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NRSO Nationally recognized statistical rating organization a credit rating agency which issues credit ratings that the U.S. Securities and Exchange Commission (SEC) permits other financial firms to use for certain regulatory purposes.

Hearing on “EXAMINING PROPOSALS TO ENHANCE THE REGULATION OF HE CREDIT RATING AGENCIES” Hearings Print Examining Proposals to Enhance the Regulation of Credit Rating Agencies

Wednesday, August 5, 2009 Testimony of Professor John C. Coffee, Jr. Adolf A. Berle Professor of Law Columbia University Law School

Unlike other gatekeepers, the credit rating agencies do not perform due diligence or make its performance a precondition of their ratings. In contrast, accountants are, quite literally, bean counters who do conduct audits. But the credit rating agencies do not make any significant effort to verify the facts on which their models rely (as they freely conceded to this Committee in earlier testimony here). Rather, they simply accept the representations and data provided them by issuers, loan originators and underwriters.

Credit rating agencies have long and uniquely been immune from liability to their users. Unlike accountants or investment banks, they have never been held liable. At the same time, because the “issuer pays” business model of the ratings agencies seems likely to persist (despite the creative efforts of many who have sought to develop a feasible “user pays” model), we have to face the simple reality that the rating agencies have a built-in bias: they are a watchdog paid by the entities they are expected to watch. Because the ratings agencies receive an estimated 90% of their revenues from issuers who are paying for their ratings,1

What It Is: In personal finance, the term credit rating commonly refers to a score issued by the Fair Isaac Corporation (a "FICO score"). A person's credit rating indicates how creditworthy he or she is.

In corporate finance, a credit rating is a "grade" assigned to a bond, bond issuer, insurance company, or other entity or security to indicate its riskiness.

How It Works/Example: Bond rating agencies like Moody's and Standard & Poor's (S&P) provide a service to investors by grading fixed income securities based on current research. The rating system indicates the likelihood that the issuer will default either on interest or capital payments.

   * For S&P, the ratings vary from AAA (the most secure) to C.
   * For Moody's, the ratings go from Aaa to D which means the issuer is already in default.

Only bonds with a rating of BBB or better are considered 'investment grade'. BBB bonds are considered to be suitable for investment by institutions. Anything below the triple B rating is considered to be junk, or below investment grade. Bond ratings are periodically revised based on recent data.

A sovereign spread is supposed to compensate investors for the risk of default. One component of this compensation should be the expected loss from sovereign default. For investors who hold the sovereign bond to maturity, this loss is simply the product of the probability of default and the loss-given-default. For investors who plan to sell before maturity, the expected loss would also incorporate the prospect of a decline in credit quality short of default. Another component of the spread is attributable to the risk premium. Such a premium compensates investors for the fact that the realised loss from default may exceed the expected loss. Such a default risk is asymmetric because the possible losses from default are large relative to the possible gains from an absence of default. Hence, as a measure of credit risk, the probability of default enters the spread in two ways. First, it is part of expected loss in conjunction with the expected recovery rate. Second, it is part of the risk premium, the other part being the price of risk

Links

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Abstracts

creates a Consumer Protection Agency and a Financial Stability Council; provides for for the dismantling large, failing financial institutions, and introduces new regulations for the regulation for mortgages, credit rating agencies, hedge funds and private equity companies and trading in derivatives.

Proposals for reform

Overview

As instructed by the London Summit, the Financial Stability Board issued a framework for strengthening adherence to international financial standards.

G20 summit proposals

The explanatory note on the subject following the London Summit included the following diagnosis:

While market participants were unable to understand the nature of the risks they were exposed to, the regulatory system allowed them to increase leverage dramatically in the run up to the crisis. The tendency of the financial sector to over-expand during up swings was exacerbated by a number of factors: over reliance on Credit Ratings Agencies (CRAs) assessments of the credit risk and potential CRA conflicts of interest, inadequate accounting standards and capital requirements that served to reinforce rather than dampen financial market over expansion, and remuneration policies that encouraged excessive leveraging and risk-taking.

The Volcker Rule

At a press conference on January 21st 2010, President Obama announced that

"Banks will no longer be allowed to own, invest, or sponsor hedge funds, private equity funds, or proprietary trading operations for their own profit, unrelated to serving their customers. If financial firms want to trade for profit, that's something they're free to do. Indeed, doing so –- responsibly –- is a good thing for the markets and the economy. But these firms should not be allowed to run these hedge funds and private equities funds while running a bank backed by the American people. In addition, as part of our efforts to protect against future crises, I'm also proposing that we prevent the further consolidation of our financial system. There has long been a deposit cap in place to guard against too much risk being concentrated in a single bank. The same principle should apply to wider forms of funding employed by large financial institutions in today's economy.".