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SEC Chairman,
Christoper Cox
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Following the sub-prime credit crisis, ratings agencies have been criticised by regulators and central banks for over-optimistic ratings of the key mortgage-backed securities, ratings which would also have had a direct impact on Basel II capital calculations. Now the US’s Securities and Exchange Commission (SEC) has brought seven of the largest rating agencies under its control and will oblige them to disclose their procedures and methodologies for assigning ratings.
Basel II revolves around the calculation of risk-weighted assets, from which regulatory capital requirements are derived. The largest element of this is from the calculation of credit risk weightings, and these are in direct relation to the credit ratings assigned. So the argument goes – get the ratings wrong and the capital will be incorrectly calculated. As rating agencies are paid by those they rate, the market view is that they are under pressure to give their clients a favourable rating – or the client will move to another agency.
The SEC’s new powers, based on the Credit Rating Agency Reform Act which took effect on June 26th, mean that the agencies must register as “nationally recognized statistical rating organizations” (NRSRO) and must make public the basis for their ratings including performance measurement statistics historical downgrades and default rates. SEC Chairman Christopher Cox said “The Commission’s newly-granted oversight of credit rating agencies will protect investors and enhance the reliability of credit ratings by fostering accountability, transparency, and competition in the credit rating industry”.
As well as the question of independence and accuracy of ratings, there is also a question of consistency. According to Moody’s, corporate bonds rated Baa (the lowest investment grade) had a 5-year average default rate of 2.2% over a 22 year period. However, CDOs (Collateralised Debt Obligations) with the same ratings suffered 5-year default rates of 24%. The difference is even larger in Baa-rated municipal bonds which have a default rate of only 0.09% giving a 250-fold difference in probability of default compared with CDOs – yet assets in both will have the same capital impact.
Was the BIS aware of these discrepancies when it controversially selected the rating agencies as the main influencers of Basel II capital calculations?
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