New report calls for elimination of regulatory reliance on credit rating process

A new report from the C.D. Howe Institute argues the accountability and effectiveness of credit rating agencies (CRAs) in Canada are in need of major reform, including elimination of regulatory reliance on the rating process.

“In Canada, the European Union and the United States, policymakers have opted for registration systems,” Stéphane Rousseau, chair in business law at Université de Montréal, notes in A Question of Credibility: Enhancing the Accountability and Effectiveness of Credit Rating Agencies. “But registration regimes can stifle competition, induce undue reliance on ratings and burden regulators.

“From a Canadian perspective, it is unfortunate that the [Canadian Securities Administrators] CSA had to move away from the disclosure-based registration because of compatibility concerns with the European framework.”

Numerous reports have identified failures on the part of CRAs that affected the quality and integrity of the rating process, Rousseau notes.

A registration system has several drawbacks, he writes. For example, a flawed framework can create significant barriers to entry; innovation can be hampered because regulators have difficult keeping abreast of the flow of new products; and regulators may not be able to effectively oversee CRAs.

“The organization and activities of CRAs [in Canada] are not regulated per se,” the report says. “Whereas regulatory regimes recognize only ratings issued by ‘approved’ or ‘recognized’ rating agencies, these categories are not defined except through a simple listing of large CRAs that is based on undisclosed criteria,” the report adds.

In the wake of the financial crisis, Rousseau notes that CRAs have been criticized for playing a significant role in the market turmoil. But regulatory responses so far by Canada, like those in the United States and the European Union, do not “go far enough and arguably [go] in the wrong direction by adding another layer of cumbersome regulation.”

Recommended reforms include eliminating regulatory reliance on ratings; developing a due diligence obligation for institutional investors with respect to the creditworthiness of issuers; and disclosing information on underlying assets by issuers of structured finance products.