Rightly or wrongly, credit rating agencies have been widely blamed for their role in the financial crisis. How will this affect how they are used—and how they are regulated—in the future?
At a Capital Markets Institute session, “The Future of Credit Rating Agencies: Regulation and Accountability,” Stephane Rousseau, associate professor and chair in business law and international trade with the Faculty of Law at the University of Montreal, presented a critical analysis of reform initiatives relating to credit rating agencies (CRAs) post-credit crisis.
Rousseau’s paper focused on two elements that he views as the driving force behind the current debate about CRAs: accountability and power. “Rating agencies have a lot of power,” he said, “but we want them to be accountable to the public and markets in general.”
Concerns around CRAs
Looking back at the origins of the crisis, Rousseau described how the asset-backed commercial paper (ABCP) market developed—from its inception in Canada in the 1980s, to its role in structured products starting in the 2000s, to the appetite that fuelled its widespread growth from 2000 to 2007, to increasing concerns around the underlying assets and the rapid downgrading of ABCP that triggered the liquidity crisis.
Given the limited amount of publicly available information—and the lack of historical data—on these products, CRAs played an important role for investors, Rousseau noted. And certain issues relating to CRAs have come to light in the wake of the financial crisis.
Investors have raised concerns around the quality of CRA ratings and their due diligence into the underlying assets of asset-backed securities. There have been questions on the effectiveness of the methodologies used by CRAs in the rating process and on possible conflicts of interest (since, in the current model, issuers pay the CRAs to rate their products). Investors have also taken CRAs to task for lack of transparency with regard to their rating criteria, methodologies and processes.
Until now, noted Rousseau, CRAs have been largely unregulated. But given deep impact of the financial crisis, they have since been subject to criticism and calls for change. “On a high level, I think we can say that there is a strong consensus for reform.”
Ready for reform?
The dialogue around CRAs has changed since the crisis. “To some extent, the question is no longer whether to regulate rating agencies, but how to regulate them,” affirmed Rousseau, adding that Canada, the U.S. and the E.U. are all currently looking at reform initiatives.
What form might CRA regulation take? A number of different models have been proposed—from a market-based approach (which relies on competition to keep CRAs in check) to the registration model (which focuses on rules of conduct and registration requirements for new entrants) to the “investor pays” model (in which investors, rather than issuers, would pay for the ratings) to self-regulation, to the government utility model (in which the government would do the rating).
However, Rousseau sees a disclosure-based model as the most appropriate path for Canada moving forward. “Leave open entry for new rating agencies [and] still provide some form of regulatory oversight,” he says, “but, at the same time, that’s not the silver bullet. We’ll see radical change in the industry. Natural barriers to entry will remain and reputational pressures will have a limited role.”
Still up for debate
The panelists who spoke following the presentation (Alan White, professor of finance with the Rotman School of Management; Sean Rogister, president of STR Capital; Marlene Puffer, managing director of Twist Financial Corporation; and Ted Price, assistant superintendent, supervision sector, with OSFI) represented different perspectives on CRAs and their role in the ABCP crisis. But they agreed that while there may be some legitimate concerns around these agencies, they’re also getting more than their fair share of the blame.
White believes the concerns around CRAs are somewhat overblown. “I don’t think the problems are as severe as people make them out to be,” he said. Pointing out that they have been rating debt issues for around a hundred years, White remarked that the role of a rating agency is to provide an opinion about the credit quality of an issue and that part of the problem is inappropriate use of ratings rather than the ratings themselves. “There have been some problems with debt ratings, but they haven’t been large problems so I don’t think large solutions are necessary.”
Rogister agreed that a big part of the problem is the way CRAs are used. “They are not indentured to an institutional investor in any way,” he said. “They have not promised to deliver something that they’ve been paid for.” Drawing from his experience with the Ontario Teachers’ Pension Plan, he suggested that the focus of any future regulatory reform in this area should be transparency. “It’s really not addressed, it’s not broadly required, but as a user of these instruments and of ratings, I would say it’s the biggest problem I ever had.” However, he added, investors can’t abnegate their responsibility for due diligence and risk assessment. “If you don’t know what you’re doing, then you shouldn’t be investing.”