Regulatory Measures Introduced During the Financial Crisis

7.1 Revision of the IOSCO Code

The financial crisis led financial regulators to conclude that provisions of the IOSCO Code were inadequate. As a result, the Code was fundamentally revised in 2008. The changes made were intended to address issues that arose in relation to the activities of CRAs in the market for structured finance products. Although the IOSCO Code still contains no specific rules concerning methodologies, it now sets out extensive disclosure requirements aimed at enabling both investors and regulators to gain better insight into ratings and avoid an excessive reliance on CRAs at the expense of their own judgment. The main changes in the revised Code are as follows (see IOSCO 2008a).

To protect the quality and integrity of the rating process, CRAs should:

• prohibit CRA analysts from making proposals or recommendations regarding the design of structured finance products that the CRA rates;
• ensure the quality of the information needed for ratings and inform users about the limitations of the rating;
• periodically review the methodologies and models they use;
• ensure that the decision-making process for rating action is conducted in an objective manner;
• ensure that rating analysts have appropriate knowledge and experience;
• establish procedures to review the feasibility of providing ratings for new structures;
• ensure that methodologies and models for determining credit ratings of structured products are appropriate when the risk characteristics of the assets underlying a structured product change materially; and
• ensure that adequate resources are allocated to monitoring and updating their ratings.

To ensure CRA independence and avoidance of conflicts of interests, CRAs should:

• state whether issuers will publicly disclose all relevant information about the product being rated;
• disclose whether any client accounts for more than 10% of the CRA's annual revenue;
• review the past work of analysts that leave the CRA;
• review remuneration policies to ensure the objectivity of the CRA's rating process; and
• define what they do and do not consider to be an ancillary business and why.

Regarding their responsibilities to the investing public and issuers, CRAs should:

• publish historical information about the performance of their rating opinions;
• differentiate ratings of structured finance products from other ratings, preferably through different rating symbols;
• indicate the attributes and limitations of each credit opinion;
• provide investors with sufficient information so that an investor can understand the basis for the CRA's rating; and
• disclose the principal methodology or methodology version used in determining a rating.

This was not the end of the response to the financial crisis by international supervisors, however. At the end of July 2008, IOSCO (2008b) published a statement announcing that a task force would explore possible cooperation between its members with the aim of ensuring that CRAs disclosed information in the due and complete form envisaged by the IOSCO Code. The tightening of regulatory requirements culminated in the following announcement in September: “IOSCO favours a consistent global regulatory approach to monitoring the activities of CRAs. It urges legislators to consider the regulatory consensus represented by the IOSCO Code of Conduct when framing legislation as any fragmentation runs the risk of a recurrence of problems with product ratings” (IOSCO 2008c). Financial supervisors thus paved the way for the formal regulation of credit rating agencies.

7.2 Revision of the Credit Rating Agency Reform Act

In the US, the SEC sought during the financial crisis to further improve the regulation of CRAs. In June 2008, it released a report outlining serious deficiencies in the ratings process. It subsequently adopted new rules designed to increase the transparency of NRSRO rating methodologies, strengthen NRSRO disclosures of ratings performance, prohibit certain NRSRO conflicts of interests, and enhance NRSRO recordkeeping. NRSROs were required to start making publicly available their rating histories in the form of a random sample of 10% of issuer-paid ratings for each class of ratings.

At the end of 2008, building on earlier rulemakings, the SEC adopted requirements to enhance NRSRO transparency and further address potential NRSRO conflicts of interests (see SEC 2008b). It also proposed additional rules (see SEC 2008c), which were introduced in April 2009.

7.3 Measures in the EU

After the outbreak of the financial crisis, the European Commission asked CESR to prepare a report on problems associated with credit ratings. CESR was instructed to focus on the following issues:

• the transparency of rating methodologies,
• number and expertise of staff at CRAs,
• regular monitoring of ratings and topicality of rating actions, and
• potential conflicts of interests (e.g., remuneration schemes at CRAs).

In addition, the Commission requested ESME to examine credit ratings in the securities market. CESR (2008) made the following recommendations on regulating CRAs:

• The IOSCO Code should be a minimum standard.
• An international body should be established to set standards for CRAs on the basis of the IOSCO Code and monitor compliance. The names of CRAs deviating from the Code should be made public (“name and shame”). Issuers, investors, and investment firms should be represented on the body. CRAs' participation in this body should be limited to involvement in drawing up the standards. Members of the body should be appointed by the international supervisors to which the body would report.
• CRAs should deliver the necessary information.
• If this international body cannot be set up at short notice, a European authority reporting to CESR should be established.
• Only if market participants fail to provide the necessary support or if the body is unable to adequately ensure the integrity and transparency of ratings should financial supervisors consider further measures, including regulation.
• The European Commission should set the process in motion as soon as possible. In the event of undue delay, regulatory action should be taken.

In its report, CESR (2008: 3) concluded that: “there is no evidence that regulation of the credit rating industry would have had an effect on the issues which emerged with ratings of US subprime backed securities and [CESR] hence continues to support market driven improvement.”

CESR nevertheless took the view that greater commitment was required on the part of market participants and CRAs if the necessary discipline was to be ensured. It also pointed out that the use of ratings for regulatory purposes could result in excessive confidence being placed in ratings.

The IOSCO Code remained the relevant benchmark for the credit rating industry, although CESR now considered it merely a minimum standard on which to base an extended model aimed essentially at refining and enforcing the Code.

ESME (2008) believed that the CRAs themselves had to solve the problem of the loss in confidence. It saw no regulatory magic bullet. On the contrary, full, formal regulation might result in credit ratings being trusted to a point that could not possibly be justified. ESME therefore recommended revising the IOSCO Code and adding provisions to remedy the problems that had come to light in the rating of structured finance products. In addition, ESME recommended that the Code be complemented by the external monitoring of CRAs' corporate governance, and that an advisory group be set up to report to CESR.

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