Blueprint Eu Rating Agency

BLUEPRINT for anEUROPEAN RATING AGENCY

Brussels, October, 2011

Contents

1 Vision and executive summary

2 Current setup of the rating industry

2BLUEPRINT EUROPEAN RATING AGENCY.pptx

3 Suggested solution

4 The European Rating Agency

5 Investor-based revenue platform

6 Approach/next steps

Vision, mission and strategic goals of a European r ating initiative

VISION Strengthening and maintaining financial market stability and reducing systemic risks rooted in the current setup of the rating industry


MISSION

STRATEGY

Promoting effective and efficient rating information, facilitating more open and competitive European capital markets, improving investor information, and ensuring the public's trust in the capital markets

Establishing a European Rating Agency based on a new operating model, designed to address the inherent weaknesses and conflicts of interest of the current setup; creating an investor-based revenue platform

Source: Roland Berger

Executive summary – The case for a European Rating A gency

• Situation: The commercial credit rating agencies (CRAs) acted as catalysts in the global financial crisis • Diagnosis: This role was triggered by a set of wrong microeconomic incentives and problems in the current

setup of the rating industry that can be summarized as follows:• Monopolistic structure: Systemic concentration risk and monopolistic pricing• Conflict of interest I: Revenue model • Conflict of interest II: Provision of additional services• Liability gap: Rating defined as an "opinion"

STRUCTURAL PROBLEMS OF THE RATING INDUSTRY


• Liability gap: Rating defined as an "opinion"• Quality problems in methodology and processes/approach• Cyclicality mismatch/rating philosophy • Regulatory mismatch – Ratings form basis for regulation but are unregulated themselves• "Home bias": Rating approach is based on US model• Conclusion: These issues justify an initiative to reshape the industry to create more transparency and market

efficiency, to reduce systemic risk and to remove the monopolistic rates currently paid by capital market participants (issuers and investors)

• Suggested solution : Establish a globally operating European Rating Agency in the form of a foundation created by the financial sector, based on an extremely transparent operating concept and introduce a new investor-based revenue system to eliminate the conflict of interest I (revenue model)

Source: Roland Berger analysis

The current status of the rating industry has expos ed a range of problems (1/2)

Current situation in the rating business Implications for the market

STRUCTURAL PROBLEMS OF THE RATING INDUSTRY − BACKUP

Monopolistic structure

• Moody's, S&P and Fitch rating agencies dominate, with 95% global market share

• 80% is held by the US institutions Moody's and S&P with overlapping shareholder structures

• Concentration risk and lack of competition have a negative impact on the quality of credit ratings

• Monopolistic pricing reflected in 40% return on revenues

Conflict of interest I − Revenue model


Conflict of interest I − Revenue model

• Rating services are paid by those whose products are rated (issuer-based revenue model)

• CRAs are private firms

• Incentives for inflated ratings , in particular for mortgage products

• Insufficient incentives to achieve highest-quality rating

Conflict of interest II − Provision of additional services

• CRAs rate products that they structured them-selves: Arbitrary structuring until the required rating is achieved

• CRAs offer a range of non-rating services, including transaction structuring

Liability gap

• Due to this business model, the CRAs cannot be held accountable, even in cases of intent or gross negligence, shielding them from legal intervention and product liability claims

• Rating is defined not as a product but as an "opinion"shielded from liability by the US Constitution (1st Amend-ment)


The current status of the rating industry has expos ed a range of problems (2/2)

STRUCTURAL PROBLEMS OF THE RATING INDUSTRY − BACKUP

Cyclicality mismatch/rating philosophy

Quality problems

• Rating errors/methodological weaknesses and lack of rating transparency led to misallocation of capital resources amounting to approx. USD 3 trillion in the structured finance market

• Lack of consistency in rating methodology and substantial gaps in know-how

• Unsatisfactory level of transparency

Current situation in the rating business Implications for the market


Regulatory mismatch

• Rating errors and quality problems lead to suboptimal decision making in financial institutions and regulatory authorities

• Although CRAs are largely unregulated , their ratings form the basis for financial sector regulation (banks, investors)

Cyclicality mismatch/rating philosophy

• Undifferentiated ratings lead to untimely downgrades ("cliffhanger downgrades") exaggerating market volatility

• Deviation from "fair and true" ratings

• US-based CRAs aim at constant ratings over the business cycle ("through-the-cycle rating")

"Home bias"

• CRAs primarily take a US investor's perspective• They face criticism for showing a lack of

understanding of European specifics

• Two of the top three CRAs are US-based firms with an Anglo-Saxon approach to credit analysis


Monopolistic structure? – Three CRAs control 95% of t he global market, 80% is held by two US institutions (Moody's and S&P)

5%

REGULATORY entry barriers• Since 1975, the SEC1) has been responsible for granting NRSRO2)

status. Despite many applications for NRSRO status, only one new general-purpose CRA was approved by the SEC between 1975 and 2002

