Cracks appear in the Dodd-Frank Act (Part 2)
March 17, 2010 - David Buckham CEO of Monocle
This is the second part of a 2-part opinion article. It explores the reasons why regulators themselves have publicly questioned the clause that limits banks` use of external credit ratings in capital calculations.
In contrast, take the equity analyst industry. Here is an example of an industry which is fairly self-regulating, which is based on the same principle of predicting the future, and which is used extensively by banks and institutions worldwide. There are no significant barriers to entry to this industry. In this business, analysts work for research houses, which are paid either directly for the research or through the trades that take place, based on the research provided. In this business, the skills of individual analysts are easily discernible over time, in that their predictions can be back-tested on a regular basis against actual empirical data – much as one imagines would be the case in the credit rating industry. In the equity analyst industry, poor predictive performance is quickly punished with analyst replacements. Anyone can start a research house, and, if one’s published predictions are consistently accurate, people will buy the research. The costs of entering this business are remarkably low, and many thousands of research houses exist worldwide, providing equity research and price predictions on the same firms that credit rating agencies provide debt ratings for. It seems somewhat ironic that a vibrant, highly competitive and unforgiving industry exists for the ‘rating’ of equity, and only three significant players exist within the market for the rating of debt.
Sheila Bair, the Chairman of the Federal Deposit Insurance Corporation, as reported by the Wall Street Journal, states that, while she recognizes that poor credit ratings were a “key contributing factor” to the crisis, she still thinks, however, that “we will also find that some of the more likely replacements … are far from perfect”. What she is really saying is that the Act may have been premature in simply imposing the limitation. Perhaps she is also saying that we should stick with the devil we know, rather than the one we don’t. John Dugan, the Comptroller of the Currency, a Federal body that is directly responsible for the implementation of capital controls within banks, goes further, and in his quoted statement appeals to one of the great platitudes of all time: “I do worry … there is a little bit of throwing out the baby with the bath water. It might be worth Congress taking a second look at it.” This seems of course massively ironic, given not only John Dugan’s position within the regulatory body of the US, but also given the fact that the rating agencies were absolutely vilified during hearings post-crisis.
So the question really becomes: why are the US government’s own regulatory instruments so quickly reversing the admittedly rushed decision to impose this limitation? Conspiracy theorists may look towards the lobbyists, who, whilst clearly having lost the first battle – the one related to what goes into the Dodd-Frank Act – may be ahead on the second battle – the one where the implementation of the Act diverges from its original intention. Conspiracy theorists may also point to the recent bond market turmoil, particularly the turmoil within the asset-backed securities market. Rating agencies, quoting clauses from the Dodd-Frank Act, refused to allow their ratings to be used in this market, claiming that new requirements within the Act effectively increased their legal liability beyond reasonable business levels. The rating agencies held steadfast, and the Securities and Exchange Commission had to allow bond sales to go ahead without ratings. The conspiracy theorists interpretation would simply be: the agencies feel spurned and are fighting back by withdrawing their favours, in this case the use of their ratings in exchange-traded bond sales. Of course, the rating agencies may well have a good point: that the costs of insuring that they are correct in their predictions is prohibitively high.
There is another critical issue here. If we look at the three major ECAIs at present, we may conclude that their dominance introduces, and introduced, significant systemic risk into the market. The strong covariance in the rating agencies transition matrices provides some empirical evidence for this. Every money manager, institution, and bank Every Evehad the same rating for General Motors, for Iceland, for General Electric, and for Greece. There were no divergent opinions. If there were, we certainly didn’t hear them. As a result, all institutions pretty much priced credit risk the same, with the same spread, and with the same reference rate. Those who had other views either kept their mouths shut (although many now claim they saw it all coming), or they made billions in very cleverly constructed contrarian trades. Amusingly, during certain of the fascinating series of hearings, politicians actually had the temerity to ask these contrarian traders why they hadn’t told anybody before it all fell down.
By having allowed the dominant rating agencies to remain critically and indelibly linked to the capital requirements regulation until three weeks ago, authorities basically ignored this systemic risk. By insisting on the limitation within the Act, regulators would appear to have solved this problem – but for the back-pedalling of the regulatory bodies themselves. If the limitation were to be removed, the argument that smaller banks cannot afford to measure their own credit risk effectively transforms into a view that the collective of all ‘smaller banks’ responds and reacts to the market as one amorphous (and confused) entity. More specifically, we would continue to have things pretty much stable and acceptable, that is, until things go wrong. At that point – all hell breaks loose, everybody runs in the same direction, we have more hearings, new laws, and a whole lot more back-pedalling.
It is telling that the Federal Deposit Insurance Corporation keeps their arguments against the limitation vague: “more likely replacements”, “baby with the bath water”, and “these are complicated and complex areas”. Looking forward, excusing the conspiracy theorists from the room and the cynics and naysayers from the conversation, one is left with a view that the objective of rating one’s borrowers needs to be achieved. Also, there is nothing wrong in getting help with this, in the same way that asset managers purchase equity research to help them make asset allocation and trade decisions. Nor is there necessarily anything wrong with making use of these ratings in both one’s lending practice and one’s capital calculations (actually a regulatory requirement called the ‘use test’). Perhaps the only thing that is wrong here is that the business of rating agencies is overly restricted. Perhaps, if banks were able to choose rating agencies more freely, and if there were more of them, as they choose their borrowers, and perhaps if there were lower barriers to entry into this market, its participants would be a little more precise in their predictions, and a little more circumspect in their levels of certainty.
David Buckham, CEO of Monocle