Friday, March 30, 2012

Credit Rating Agency Regulation in the US

This week, I would like to build on my last week’s article about the existing and proposed regulation of credit rating agencies (CRA) in the EU by discussing the current status of such regulation in the US.

Basics of the Dodd Franck Reform of CRA Regulation

On January 5, 2010, the Dodd Franck Act has provided for significant changes in the US regulation on CRA.

The reasons for the American legislator to amend the existing regulation were

  • the systemic importance of credit ratings;
  • the reliance placed on credit ratings by individual investors, institutional investors, and financial regulators;
  • the central role of CRA in capital formation;
  • the importance of credit ratings for the efficient performance of the US economy.

The Dodd Franck act starts off with the basic finding that “credit rating agencies face conflicts of interest”. The new legislation intends to contain such conflicts by “careful monitoring” and by “giving clearer authority to the Securities and Exchange Commission”.

First of all, the new regulation distinguishes 3 types of rating agencies:

  • Credit Rating Agency: The legal definition comprises only such agencies whose ratings are publicly available for free or a reasonable fee, which employ a quantitative and/or qualitative model, and whose business model is based on a payment by issuers, investors, or other market participants. The aforementioned conditions are cumulative conditions.
  • Nationally Recognized Statistical Rating Organization (NRSRO): Such rating organization must be registered with the SEC to issue ratings certified by qualified institutional buyers such as financial institutions, insurance companies, corporate issuers, issuers of asset-backed securities, and issuers of government and municipal securities.
  • Person associated with a NRSRO: The legal definition includes any person controlling a NRSRO (partner, officer, director, branch manager, etc.) as well as any person controlled by a NRSRO (namely employees).

The bulk of new legislation applies to NRSRO and any person associated with a NRSRO.

Current Status of US CRA Regulation

Relationship CRA / SEC

The relationship between the CRA and the SEC is characterized by the obligation of the CRA to register and the possibility of the SEC to cancel this registration.
It is important to note that the obligation to register only applies to CRA who want to be treated as NRSRO. The Securities Exchange Act 1934 contains detailed information regarding the content of the CRA’s application. The main reason for the SEC to refuse registration is an applicant CRA “not having adequate financial and managerial resources to consistently produce credit ratings with integrity and to materially comply with the procedures and methodologies disclosed”.
Generally speaking, the SEC can cancel the registration if this is “necessary for the protection of investors and in the public interest” and one of the enumerated cases of cancellation (such us commission of crimes and violation of securities laws) exists.

Relationship CRA / Investors

Prohibited acts include the following:
  • Bundle the issuing of credit ratings with other products or services of the NRSRO
  • Threaten to lower a credit rating of securities of an asset pool unless other securities of such asset pool are also rated by the same NRSRO.
  • Threaten to modify a credit rating unless the obligor purchases the credit rating or any other service or product of the NRSRO.

Relationship CRA / Issuer

As regards the international organization of CRA, the most important set of regulations is the management of conflicts of interest. The current US CRA regulation distinguishes conflicts of interests as per § 240.17g-5 (b) and prohibited conflicts of interests as per § 240.17g-5 (c). In the first case the NRSRO must disclose the existence of the conflict of interest but can nevertheless issue a credit rating. In the second case, it is not allowed to issue a credit rating.


  • Dodd Franck Act as of January 5, 2012
  • Securities Exchange Act 1934 as amended lastly on January 3, 2012
  • SEC Rules and Regulations Part 240, §§ 240.17g-1 et seq.
  • SEC Proposed Rules for Nationally Recognized Statistical Rating Organizations as of May 18, 2011

Sunday, March 25, 2012

Credit Rating Agency Regulation

Credit Rating Agency (CRA) regulation is back in the news:

  • “According to European and UK regulators, forcing issuers to rotate the agencies that rate their bonds could do more harm than good by opening the door to lower quality ratings by inexperienced analysts.” (FT on 29 February 2012)
  • “The three big credit rating agencies must improve their transparency, IT and internal controls and strengthen the committees that oversee decisions on individual securities.” (FT on 22 March 2012)

Regarding the ongoing discussion on CRA regulation, I would like to share with you the major findings of an article that I read recently in the Journal of Finance. The authors Bolton, Freixas, and Shapiro develop an interesting model to analyze the effects of specific (CRA) regulation on the industry as such and the reliability of ratings in particular.

