We left the final piece of evidence to the end of our defense: Basel II, our suspect, was not on the crime scene or, rather, showed up later. In the United States, the epicenter of the financial crisis, the introduction of the new prudential discipline has been postponed (so far) to 2010. In Europe, the actual use of the new rules was very limited in 2007, when the crisis erupted.
Therefore, the financial turbulence occurred under the old Basel framework, making very palpable its shortcomings, particularly its low risk sensitivity and the scarce adaptability to financial innovation.
Certainly, many banks, while still meeting Basel I minimum requirements, had already reviewed their credit standards so they could make them consistent with the incoming Basel II discipline. It is therefore likely that some (or many) banks, in the attempt to transform well-established credit processes and risk management methodologies, may have misjudged the actual exposures to new risk types (or new manifestations of traditional risks). In our view, this does not imply that the new framework should be discarded, but rather it confirms the need that the testing phase of the new rules be quickly completed.
CONCLUSION
The Basel II prudential framework for banks has been often identified as one of the major, if not the major, driver of the turmoil. In this chapter, we have tried to show that not all arguments raised by Basel critics are well-founded.
We have argued that some of the regulatory failures that have been highlighted are failures of Basel I, rather than of the new framework. In other cases, they are indeed related to Basel II, but international and domestic regulators are already in the process of making important adjustments. Finally, other issues, such as fair value assessment, have nothing to do with prudential regulation. Last, but not least, we have loudly emphasized something that should be plain enough, but that it is very often forgotten: the Basel II rules were not actually applied in major countries when the crisis erupted.
Clearly, we do not deny that the financial turmoil has highlighted some draw- backs of the new framework. As a matter of fact, in the last months, international regulators have been intensively working on some of these issues: among others, Pillar 1 rules for structured products; the treatment of credit lines to off-balance vehicles; the prudential framework for trading book assets; a stricter regulatory regime for rating agencies. Last but not least, the two consultative documents
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published by the Basel Committee in December 2009 aim at strengthening banks, liquidity risk management and capital levels.
Against this background, we think that it is not sensible to blame Basel II because it did not prevent unregulated intermediaries from excessive leveraging and risk taking. It is much more meaningful to propose the extension of the scope of application of the new prudential regime to those intermediaries. With regard to simplified supervisory tools, such as the leverage ratio, which are becoming increasingly popular, we do believe that these are likely to raise the same problems posed by Basel I. While we cannot exclude that such tools could be used as a complement to Basel II, we are skeptical that they can serve as a full substitute for a risk-sensitive regulation.
At this point, we stop and leave the reader free to surmise. If our arguments have been convincing, it should be clear that it is urgent to strengthen Basel II, but there are not sound reasons for abandoning the philosophy underlying the new framework. Conversely, if Basel II is judged guilty, the only remedy is not going forward to Basel III but going back to Basel I.
REFERENCES
Benink, H., and G. Kaufman. 2008. Turmoil reveals the inadequacy of Basel II.Financial Times, February 28.
Borio, C. 2008.The financial turmoil of 2007–? A preliminary assessment and some policy consid- erations. Bank for International Settlements, working papers 251.
Draghi, M. 2009.The Governor’s Concluding Remarks.
EU Ecofin. 2004.Press Release—2628th Council Meeting.
FSF (2008), Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience, Basel.
Goodhart, C., and A. Persaud. 2008. How to avoid the next crash.Financial Times, January 30.
Onado, M. 2008.Il problema `e il capitale (Capital is the problem). www.lavoce.info.
Sironi, A. 2008.Addio a Basilea II (Farewell to Basel II). www.lavoce.info.
Tarullo, D. 2008.Banking on Basel: The future of international financial regulation. Washington, DC: Peterson Institute for International Economics.
Zingales, L. 2008. La sospensione del mark-to-market (The suspension of mark-to-market).
Il Sole24Ore, October 15.
ABOUT THE AUTHORS
Francesco Cannataholds a M.Sc. in finance from the Cass Business School (United Kingdom) and a Ph.D. in banking and finance from III University of Rome (Italy).
He is the head of the Regulatory Impact Assessment Unit in the Regulation and Supervisory Policies Department of Banca d’Italia, the Italian central bank. His interests concern mainly economics of financial regulation, Basel II, and risk man- agement. He has published several articles in Italian and international journals.
He is also the editor of a comprehensive book on internal ratings (The IRB Method, Bancaria Editrice). A new edition is forthcoming.
