Regulatory Reliance on Credit Ratings

Regulators are important users of credit ratings. They have created rating-based regulations, thereby forcing market participants to rely on credit rat-ings. Regulators also use credit ratings on their own behalf. For instance, central banks may rely on credit ratings when deciding which securities to accept as collateral.

a. Rating-Based Regulations

There are several mandates to use credit ratings in financial market regula-tions. Two types of regulatory intervention have system-wide impacts on the financial markets.

964 DE LAROSIÈRE Report, at 19.

965 PARTNOY, Overdependence on Credit Ratings was a Primary Cause of the Crisis, at 10.

First, risk-sensitive measures of regulatory capital increase the importance of certified CRAs if their credit ratings are widely used to attribute the var-ious risk weights to assets in the financial markets. The Basel II framework encouraged global implementation of risk-sensitive bank capital require-ments, and the Basel III framework continues to do so. The use of external credit ratings in order determine the appropriate risk weights is described under the Standardized Approach of Basel II and III.⁹⁶⁶ The system-relevance of this method is derived from the use of credit ratings and its global acceptance. The fact that regulatory-prescribed risk models were widely adopted contributed to homogenizing market participants behav-ior.⁹⁶⁷ Before the subprime mortgage crisis, banks were able to report rela-tively high risk-weighted capital ratios.⁹⁶⁸ Basically, banks could benefit from risk-sensitive capital requirements. They were holding triple-A-rated assets on their balance sheets. The contrast between the risky activities that banks were increasingly associated with and the increasingly healthy ratio of their regulatory capital was striking.⁹⁶⁹ As long as bank assets were high-ly rated, banks could extend their balance sheets and enjoy high leverage ratios with the consent of regulators.⁹⁷⁰ However, troubles became visible along with massive credit rating downgrades in July 2007. In the subprime mortgage crisis triple-A-rated assets were downgraded to junk status in an extremely short space of time. This phenomenon had negative impacts on the capital ratios of banks using credit ratings to define the risk weights of their assets. Bank capital ratios deteriorated instantly after the downgrades so that affected banks had to raise new capital or dispose of assets.⁹⁷¹ Therefore, the use of credit ratings in bank capital market regulations exac-erbates market trends if widely adopted by regulators and market partici-pants. In this respect, a significant improvement of the Basel III reform measures is the idea of countercyclical capital buffers to mitigate the pro-cyclical effects of the risk-weighted capital requirements. ⁹⁷²

966 BCBS,International Convergence of Capital Measurement and Capital Standards, A Revised Framework (Basel II), para. 50.

967 ALEXANDER ET AL., Financial Supervision and Crisis Management in the EU, at 20.

968 Id. (arguing that at the end of 2006, the ratio of regulatory capital to risk-weighted assets was 13 percent in the US, 12.9 percent in the UK, 12.2 percent in Germany, 10.7 percent in Italy – significantly above the 8 percent minimum).

969 Id.

970 BCBS, Consultative Document, Strengthening the Resilience of the Banking Sector, at 60 (recognizing that the Basel II framework allowed banks to build up excessive leverage while still reporting strong risk-based capital ratios).

971 DE LAROSIÈRE Report, at 12 (“Once [CRAs] started to revise their credit ratings for CDOs downwards, banks were required to adjust their risk-weighted capital requirements upwards.

Once again, already highly leveraged, and faced with increasing difficulties in raising equity, a range of financial institutions hastened to dispose of assets, putting further pressure on asset prices”).

972 BCBS, Consultative Document, Countercyclical Capital Buffer Proposal, at 1.

Second, investment limitations imposed on charter-constrained investors can – under certain regulations – depend on credit ratings.⁹⁷³ Financial market regulations using credit ratings to design permitted investments have essentially been developed in the US for the pension funds and insur-ance sectors. Highly regulated entities are subject to portfolio restrictions in view of investor protection.⁹⁷⁴ As a consequence, market participants may be forced to sell their holdings for regulatory reasons.⁹⁷⁵

Such rating-based regulations can have unintended and counterproductive effects. At any rate, they contribute to increasing the importance attributed to the credit ratings of certified CRAs.⁹⁷⁶ Especially massive credit down-grades may have negative impacts on the financial markets. Before the sub-prime mortgage crisis, charter-constrained investors were allowed to buy mortgage-related securities as long as they were rated investment grade by the certified CRAs. As a direct consequence of the massive credit rating downgrades in July 2007, charter-constrained investors were forced to sell the assets downgraded to a level below the investment grade.⁹⁷⁷ They had to sell at the worst moment since the repricing of credit risk implied a re-pricing of asset prices at lower levels. Moreover, the fact that market par-ticipants were homogeneously selling dropped asset prices even further.⁹⁷⁸ Therefore, regulations forcing market participants to rely on credit ratings cause exacerbated market reactions to credit rating downgrades. The pur-pose of investor protection was not achieved when highly regulated market participants had to sell at the worst time.