Their main findings are:

  • The competition among CRAs may reduce market efficiency since it facilitates ratings shopping by issuers and results in excessively high reported ratings. In particular, as a result of issuer shopping, efficiency may be higher under a monopoly CRA than under a duopoly despite the potential for the increased informativeness of two ratings.
  • CRAs are more prone to inflate ratings during booms when there is a larger clientele of investors in the market who take ratings at face value and when the risks of failure that could damage CRA reputation are lower. In other words, when times are good, the probability of defaults is lower, which may decrease due diligence on the part of investors as well as evidence of ratings bias.
  • When an issuer is more important to a CRA, either because it is a repeat issuer or because it has larger issues, the CRA is more prone to inflate that issuer's ratings.

In the authors' view, CRA regulation should address the following key issues:

  • Eliminate the CRA conflicts of interest by preventing issuers from influencing ratings
  • Prevent issuers from shopping for ratings and disclosing only those ratings they prefer
  • Monitor the quality of the ratings methodology

As a reminder, the current European CRA regulation may be summarized as follows:


The overall purpose of European CRA regulation is to enhance the integrity, transparency, responsibility, good governance, and reliability of credit rating activities.

Use of credit ratings for regulatory purposes

Where European legislation requires a credit rating to be obtained for a specific investment, such rating must comply with one of the following alternatives:

  • The CRA is registered with the European Securities and Markets Authority (ESMA) and the rating is issued in the EU.
  • The CRA is registered with ESMA and the rating, that has been issued outside the EU, is in line with specific endorsement conditions such as material compliance with European CRA regulation and the existence of an objective reason for the credit rating to be elaborated in a third country.
  • The CRA is not registered with ESMA, the rating, that has been issued outside the EU, opines on a non EU investment, and the foreign CRA regulation is comparable to European CRA regulation.

It should be noted that the registration process with ESMA is described in detail by the European regulation 2009-1060.

Independence and avoidance of conflicts of interest

The European regulation 2009-1060 contains very detailed provisions in this regard that apply to the rating agency as such as well as its rating analysts.

Credit Ratings

The credit ratings issued must ensure compliance with two major sets of conditions:

  • First, they must be developed on the basis of methodologies, models, and key assumptions that respect the framework set by European CRA regulation.
  • Second, credit rating must be disclosed to the general public.

Supervision by ESMA

The supervision by ESMA is a continuing process that includes the elaboration of an annual report, the right to request information, the right to lead general investigations, and the right to carry out on-site inspections.

Penalties and Fines

A detailed set of rules, including penalties and fines, ensure that European CRA regulation shall be effectively applied in practice.

On November 15, 2011, the European Commission has proposed to further refine the current CRA regulation as follows:

  • Necessary notification of stakeholders (including ESMA) prior to changing rating methodologies (Art. 5 a)
  • Ownership structure of CRA: The same investor cannot hold more that 5 % in two or more CRA simultaneously. (Art. 6 a)
  • Except for sovereign ratings, mandatory rotation of CRA after one year and 10 consecutive ratings or, at least, after 3 years. (Art. 6 b)
  • Transfer of relevant information in a handover file upon mandatory rotation (Art. 6 a)
  • Necessity to get a structured finance instrument rated by at least two independent CRA. (Art. 8 b)
  • Publication of all ratings in form of a centralized European Rating Index (EURIX) (Art. 11 a)
  • Development of common standards for rating scales (Art. 21 (4a))
  • Civil liability of CRA towards investors in case of intentional or gross negligent violation of European CRA regulation (Art. 35 a)


  • Bolton, Freixas, Shapiro: The Credit Ratings Game in Journal of Finance 2012, pages 85 et seq.
  • EC Regulation 2009-1060 of 16 September 2009, lastly amended on 1 July 2011
  • European Commission Proposal of a Regulation amending EC Regulation 2009-1060 (published on 15 November 2011)

Saturday, March 17, 2012

Euro Zone Financial Governance – EFSF, EFSM, ESM, and ESFS

Financial governance in Europe is obviously a hot topic these days. Every day, we can read in the financial press the latest news on

  • how European banks are doing;
  • whether Euro zone countries are able to pay their debt;
  • if and how the whole project of a unique European currency can be rescued.

In this discussion, we can read about ever new mechanisms, facilities, and rescue funds that are created by Euro zone and/or EU members. I voluntarily admit that I feel a little bit lost in all these shortcuts used to designate the different institutions.

In this article, I would like to summarize which basic institutions have been created so far and what their respective purpose is.

I. Protection of Euro zone member states' solvability

European Financial Stability Facility (EFSF)

The EFSF has been created on October 19, 2011 by an international treaty. It constitutes a limited liability company under Luxemburg Law and has its registered office in Luxemburg.