Mario Quagliariello holds a Ph.D. in economics from the University of York (United Kingdom) and is a senior economist in the Regulation and Supervisory Policies Department of Banca d’Italia, the Italian central bank. His interests con- cern macroprudential analysis and stress tests, Basel II, and procyclicality, the economics of financial regulation. He has published several articles in Italian and international journals, including theJournal of Banking and Finance,theJournal of Financial Services Research,theJournal of International Financial Markets, Institutions and Money, Applied Economics, Applied Financial EconomicsandRisk.He is the edi- tor of the volumeStress Testing the Banking System: Methodologies and Applications, published by Cambridge University Press.
CHAPTER 47
Credit Rating Organizations, Their Role in the Current
Calamity, and Future Prospects for Reform
THOMAS J. FITZPATRICK IV
Economist in the Office of Policy Analysis at the Federal Reserve Bank of Cleveland
CHRIS SAGERS
Associate Professor of Law at the Cleveland-Marshall College of Law, Cleveland State University∗
In light of the present economic crisis and their role in it, the world has taken a sudden interest in a small group of private corporations, often referred to as bond rating agencies, credit rating agencies, or credit rating organizations (CROs). Two significant CROs dominate the CRO market worldwide: Moody’s Investors Services and Standard and Poor’s.1Their debt ratings are incorporated into numerous federal and state regulations, granting them regulatory control over certain financial institutions. CROs have frequently been criticized by observers for failing to warn of major bond defaults, while simultaneously earning substantial profits for rating and monitoring bond issuances on their probability of default.
Most recently, CROs have drawn criticism for their active complicity in the melt- down in structured finance and related investment vehicles that are at the heart of the current economic crisis.
Historically, the CROs have operated free of regulation. This is now changing, as policy makers and academics struggle with how to effectively regulate CROs.
∗This paper briefly summarizes our more extensive treatment of the credit rating organiza- tions and their role in the present economic crisis, Thomas J. Fitzpatrick IV and Chris Sagers,
“Faith-Based Financial Regulation: A Primer on Oversight of the Credit Rating Organizations,” 61 Admin. L. Rev. 557 (2009).
The views and opinions expressed are those of the authors and not necessarily those of the Federal Reserve Bank of Cleveland, the Board of Governors, or other banks in the Federal Reserve System.
377 Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future
by Robert W. Kolb Copyright © 2010 John Wiley & Sons, Inc.
This debate has been dominated by two policy concerns: whether private credit ratings improve capital asset pricing efficiency and whether they reduce systemic risk. Noticeably absent from the debate, however, is an assessment of the current and proposed law surrounding the CROs and their likely future regulability. In this paper we provide this assessment and posit two propositions. First, the industry in its current posture cannot be meaningfully regulated. Second, it is likely to remain this way under proposed policy changes that contemplate a major private role in the formal assessment of credit risk.
HOW THE CROs CAME TO BE
Providing credit ratings is an old business in the United States. Companies pro- vided reports on the creditworthiness of merchants as early as the 1840s,2and both of the major CROs started rating debt in the early 1900s. The role of credit ratings in capital markets was expanded numerous times by U.S. government regulations, beginning in 1936 when the Office of the Comptroller of the Currency incorpo- rated credit ratings into federal banking capital requirements and peaking in the 1970s when the Securities and Exchange Commission (SEC) began making regula- tory use of credit ratings when setting capital requirements for securities firms.3It was in this latter period that the SEC created the familiar “Nationally Recognized Statistical Rating Organization” (NRSRO) designation.4
The regulatory use of credit ratings today, which essentially outsources reg- ulatory risk assessment to CROs, abounds: NRSRO ratings can be found in eight federal statutes and more than 60 regulations.5States, courts, private parties, and even foreign governments have also outsourced risk assessment to CROs. This regulatory use of NRSRO ratings has dramatically increased demand for them, making them necessary even when no independent reason for their use exists.
In addition, CROs have benefited from three major trends in capital markets since the 1970s. The first is the significant amount of deregulation that has taken place over the past 30 years,6and the second is the creation of increasingly complex financial products that deregulation facilitated. The third critical trend is disinter- mediation, which is the erosion of the buffer that once existed between investors and investment products. Instead of savings and relatively low-risk institutional investments, retail investors increasingly invest directly in riskier channels in hopes of greater returns. As the complexity of financial products has increased, the so- phistication of parties investing in them has decreased. Information asymmetries increase demand for third-party risk assessment, which has increased demand for and regulatory reliance on CRO debt ratings.
The problems caused by regulatory outsourcing, deregulation, disintermedi- ation, and complex financial innovation came to a head with the recent failings in structured finance.7 CROs found themselves at the center of the creation of asset-backed securities (ABS)—debt issues unlike traditional corporate debt—and derivatives thereof. ABS markets like those for mortgage-backed securities and collateralized debt obligations could thrive only with high credit ratings.