• Originally there were 3 NRSRO agencies: Moody's, S&P, Fitch. Four


Global sales development

Total: approx. USD 5 bn


16%

32%

47%

OtherFitchMoody’sS&P

• Originally there were 3 NRSRO agencies: Moody's, S&P, Fitch. Four more (one general-purpose CRA as mentioned above, three specialist CRAs) joined them in the period up to the early 1990s, but were bought out by the original three (especially Fitch)

• Rating agencies without NRSRO status are ignored by investors and thus have no market

1) U.S. Securities and Exchange Commission 2) Nationally Recognized Statistical Rating Organization

Sources: 2009 financial reports of The McGraw-Hill Companies, Fimalac Group, Moody's, Roland Berger

ECONOMIC entry barriers• Economies of scale and product standardization • Benefits of experience and special industry expertise• Reputation – high level of acceptance by issuers and investors• High startup costs

Monopolistic structure is among the root causes of the problems

Monopolistic structure? − S&P and Moody's are ultimat ely controlled by the same investor groups


Davis Selected Advisers

Fidelity Investments

T. Rowe Price Associates

VanguardGroup Inc.

State StreetCorp.

OppenheimerFunds Inc.

Northern Trust Corp.

Capital Group Companies

Warren Buffet

Black Rock Inc.

Fidelity founder:Johnson family

Morgan Stanley Bank

BerkshireHathaway Inc.

Bank of New York

Majority owned by Mass.

Mutual Life Insurance

Oppenheimer & Co, Inc.

49% 4.86%

X%Gates

Foundation

8.73%

Massachusetts Financial Services


Shareholders in both organizations Cross shareholdings

Sources: Bloomberg data of December 2010, websites of shareholders and CRAs

38.0% 53%

S&P Moody's

Shareholders in both organizations

Moody's Corporation(Delaware)

Standard & Poor’s(New York)

The McGraw-HillCompanies (US)

100%

1.75%2.95% 16.15% 4.44% 4.41% 3.90% 1.27% 4.59% 1.23%

76.25%

12.13% 3.50%7.55%2.25%6.89%8.15%3.91% 3.98%3.97%21.98%

40.91%

1.32%

0.21%

0.62%

Direct & Indirect shareholding

Suggested two-pillar solution: European Rating Agen cy and an independent investor-based revenue platform

European Rating Agency Investor-based revenue platform

• Maximum independence through private nonprofit foundation with a strong

• New platform in cooperation with stock exchanges and independent of the European


foundation with a strong academic council

• Additional competition by breaking up the monopolistic structure

• Cost efficiency through "Basel II+" operating model

• Global market entry/full-service provider

• Public monitoring via a "super-transparent" rating agency

independent of the European Rating Agency

• Open to all licensed independent rating providers

• Paid for by investors with robust price competition

• Regulatory adjustments required to avoid the free rider problem

Cornerstones of the concept – What is new?

THE CASE FOR A EUROPEAN RATING AGENCY – BACKUP

Institution

TOPIC WHAT IS NEW? OBJECTIVE

Legal form & ownership

Nonprofit foundation, public support in the startup phase

• Allows fast setup and creates credibility in the market• Permanent link to political institutions is not desirable in

order not to jeopardize the agency's independence

1.

Governance Independent foundation • Minimize third-party influence, ensure independence2.Transparency Maximizing public information • Ensure CRA control by all stakeholders through timely

disclosure3.

10BLUEPRINT EUROPEAN RATING AGENCY.pptxSource: Roland Berger analysis

Operations

disclosure

Revenue model Investor based • Turn away from the issuer-based revenue model to avoid current conflict of interest

• Allocate rating costs to investors – different models are possible (volume charge, exchange-based fee, etc.)

4.

Organization Basel II a. banks as benchmarks • Significantly reduce costs by using an efficient model5.Processes Maximizing transparency • Ensure CRA control by all stakeholders through timely

disclosure6.

Services and products

Comprehensive coverage, but with complexity control

• Concentrate know-how, ensure competitiveness through efficient operations and limiting costs

• Don't offer any products whose complexity cannot be modeled

• Gradually cover products, starting with country and bank ratings, followed by corporate bonds, structured fin., etc.

7.

Methodology State-of-the-art quantitative methods, implementing early warning elements and "through-the-cycle rating"

• Avoid undifferentiated ratings, prevent untimely downgrades ("cliffhanger downgrades") that could exacerbate a crisis

8.