The purpose of the EFSF is to grant financial assistance to beneficiary member states to protect their solvency. It can do so by

  • purchasing bonds in the primary or secondary market;
  • granting precautionary facilities or facilities to finance the re capitalization of financial institutions in a Euro area member state by a loan to the government of such member state.

The EFSF is backed by irrevocable and unconditional guarantees of the member states totalling 780 BEUR.

It shall be liquidated on June 30, 2013.

European Financial Stabilization Mechanism (EFSM)

The EFSM was put in place in May 2010 to preserve financial stability in the EU.

It grants financial assistance to a member state which is experiencing, or is seriously threatened with, a severe economic or financial disturbance caused by exceptional occurrences beyond its control. Such financial assistance may be granted in form of a loan or credit line.

European Stability Mechanism (ESM)

The ESM is an international financial institution that has been created by the ESM treaty signed on February 2, 2012. It has full legal personality; its principal office is in Luxemburg and it may establish a liaison office in Brussels.

The authorized capital of the ESM is 700 BEUR. Such capital is divided into paid-in shares (80 BEUR) and callable shares (620 BEUR). Annex I of the ESM treaty defines the proportion of authorized capital that each ESM member state shall contribute. Germany and France are the biggest contributors with 27 % and 20 % respectively.

The purpose of the ESM is to protect the financial stability of the Euro area by providing funding and other financial support to ESM members which face severe financing problems. It can support its member states through

  • granting precautionary financial assistance in the form of a precautionary conditioned credit line;
  • granting loans under the condition that a macro-economic adjustment program has been put in place;
  • purchasing bonds of an ESM member state on the primary market;
  • arranging for operations on the secondary market.

II. Banking Regulation – European System of Financial Supervisors (ESFS)

The ESFS is a network of national and Union supervisory authorities whose main objective is to ensure that the rules applicable to the financial sector are adequately implemented to preserve financial stability and to ensure confidence in the financial system as a whole and sufficient protection for the customers of financial services.

European Systematic Risk Board (ESRB)

The ESRB is based in Frankfurt am Main. Its purpose is to ensure the macro-prudential oversight of the Union's financial system. It

  • collects and analyzes all relevant and necessary information;
  • identifies and prioritizes systemic risks;
  • renders warnings and recommendations and monitors them.

European Banking Authority (EBA)

With the creation of the EBA, the EU wants to face the shortcomings in the areas cooperation and coordination among national supervisors of the EU financial market. In other words, it wants to ensure an integrated European supervision of the EU financial market.

The EBA has its seat in London and has legal personality as well as administrative and financial autonomy. It shall

  • improve the functioning of the internal market;
  • ensure a high, effective, and consistent level of regulation and supervision;
  • protect public values such as the stability of the financial system;
  • foster dialogue and cooperation with supervisors outside the EU.

The EBA is best known for carrying out stress tests of European banks.

European Insurance and Occupational Pensions Authority (EIOPA)

The objective of the EIOPA is to protect the public interest by contributing to the short, medium and long-term stability and effectiveness of the EU financial system. More specifically, it deals with the activities of insurance undertakings, reinsurance undertakings, financial conglomerates, institutions for occupational retirement provision and insurance intermediaries.

It has legal personality and its seat is situated in Frankfurt am Main.

European Securities and Markets Authority (ESMA)

The objective of the ESMA is the same as EIOPA's objective, e.g. to protect the public interest by contributing to the short, medium and long-term stability and effectiveness of the EU financial system. However, as its name indicates, its focus is on protecting the stability of securities markets.

The ESMA has legal personality and it has its seat in Paris.

Joint Committee of the European Supervisory Authorities

The purpose of the Joint Committee is to settle cross-sectoral disagreements between the European Supervisory Authorities.


  • EFSF Framework Agreement dated October 19, 2011
  • Treaty establishing the European Stability Mechanism dated February 2, 2012
  • EU Regulation 1092/2010 establishing the European Systematic Risk Board
  • EU Regulation 1093/2010 establishing the European Banking Authority
  • EU Regulation 1094/2010 establishing the European Insurance and Occupational Pensions Authority
  • EU Regulation 1095/2010 establishing the European Securities and Markets Authority

Thursday, March 8, 2012

What is a Collective Action Clause?

Collective action clauses (CAC) are very much discussed today as they are at the heart of the Greek bond restructuring and its outcome.

A collective action clause treats a very simple problem: If you pass a contract and on both sides of this contract there are several parties, basic civil law principles provide that every party must agree to any modification of the contractual terms. The “pacta sunt servanda.” principle says that every party must be in the position to rely on the contents of the signed agreement without running the risk of seeing the contractual terms changed against one’s own will.

