Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Non-use of ratings in SEC regulations

I am not fully satisfied with the 222 page proposal
that the US SEC has put forward for eliminating the use of credit
ratings in various regulations. It is certainly commendable that the
SEC has done a comprehensive job of identifying all regulations that
refer to ratings and then systematically eliminated every one of
them. Moreover, in many cases, the SEC has also identified meaningful
alternatives to the use of ratings. My disappointment is in relation
to the two or three truly critical uses of rating in the SEC
regulations.

The first is in capital requirements for broker dealers where the
existing regulations specify different levels of haircuts for their
proprietary positions in debt securities with different levels of
credit rating. A good solution to this problem could have provided the
template for eliminating the use of ratings in Basle 2 as
well. Instead what the SEC proposes is:

We are proposing the substitution of two new subjective standards
for the NRSRO ratings currently relied upon under the Net Capital
Rule. For the purposes of determining the haircut on commercial
paper, we propose to replace the current NRSRO ratings-based
criterion — being rated in one of the three highest rating categories
by at least two NRSROs — with a requirement that the instrument be
subject to a minimal amount of credit risk and have sufficient
liquidity such that it can be sold at or near its carrying value
almost immediately. For the purposes of determining haircuts on
nonconvertible debt securities as well as on preferred stock, we
propose to replace the current NRSRO ratings-based criterion — being
rated in one of the four highest rating categories by at least two
NRSROs with a requirement that the instrument be subject to no greater
than moderate credit risk and have sufficient liquidity such that it
can be sold at or near its carrying value within a reasonably short
period of time.

We further believe that broker-dealers have the financial
sophistication and the resources necessary to make the basic
determinations of whether or not a security meets the requirements in
the proposed amendments and to distinguish between securities subject
to minimal credit risk and those subject to moderate credit risk. The
broker-dealer would have to be able to explain how the securities it
used for net capital purposes meet the standards set forth in the
proposed amendments.

Notwithstanding our belief that broker-dealers have the financial
sophistication and the resources to make these determinations, we
believe it would be appropriate, as one means of complying with the
proposed amendments, for broker-dealers to refer to NRSRO ratings for
the purposes of determining haircuts under the Net Capital Rule.

The last paragraph above means that while technically the SEC gets
ratings out of its rule book, for all practical purposes nothing
really changes. Broker dealers would use ratings exactly as before
with the full blessings of the SEC.

The SEC has a similar non solution in the second place where
ratings play a critical role. Money market funds are allowed to value
their holdings at amortized cost rather than fair value on the ground
that regulations restrict their investments to short term debt
securities in the two highest short-term rating categories. The
proposal is to rely on a determination of “minimal credit
risk” by the board of directors of the fund. In the context of
the large losses that many money mutual funds have taken during the
sub prime crisis, I would have thought that the logical thing to do
would have been to mandate fair value accounting for money market
funds and treat them like any other mutual fund.

The third critical use of rating and rating agencies is in the
field of disclosure. Rating agencies are exempted from the prohibition
of selective disclosure under Regulation FD. The SEC proposes to
maintain this exemption. I think this exemption is inconsistent with
the stand of the ratings agencies that their ratings are
“editorials”. Similarly, the SEC permits but does not
require issuers to disclose credit ratings in their offer documents.
The SEC’s proposal leaves this substantially unchanged. My problem
here is that if ratings are editorials, then they should be permitted
to be disclosed in offer documents only in the same way and to the
same extent that other editorials, research reports or expert opinions
are permitted to be disclosed.

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One response to “Non-use of ratings in SEC regulations

  1. Prof. Jayanth R. Varma September 2, 2008 at 12:51 pm

    Test comment

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