Credit Rating Agencies and their Regulation

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Credit Rating Agencies and their Regulation

• Viktoria Baklanova, CFA
• PhD candidate
• School of Law
• LLM Corporate Finance Law
• Residential Weekend 16-18th October 2009

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• Agenda
• History
• Mission
• Rating scale
• Rating types and rating process
• CRA regulation in the U.S.
• CRA regulation outside of the U.S.
• Future of CRAs

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• History
• 1860 Henry Varnum Poor's History of Railroads
  and Canals in the United States, a precursor of
  modern stock reporting and analysis
• 1900 John Moody Company published Moody's
  Manual of Industrial and Miscellaneous
  Securities
• 1906 Luther Lee Blake formed Standard
  Statistics Bureau
• 1909 John Moodys started using letter symbols
  to express his conclusions
• 1913 John Knowles Fitch registered Fitch
  Publishing Company, which published Fitch Bond
  Book ? Fitch Stock and Bond Manual
• 1914 Moody's Investors Service incorporated
• 1941 Poor's Publishing and Standard Statistics
  merged to form Standard Poor's Corporation
• 2008 10 companies are officially recognized as
  Nationally Recognized Statistical Rating
  Organizations (NRSRO) Realpoint LLC, LACE
  Financial Corp, A.M. Best Company, DBRS,
  Egan-Jones Rating Company, Fitch, Japan Credit
  Rating Agency, Moodys Investors Service, Rating
  and Investment Information, Standard Poors
  Ratings Services.

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Mission

• Creation of stable, transparent and integrated
  financial markets
• Characteristics of Credit
• Ratings
• Independent
• Forward-looking
• Stable
• Easy to understand
• Broad coverage.

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Rating Scale Investment grade
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Rating scale Speculative grade
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Rating types

• International/National AAA, AAA(CHIN)
• Long-term/Short-term
• Fitch F1/F1, F2, F3, B, C, D
• Moodys Prime-1, Prime-2, Prime-3, Non-Prime
  (NP)
• SP A-1/A-1, A-2, A-3, B (B-1, B-2, B-3), C,
  R, SD, D
• Credit rating by sector corporate, municipal,
  sovereign, structured finance
• Non-credit ratings
• Fitch Recovery Rating (RR), Asset Manager
  Rating (AM)
• Moodys Market Risk Rating (MR), Servicer
  Quality Rating (SQ)
• SP Fund Volatility Rating (S), Stability Rating
  (SR)

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Credit rating process
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CRA regulation in the U.S.

• 1909 1975 unregulated.
• 1975 The U.S. SEC started using credit ratings
  to determine capital charges for broker-dealers
  (Rule 15c3-1 under the Exchange Act). The term
  "NRSRO" was used to designate credit rating
  agencies whose ratings would be eligible.
• 1994 1997 SEC solicited comments the
  appropriate role of credit ratings in rules under
  the federal securities laws, and the need to
  establish formal procedures for recognizing and
  monitoring the activities of NRSROs. Comments
  received by the Commission led to a rule proposal
  in 1997. However, the Commission has not acted
  upon that rule proposal.
• 2002 the SEC submitted to Congress its Report on
  the role of credit rating agencies in the
  operation of the securities markets in response
  to the the Sarbanes-Oxley Act of 2002.

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CRA regulation in the U.S. (cont.)

• 2006 Credit Rating Agency Reform Act of 2006
• Formalize NRSRO designation
• Establish NRSRO oversight
• Promote competition
• June 2007 Oversight of Credit Rating Agencies
  Registered as Nationally Recognized Statistical
  Rating Organizations
• Aug 2007 C R E D I T C R I S I S
• June 2008 Proposed Rules for Nationally
  Recognized Statistical Rating Organizations
• Enhance integrity of rating process
• Structured finance rating symbology
• Feb 2009 Final Rule Amendments to Rules for
  Nationally Recognized Statistical Rating
  Organizations
• Increase transparency of methodologies,
  disclosure of rating performance
• Manage conflicts of interest

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CRA regulation outside of the U.S.

• 2003 the International Organization of
  Securities Commissions Technical Committee
  published a Statement of Principles Regarding the
  Activities of Credit Rating Agencies
• Improve investor protection
• Improve fairness, efficiency and transparency of
  securities markets
• Reduce systemic risk
• 2004 IOSCOs The Technical Committee issued a
  12-page document Code of Conduct Fundamentals
  for Credit Rating Agencies
• 2004 the European Parliament identified issues
  of concerns
• The quality of the ratings
• The agencies' independence and objectivity
• Transparent credit rating methods
• A high degree of concentration in credit rating
  activities and its possible anticompetitive
  effects
• 2006 IOSCO reported back to the EU Parliament no
  further regulation is needed.

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CRA regulation outside of the U.S. (cont.)

• May 2008 6-page document Changes to Code of
  Conduct for Credit Rating Agencies
• Quality and integrity of the rating process
• CRA independence and avoidance of conflicts of
  interest
• CRA Responsibilities to the Investing Public and
  Issuers
• Disclosure of the Code of Conduct and
  Communications with Market Participants
• April 2009 the European Parliament approved a
  43-page document an initial proposal of
  Regulation of the European Parliament and of the
  Council on Credit Rating Agencies
• to ensure that credit rating agencies avoid
  conflicts of interest in the rating process or at
  least manage them adequately
• to improve the quality of the methodologies and
  the quality of ratings
• to increase transparency by setting disclosure
  obligations
• to ensure an efficient registration and
  surveillance framework, avoiding forum shopping
  and regulatory arbitrage between EU
  jurisdictions.

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Future of CRAs

• Should credit rating agencies be held liable for
  the rating performance?
• Yes____________
• No____________

Information assymetry
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Contact information

• v.baklanova_at_my.westminster.ac.uk
• Papers
• Regulatory Use of Credit Ratings How It Impacts
  the Behavior of Market Constituents
• http//papers.ssrn.com/sol3/papers.cfm?abstract_id
  1378627
• http//westminster.academia.edu/ViktoriaBaklanova/
  Papers

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