Triggered by the recent financial crisis, the regulation of banks has gained new traction among academics, regulators, and politicians. One of the key challenges in effective regulation is time inconsistency of regulation. While a regulator would like to commit not to bail out banks in order to set the right ex-ante incentives, this threat is generally not credible since the government does not follow through in the event of a crisis. Banks therefore have an incentive to expose themselves to risk that is partially insured by the government.

To mitigate this problem, regulators attempt to reduce the likelihood of banking crises by regulating both banks’ asset side and liability side. While there has been a recent push to focus on the liability side by mandating higher equity capital requirements, the very nature of a deposit-taking institution implies that leverage is an integral part of the business model of banks, unlike for other firms. In this paper, we therefore focus on the regulation of banks’ asset holdings. The starting point of our paper is the natural assumption that a regulator cannot directly observe the riskiness of assets, but needs to rely on an external (private) assessment of risk. Since the introduction of the Basel I framework, credit ratings have played an important role in bank regulation as “objective” measures of credit risk. This role has been confirmed in the Basel III (2011) guidelines, which still rely on credit ratings as measures of creditworthiness.

…continue reading: Bank Regulation with Private-Party Risk Assessments

The Federal banking agencies have recently issued three notices of proposed rulemaking (and applicable related guidance) in connection with the implementation of Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Section 939A generally requires that all Federal agencies remove from their regulations references to and requirements of reliance on credit ratings and replace them with appropriate alternatives for evaluating creditworthiness.

Market Risk Capital NPR:

The Office of the Comptroller of the Currency (the “OCC”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the Federal Deposit Insurance Corporation (the “FDIC” and, together with the Federal Reserve and the OCC, the “agencies”) issued a joint notice of proposed rulemaking (the “Market Risk Capital NPR”) concerning their market risk capital rules applicable to certain U.S. banking organizations with significant trading operations by proposing standards of creditworthiness to be used in place of credit ratings when calculating the specific risk capital requirements for covered debt and securitization positions, including the following:

…continue reading: Proposed Federal Rules Regarding Alternatives to Credit Ratings

In our paper, Does It Matter Who Pays for Bond Ratings? Historical Evidence, forthcoming in the Journal of Financial Economics, we examine whether charging issuers for bond ratings is associated with higher credit ratings employing the historical setting wherein S&P switched from an investor-pay to an issuer-pay model in 1974, four years after Moody’s made the same switch.

Many commentators and policy makers claim that charging bond issuers for ratings introduces conflicts of interest into the rating process. For corporate bonds issued between 1971 and 1978, we find that, for the same bond, Moody’s rating is higher than S&P’s rating prior to 1974 when only Moody’s charges issuers. After S&P adopts the issuer-pay model in July 1974, the evidence indicates that S&P’s ratings increase to the extent that they no longer differ from Moody’s ratings. Because we use Moody’s ratings for the same bond as our benchmark, we can conclude that this increase in S&P’s ratings is not due to general changes affecting bond ratings.

…continue reading: Does It Matter Who Pays for Bond Ratings?

In the paper, Capital Structure and Debt Structure, forthcoming in the Review of Financial Studies, we use a novel data set on the debt structure of a large sample of rated public firms and show that debt heterogeneity is a first order aspect of firm capital structure. The majority of firms in our sample simultaneously use bank and non-bank debt, and we show that a unique focus on leverage ratios misses important variation in security issuance decisions. Furthermore, cross-sectional correlations between traditional determinants of capital structure (such as profitability) and different debt types are heterogeneous. These findings suggest that an understanding of corporate capital structure necessitates an understanding of how and why firms use multiple types, sources, and priorities of corporate debt.

…continue reading: Capital Structure and Debt Structure

The Financial Panic of 2008

The first signs of an impending financial crisis appeared in the US in 2007, when US real estate prices began to collapse and early delinquencies in recently underwritten sub-prime mortgages began to spike. It culminated in a genuine financial panic during September and October of 2008. The most serious recession since the Great Depression of the 1930s followed. The Federal Reserve and other organs of the US Government responded by flooding the markets with money and other liquidity, reducing interest rates, providing extraordinary assistance to major financial institutions, increasing Government spending, and taking other steps to provide financial assistance to the markets.

…continue reading: The Financial Panic of 2008 and Financial Regulatory Reform

We are proposing rules today that are mandated by, or that are intended to implement, provisions in the Dodd-Frank Act relating to issuer and third-party review of the assets underlying asset-backed securities.