The two aforementioned examples highlight the serious repercussions of rating-based regulations on the behavior of market participants. When de-signing financial market regulations, regulators should take into account the unintended effects of their regulatory activities. A macroprudential ap-proach to financial market regulations is required in order to assess the side effects of the regulatory frameworks.⁹⁷⁹

973 THE JOINT FORUM,Stocktaking on the use of credit ratings, at 7.

974 See further id. at 8 (explaining that, for instance in Italy, credit ratings are required by regulation only when securities are sold to non-professional investors; in this regard, regulatory interven-tion aims at protecting unsophisticated investors).

975 CASEY &PARTNOY, Downgrade the Ratings Agencies.

976 ABDELAL,Capital Rules, The Construction of Global Finance, at 171 (stating that the dangers of using credit ratings in regulations to limit investors’ exposure to risky securities became clear very quickly).

977 CASEY & PARTNOY, Downgrade the Ratings Agencies (arguing that – due to investment restrictions requiring so many funds to hold highly rated assets – a credit rating downgrade can set off a financial collapse by forcing investors to sell).

978 ALEXANDER ET AL., Financial Supervision and Crisis Management in the EU, at 25.

979 SY, The Systemic Regulation of Credit Rating Agencies and Rated Markets, at 3.

b. Collateral Policy of Central Banks

Regulators can also use credit ratings for their own purposes. More particu-larly, the use of credit ratings by central banks plays a crucial role in mod-ern financial markets and partly contributes to over-reliance on credit rat-ings.⁹⁸⁰ Central banks have, to a considerable extent, incorporated credit ratings into their lending rules in order to determine eligible collateral for loans. In other words, certified CRAs play a crucial role in helping central banks decide what assets can be used as a guarantee for central bank loans.

Central banks’ collateral rules gain prominence in times of crisis. Central banks extend facilities in a liquidity crisis. During a financial crisis, central banks extensively intervene as providers of liquidity since financial institu-tions do no longer adequately perform this function. Generally, central banks agree to lend money if borrowers provide investment-grade securities as a guarantee. Credit ratings are typically used in central bank policies due to their convenience. Although CRAs proved to be unreliable in the sub-prime mortgage market, central banks continued to use credit ratings to de-termine eligible collateral at the height of the financial crisis.⁹⁸¹

In the US, the Fed’s 1 trillion US dollar TALF plan – a colossal program to encourage lending – mandated that only securities rated by at least two ma-jor NRSROs were eligible for aid.⁹⁸² Borrowers could only use triple-A rat-ed assets as collateral.⁹⁸³ In other words regulatory reliance on credit ratings still persisted in the aftermath of the subprime mortgage crisis. Critics ques-tioned the use of credit ratings in the Fed’s collateral rules, yet central banks seemed to have difficulty finding a practical alternative.⁹⁸⁴

In Europe, the ECB experienced the downside of using credit ratings to de-termine eligible collateral with respect to the Greek rescue package. The ECB took steps to accept below-investment-grade bonds as collateral for ECB loans, which was not welcomed by the financial markets.⁹⁸⁵ Investors interpreted this decision as a bad signal. They believed that the situation had deteriorated to such a considerable extent that the ECB was willing to accept junk bonds as collateral.

980 FSB, Principles for Reducing Reliance on CRA Ratings, at 3.

981 THE WALL STREET JOURNAL, The Big Barofsky, Someone in Washington is Standing up for Taxpayers (quoting NEIL BAROFSKY, Special Inspector General, Troubled Asset Relief Program (TARP)).

982 DARBELLAY &PARTNOY, Credit Rating Agencies and Regulatory Reform.

983 CASEY &PARTNOY, Downgrade the Ratings Agencies.

984 See, e.g., THE WALL STREET JOURNAL, The Big Barofsky, Someone in Washington is Standing up for Taxpayers (quoting NEIL BAROFSKY, Special Inspector General, TARP).

985 KENNEDY &TOTARO, ECB Comes to Greece’s Aid by Waving Collateral Rules.