GARP Webcast

Credit Ratings and the Dodd-Frank Act

Presented by:

Jess Cornaggia
Kelly School of Business, Indiana University
Anastasia Kartasheva
Wharton School, University of Pennsylvania
Peter Went
Senior Researcher, GARP Research Center

April 12, 2011

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1 • Webcast starts at the top of the hour
Credit Ratings and the Dodd-Frank Act

The Dodd-Frank Act Changes the Functioning of Credit Rating Agencies, or Nationally
Recognized Statistical Rating Organizations (NRSROs)

 Significant alterations to how NRSROs will function in the future

o NRSROs faced criticism for the failure of credit ratings to accurately reflect the
riskiness of complex structured products.
o Ratings failures were attributed to weak internal controls, the issuer-pay business
model, poor transparency and limited accountability for credit rating agencies.
o Regulatory use of credit ratings serves as an implicit government guarantee.

 The Dodd-Frank Act

o Governance and compliance of NRSROs
o Management of conflicts of interest
o Accountability for ratings process
o Using ratings for regulatory purposes
o SEC oversight

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Using Ratings for Regulatory Purposes

Federal Agencies to Review and Modify Regulations, Providing an Alternate Standard

of Creditworthiness

 Remove references to credit ratings from federal laws

 Finding viable alternatives has proven problematic

o Prohibiting the use of credit ratings complicates risk-sensitive capital calculations
o Issues raised for investment decisions and prudential requirements
o Large banks may already have sophisticated internal rating models
o The use of internal ratings presents incentive problems

 Potential conflicts with the Basel frameworks

o Basel II Accord – capital requirements
o Basel III Accord – capital requirements, liquidity standards

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 The Role of Credit Ratings in U.S. Bank Regulatory Framework

General Basel II – Basel Market Risk

Exposure Risk-Based Advanced Market Standardized Framework
Category Capital Rules Approaches Rules Risk Rules Approach (Basel III)
Sovereign X X X
Public Sector
Entity
X X X

Bank X X
Corporate X X X X
Securitization X X X X X
Credit Risk
Mitigation
X X X

Source: Advance Notice of Proposed Rulemaking Regarding Alternatives to the Use of Credit Ratings in the Risk-Based Capital
Guidelines of the Federal Banking Agencies

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Implications for U.S. Banks

U.S. Banks May Be Holding More Capital Under the Basel III Framework Than
Non-U.S. Banks

 Removing ratings reduces the ability to distinguish between risks

o U.S. banks are faced with less risk-sensitive capital determination

 Implementation imbalance between U.S. and the rest of the world

o Basel III is being implemented slowly
o Basel II has been delayed, due partially to regulatory concerns with capital levels
in the more advanced approaches

 Basel Committee is focusing on implementing standards consistently

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 The Use of Credit Ratings in the
Post Dodd-Frank World

Jess Cornaggia, Kelly School of Business, University of Indiana

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Regulators and Credit Ratings

Dodd-Frank Nullifies Regulatory Reliance on NRSRO Credit Ratings

 At first glance, this change would appear to wipe out the usefulness of
credit ratings altogether

 However, credit ratings will continue to play an important role in the U.S.
economy

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The Future of Credit Ratings

The Use of Credit Ratings Will Change Dramatically

 Affected parties:
o Banks
o Funds
o Insurance companies
o Corporations

 How will credit rating agencies (CRAs) be affected?

