection criteria used by the SEC

To cut a long story short:

Regulatory protection + high barriers to entry

=

Dominant position of the « Big Three »

Conclusion

CRAs have gained in importance thanks to Basel II (first pillar)

Lack of transparence from CRAs in their methodologies and processes

CRAs are not perfectly independent (conflict of interest,…)

Ratings industry is an oligopolistic market due to high barriers to entry and regulatory protection

• Do you think that because of Basel II, banks and investment firms rely too much on CRAs ?

• Is the oligopolistic situation of CRAs sustainable?

•Should we implement an indepedent CRA in Europe? If yes, why ?

Some questions