When we look at bond issues to which a multitude of parties subscribe, the backdrops of this principle are obvious:

  • In practice, you will often not be able to reach all creditors to renegotiate.
  • Because every bondholder has diverging interests, you will never find a solution.
  • If you need every party to agree, each individual bondholder gains considerable bargaining power which may give rise to opportunistic behaviour.

Collective action clauses intend to solve the above described problem by providing ex ante for contractual mechanisms that facilitate decision-making processes in times of crisis. The basic idea is pretty straightforward. As we know that people will not be able to find an agreement in times of crisis, we try to get their agreement beforehand, e.g. at a time when everything looks fine.

However, there is no concrete definition of which contents you can find in a collective action clause.

Usually, it contains 2 main sets of rules: the quorum and type of majority required to modify the terms of a bond’s deed of covenants and the quorum and type of majority required to accelerate the bond.

As an example, I analysed one Greek bond issue from 2004, whose CAC provisions may be summarized as follows:

The principles of CAC provisions are pretty much standardized in bond documentations. However, the problem is that their individual design varies over time and from one bond issue to another, reflecting both changing market practices and changing balances of power between investors and bond issuers. As a matter of fact, this is what contributes pretty much to restructuring negotiations getting so complicated and time consuming.

Friday, March 2, 2012

The Impact of Fair-Value Accounting on Financial Statement Analysis

Does fair-value accounting really matter when it comes to financial statement analysis? I guess that most people would answer this question intuitively in the affirmative. So does also an analytical study that Rodriguez-Perez, Slof, Sola, Torrent, and Vilardell have recently published in the ABACUS Journal of Accounting, Finance, and Business Studies.

The authors have analyzed data from 85 Spanish insurance companies which, due to specific Spanish regulation, publish both historical cost based and fair-value based valuations for different types of assets.

In their analysis, the authors draw two major sets of conclusions:

Difference in cost-based vs. fair-value based accounting

The numbers assigned in the the financial statements to financial assets and tangible fixed assets change significantly when switching from historical cost-accounting to fair-value accounting. In addition, the magnitude of such change varies a lot among companies and asset types.

This means that it is impossible for financial analysts to correctly convert historical cost data into fair-value data without having the required knowledge of asset- and company-specific information.

Relevance of such difference

In most cases, the above described changes do not have a significant influence on the DEA (Data Envelopment Analysis) scores, meaning that the overall ranking of most companies with regard to their efficiency and profitability and as compared to peers in their industry remains identical.

However, the ranking does change for a minority of companies which leads the authors to conclude that financial analysis does change according to which of the valuation methods is used.

Therefore, the findings of the above cited study nurture the criticism towards IFRS which provides for an option between historical cost based and fair-value based accounting in a sense that only a unique valuation method could lead to fully comparable financial analysis of firms in an industry.

But what exactly does IFRS provide for as regards cost based vs. fair-value accounting?

The main regulation of fair-value accounting can be found in the International Accounting Standard 16 “Property, Plant and Equipment”.

As shown in the above schema, fair-value accounting can apply when initially accounting for PP&E as well as when accounting for PP&E during its lifetime.

In the first case, accountants can be asked to determine the fair value of PP&E indirectly through valuing a non-monetary asset that the firm transfers in exchange for the acquired PP&E.

In the second case, the firm can choose among the cost model and the revaluation model.

The cost model applies the formula:

Cost of PP&E item
Initial Cost – Accumulated Depreciation – Accumulated Impairment Losses

In case of the revaluation model, the formula is as follows:

Revalued Amount of PP&E item
Fair Value at the date of Revaluation
– Subsequent Accumulated Depreciation – Subsequent Accumulated Impairment Losses

It should be noted that revaluations must be done on a regular basis to ensure that the carrying amount matches the fair value at the end of the reporting period. In addition, if a firm practices fair-value accounting it must do so for all PP&E items of the same asset class.

Now, there is only one last but crucial question left: What is fair value?

According to IFRS, fair value is „the amount by which an asset could be exchanged between knowledgeable, willing parties in an arm's length transaction“. In practice, this amount is determined through appraisal. In case no market evidence for such appraisal is available, the fair value shall be estimated using an income or depreciated replacement cost approach.


  • Rodriguez-Perez, Slof, Sola, Torrent, Vilardell – Assessing the Impact of Fair-Value Accounting on Financial Statement Analysis: A Data Envelopment Analysis Approach in ABACUS 2011, p. 61 et seq.
  • International Accounting Standard 16 – Property, Plant, and Equipment