Focus on members with the fewest possible conflicts of interest

Possible members ofthe ERA

Issuers Risk of bloated ratings due to agencies' financial interest in doing more business with issuers

Too close to issuer ("inherited conflict")Investment banks

Potential conflicts of interestStrong

FOUNDATION CONCEPT 1


State/government Influence on country ratings and related costs of public debt

Supranational institution (EU Commission)

Possible interest in country ratings of member states

Regulatory authorities Too close to government and thus "inherited conflict" regarding country ratings

Stock exchanges Virtually no conflict of interest

Credit institutions Conflict of interest if issuer is also a borrower

Investors Conflict only possible under very special conditions

Conflict of interest: Weak


Focus for forming the foundation consortium

Transparency could be greatly improved at existing rating agencies

S&P Moody's Fitch

Organization1. Organizational structure2. Members/owners3. Legal form4. Procedures

1. Detailed chart2. To be determined from

other sources3. Detailed4. Rough description

1. Detailed chart2. Main shareholders3. Detailed description4. Chart of the rating

process

1 10

Low HighTransparency

1. Aggregated only2. To be determined from

other sources3. Aggregated only4. Detailed description

4

5

3

8

4Methodology 1. Against fee-based 1. Description of markets 1. Brief description of 3

9

7

9

9

7

9

5

9

6

TRANSPARENCY CONCEPT2


4Methodology1. Models used, criteria for

rating factors, parameters

1. Against fee-based subscription

1. Description of markets and industries available, no parameters

1. Brief description of methodology by sector, no examples

3

7

1

8Rating results1. Rating grades2. Rating reports 3. Minutes of rating committee

meetings

1. Current and historical grades

2. Sometimes available for a fee

3. Not available

1. Current and historical grades with explanations

2. Analysis, creditworthi-ness reports, comments only on subscription

3. No data

1. Current grades, historical data only for a fee

2. Some industry andcountry research available, issuer data only for a fee

3. No data

Input data 1. Financial and qualitative

data

1. Sometimes available for a subscription fee

1. Issuer profile, financial reports for a subscription fee

1. Issuer profile, financial reports for a subscription fee

3

5

5

1

6

6.04.5

7

5

6

1

10

6.3Median

Source: Roland Berger analysis based on data from the agencies, Bloomberg

Basel II gives us the methods, and banks are the be nchmark for cost efficiency

• Basel II gives us a technological leap in rating methodology and the option of producing credible, scientifically verifiable rating results in a short time on the basis of publicly available empirical data

• Cost structure of banks for internal ratings (Basel II models plus credit department analysis) is 10 times less than the cost structures of the agencies � Banks are the cost benchmark for the European Rating Agency

• Costing base for the ERA after saving up risk capital for liability purposes without aiming for

43 METHODOLOGY AND COST EFFICIENCY


• Costing base for the ERA after saving up risk capital for liability purposes without aiming for profit reduces target price by another 40% (agencies' current return on sales)

Summary: New and credible model is beneficial to capital market playersfrom a cost perspective too

ERA will cover all segments worldwide

• Corporates

• Financial institutions

• Structured finance

Market segments

• North America

• South America/ Caribbean

• Europe

• Middle East

RegionsStructured finance products• Asset-backed securities (ABS), e.g. credit card

receivables, car loans, student loans, equipment loans & leases, etc.

• Structured credit:– Collateralized debt obligations (CDO)

MARKET COVERAGE5


finance

• Sovereign & public finance

• Sub-sovereign

• Infrastructure & project finance

• Middle East

• Africa

• Emerging markets


– Collateralized debt obligations (CDO)– Collateralized loan obligations (CLO)

• Commercial mortgage-backed securities (CMBS)• Residential mortgage-backed securities (RMBS)• Asset-backed commercial paper (ABCP)

Project finance across industries

• Industrial infrastructure & projects (energy, chemicals, building materials, transportation, telecom services, etc.)

• Utilities infrastructure & projects (gas, electricity, water, waste disposal, etc.)

• Social infrastructure (airports, ports, hospitals, etc.)

Investor-based revenue model can avoid the free rid er problem

• All credit transactions outside the banking system above a defined limit must be guided through a centralplatform. This applies to bonds as well as to OTC credit transactions

• Issuers are instructed by prospectus regulations to publish all rating-related data according to the given standards in a central platform. The data must be published in due time before placement

• Each rating agency has the right to equal access. This applies to presentations and Q&A sessions• Each rating agency that is (a) licensed and (b) independent is allowed to produce a rating on an unsolicited

basis and publish it on the platform


basis and publish it on the platform

• Investors are bound by (pan-European) regulations to buy a rating when buying a tranche in the primary market from this selection or be able to carry out a rating themselves. This must receive regulatory approval (Basel II IRB advanced approach )

• Investors do not buy the rating information, but compliance, as ratings have already been published• Secondary market portfolios do not require ratings to be bought if one was bought for them in the primary

market. This will lead to passing back the costs to the issuers via a price adjustment in the primary market through arbitrage, as the price including rating costs is equal to the price of a similar bond on the secondary market

• Investors act as contracting partners of the rating agency, which enables suitable product liability regulations (via terms & conditions of the rating product)

How the investor-based revenue platform works

Issuer Investor

§Prospectus regulations

§Investment regulation

Bond

PublishesBuys

Selection of ratings


DataAA A+ AA- € $

Rating agencies

Central credit platform

Rating results

Pays to agencies

Blueprint Eu Rating Agency

Documents

Transcript of Blueprint Eu Rating Agency