I believe that, properly crafted, these rules will provide decision-useful information to investors by enhancing transparency into the asset review process undertaken by issuers and by making available to investors the results of asset reviews conducted by issuers and third parties.

…continue reading: Reviewing Asset-Backed Securities – Increasing Transparency

Late last month the SEC issued a final rule amending Regulation FD to eliminate the exemption for disclosures made to credit rating agencies. (Exchange Act Release No. 63003) The amendment, which becomes effective upon publication in the Federal Register, was specifically required by the Dodd-Frank Act. We do not view this as a material development as some have suggested.

Companies routinely disclose material, nonpublic information to credit rating agencies for the purpose of developing a credit rating, including in advance of merger announcements or in connection with significant changes in capital structures. While some commentators have suggested the amendment will require issuers to make public disclosures of material nonpublic information that they disclose to credit rating agencies, the effect of the amendment is less than it seems. The public disclosure requirements triggered by Regulation FD are limited to disclosures by the issuer, or persons acting on its behalf, to certain enumerated persons, generally securities market professionals, investment advisers and holders of the company’s securities under circumstances where it is reasonably foreseeable that the person will purchase or sell the issuer’s securities on the basis of the information. In 2006, the Investment Advisers Act was amended to exclude from the definition of investment adviser any nationally recognized statistical rating organization unless it engages in issuing recommendations as to purchasing, selling or holding securities or in managing assets (including securities) on behalf of others.

…continue reading: SEC Amendment Governing Rating Agency Disclosure Will Have Little Impact

One of the lesser publicized provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) requires a registrant to obtain the written consent of a Nationally Recognized Statistical Rating Organization (“NRSRO”) in order to disclose in a registration statement or prospectus (or documents incorporated by reference into registration statements or prospectuses) that NRSRO’s credit rating of any class of debt securities, convertible debt securities or preferred stock of the registrant.

Rule 436(a) under the Securities Act of 1933 (the “Securities Act”) requires issuers to file consents for portions of reports of expert opinions used in a registration statement or prospectus. Rule 436(g), which was repealed by the Dodd-Frank Act, had provided an exception to Rule 436(a) by providing that credit ratings assigned to a class of debt securities, a class of convertible debt securities or preferred stock by an NRSRO were not considered part of a registration statement prepared or certified by an expert within the meaning of Sections 7 and 11 of the Securities Act. Therefore, prior to the repeal of Rule 436(g), issuers did not need to obtain an NRSRO’s consent in order to provide ratings information in a registration statement or prospectus. In response to the Dodd-Frank Act, certain NRSROs have stated that they will not consent to the use of their ratings in Securities Act registration statements and prospectuses since by doing so it would expose them to potential Section 11 liability for material misstatements or omissions. This position may lead to a decrease in the disclosure of ratings in registered offerings.

…continue reading: Including Credit Ratings in Registration Statements

The past couple of years have been very trying for our markets and our economy. And the path forward still poses significant challenges. But to be fully successful in meeting those challenges, it will require broad engagement—that means business, regulators, consumers and investors alike.

A key part of that challenge will be continuing to strengthen and improve our capital markets.

At the SEC, we routinely hear from investors with concerns and ideas for doing just that. We hear how investors—large and small—are worried about the structure of today’s market, concerned that they are at a disadvantage to the relative handful of sophisticated traders and market intermediaries with unfair access and built-in advantages. We hear about increased volatility and instability. These are issues the SEC has been addressing.

…continue reading: The Next Phase in Financial Regulatory Reform

In the new financial order being put in place by regulators around the world, reform of credit rating agencies should be a key element. Credit rating agencies, which play an important role in modern capital markets, completely failed in the years preceding the financial crisis. What is needed is an effective mechanism for rating the raters.

There is widespread recognition that rating agencies have let down investors. Many financial products related to real estate lending that Standard & Poor, Moody’s, and Fitch rated as safe in the boom years turned out to be lethally dangerous. And the problem isn’t limited to such financial products: with issuers of other debt securities choosing and compensating the firms that rate them, the agencies still have strong incentives to reciprocate with good ratings.

What should be done? One proposed approach would reduce the significance of the raters’ opinions. In many cases, the importance of ratings comes partly from legal requirements that oblige or encourage institutional investors and investment vehicles to maintain portfolios of assets that have received sufficiently high grades from the recognized agencies.

…continue reading: Rating the Raters