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The Big 3 credit ratings agencies have been taking heat from all sides since the financial crisis.Now James Vickery, senior economist at the New York Fed, has written about how the Dodd-Frank Act could transform their models.
Here’s his summary of the changes included in the legislation:
- New authority for the SEC to suspend or revoke a rating agency’s registration if warranted, or to penalise individual agency employees for misconduct
- Public disclosure of the assumptions and data used to arrive at each rating, and submission of an annual report on internal controls by each agency
- Rules to strengthen corporate governance and board independence
- Implementing “look-backs,” or automatic reviews of when former agency employees join firms whose ratings they may have influenced
- The creation of an Office of Credit Ratings within the SEC to administer regulations and conduct annual examinations
The government also plans to abandon any reference to an instrument’s or institution’s rating when evaluating them. Regulators will instead have to find an alternative “appropriate standard of creditworthiness.”
What might they use instead?
Vickery says more vanilla granular measures of risk, quantitative regulatory models or firms’ internal models might be suitable.
As an example, to comply with new Basel III requirements without relying on ratings, regulators have proposed a formula that depends on the seniority of the bond and the capital requirement that would apply to the assets underlying the securitization.
Dodd-Frank also stipulates an alternative to the “issuer-pays” model, responsible for the toxic conflict of interest in the runup to the crash, be found. The early money is on a “platform-pays” model, where an industry utility or self-regulatory board would be charged with collecting fees.
Of course, the legislation has been catching as much flak as the agencies themselves, so much could still change.
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