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Affected Party: Banks

 Reconciling the Basel accords with Dodd-Frank will be difficult

o Capital requirement standards in Basel II and Basel III rely heavily on NRSRO
credit ratings

 Regulators have many tools at their disposal to ease the transition.

o For example, in July 2009 the SEC issued a no-action letter exempting the
credit ratings agencies from expert liability

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Affected Party: Money Market Funds

 New rules proposed by the SEC would require funds’ boards of directors
to determine the credit quality of a security
o Credit ratings could be used in this analysis

 A similar approach could apply to pension funds and mutual funds.

o The Department of Labor (which enforces ERISA) currently relies on NRSRO
credit ratings as benchmarks of credit quality

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Affected Party: Insurance Companies

 Generally regulated at the state level, not the federal level

 In 2008, the NAIC distanced itself from the NRSRO credit ratings due to bond
insurer downgrades
o “Guilt by association”

 Dodd-Frank would appear to have a relatively small impact on insurance

companies vis-à-vis credit ratings

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Affected Party: Corporations

 If NRSRO ratings are no longer useful for regulatory compliance, investors

will exhibit less demand for them

 Therefore, corporations issuing debt will have less incentive to pay for NRSRO
ratings

 However, rating-trigger clauses are common in corporate debt issues and

other contracts
o Mass rewriting of corporate bond indentures seems unlikely

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Credit Rating Agencies

How Will the Rating Agencies Adapt to Dodd-Frank?

 Watch lists and other products may become a more valuable part of the rating
agencies’ business

 However, credit ratings should remain useful because they are low-cost
coordination mechanisms
o They are publically observable
o They dramatically reduce the need for information reproduction

 Perhaps most importantly, viable alternatives are scarce

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 Will Dodd-Frank Improve the
Information Precision of Ratings?

Anastasia Kartasheva, Wharton School, University of Pennsylvania

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Credit Ratings Industry

 The credit rating industry is dominated by a few firms

o S&P, Moody’s and Fitch in bond ratings
o A.M. Best, Fitch, S&P and Moody’s in insurance ratings

 Information is pooled in letter grades

o There are 10 to 20 rating grades in different sectors of the market

 Partial market coverage

o In 2000, A.M. Best rated 80.5% of insurance companies; S&P rated 27.5%

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2008 Credit Ratings

Outstanding Credit Ratings Reported by NRSROs by Rating Class – 2008

 At first glance, this change would appear to wipe out the usefulness of
credit ratings altogether.

 However, credit ratings will continue to play an important role in the U.S.
economy.

• Herfindahl-Hirschmann Index (HHI) is a measure of market concentration.

• 3,778 is equivalent to (10,000/3,778) 2.65 firms.

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Use of Ratings in Regulation

 Value of a rating:
1. Information about credit risk of an issuer
2. Use of rating triggers in various financial contracts
3. Regulatory compliance

 Dodd-Frank removes #3, but it is unlikely to remove #1 and #2

 Value of #1 and #2 is determined by the information content of ratings; value

of #3 need not depend on information
o The huge volume of AAA rated structured securities was mostly due to the
demands of capital requirement compliance

 How will the current trends in the ratings industry affect the information content
of ratings post Dodd-Frank?

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Effects of Competition

Does Competition Lead to More Informative Ratings?

 Contrasting models
o Focus on accuracy of ratings
 Incentives to make costly investments in rating accuracy
 Reservation price of firm for each rating depends on information content
of that rating (given existing ratings)
 Information content of each rating will decline as more ratings are available
 Competition less accurate ratings

o Focus on classification
 CRAs have incentives to use fewer rating classes in order to increase
willingness to pay for ratings
 Entrants will compete by differentiating their rating scales
 Competition finer rating classes

o These competing mechanisms could co-exist

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New CRAs

The Effects of the Entry of New CRAs

 Empirical analysis
o Insurers’ financial strength ratings
 Incumbent firm – A.M. Best
 New entrant – Standard & Poor’s in the early 1990s

 Empirical results
o S&P entered with a more stringent rating scale
o Better than average insurers in of A.M. Best’s rating categories were more likely
to solicit a rating from S&P
o Insurers with higher value of information were more likely to solicit an S&P rating

 Policy implications
o Rating standards may differ across rating agencies
o If the standards and rating performance are transparent, it leads to more
informative ratings
o But lack of transparency in rating standards from multiple CRAs is likely to create
confusion about the meaning of a rating and encourage rating shopping

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