Accountability and the Second Line of Defence

Abstract

"This paper is based on the premise that Credit Rating Agencies are essential to the smooth running of the global !nancial system due to their informational, transactional and regulatory value. Here, emphasis is placed on the regulatory value of Credit Rating Agencies and their role in the second line of defence against !nancial crises. It is the recent failure of Credit Rating Agencies in holding the second line of defence that prompted this enquiry. Here, their role in the current !nancial crisis brought to the fore key issues to address. These are the lack of competition, con"ict of interest, perverse incentives, low accuracy, endemic pro-cyclicality and systemic regulatory dependence on credit ratings. This study has shown that the current regulatory framework is inadequate to address and resolve the above-mentioned issues. Based on a cursory review of relevant literature, seven categories of regulatory proposals were identi!ed. These are nationalization, the abolishment of of!cial recognition, the provision of additional information, the introduction of legal liability, the separation of consultancy from advisory functions and the weakening of barriers to entry. After applying the options analysis public policy tool to assess the relative merit of each of these regulatory options vis-à-vis the issues mentioned above as well as the political and implementation feasibility, a ‘policy package’ with speci!c modalities is proposed. This involves the establishment of a public sector rating agency and the provision of two options to Credit Rating Agencies. These options are either; (1) delegate rating function to the public sector rating agency and continue with the structured !nance/ consultancy arm of their business or; (2) cease the structured !nance/ consultancy activities and focus only on providing ratings. Here, it is recommended that should the Credit Rating Agencies choose the second option, the following new set of rules and regulations should apply – (1) ratings should be paid for by investors and not by issuers; (2) performance management by regulators with punitive repercussions should be put in place; (3) additional information beyond ratings should be supplied; (4) regulatory structures and processes that rely on credit ratings should use aggregated ratings of licensed Credit Rating Agencies. Finally, it is proposed that there be a ‘freezing’ of ratings for up to six months from the introduction of new products for which no precedent is available. This is light of the identi!cation of the core problem, particularly in the current !nancial crisis, as dealing with innovation and the valuation of new and complex instruments."(pg 103-104)