UK Report on Financial Stability Targets FSA and Credit Rating Agencies

A seminal report by the UK Treasury Select Committee concluded that the framework by which the public authorities issue warnings of potential problems in financial markets is deficient and recommends that in future the Financial Services Authority and the Bank of England highlight the two or three most important risks in a short covering letter to financial institutions, for discussion at board level. The regulators should also seek confirmation from those institutions that the warnings have been properly considered and publish commentaries on the responses received.

Committee Chair John McFall said that many market participants failed to heed warnings about a serious under-pricing of risk and the potential for impaired liquidity in financial markets in the mistaken belief that the good times would go on and on. Regulators can no longer hedge their bets, he added, by throwing potential risks out into the ether and then washing their hands of the consequences. In future, regulators must ensure that such warnings are acted upon by those at the top of financial institutions.

The report also noted that complex financial products have introduced increased opacity into the financial system, as is demonstrated by continuing uncertainty over the scale and distribution of losses in the banking sector resulting from exposure to sub-prime mortgages. While acknowledging that financial innovation and securitization have brought real benefits and allowed for risk dispersion through the system, the report noted that product complexity has increased opacity to the point that it almost impossible to determine where risk lies and making it much more difficult to achieve financial stability.

Importantly, the report emphasizes that the financial market turmoil has highlighted inherent and multiple conflicts of interest in the credit rating agencies’ business model, as well as flaws in their rating methods. The committee calls for the credit rating agencies to tackle these perceived conflicts of interest as a matter of urgency if they are to regain trust and confidence. The committee is concerned that the ratings agencies were slow to downgrade their ratings for securities backed by sub-prime mortgages. The very fact that the rating agencies began reviewing their methods during the crisis is an implied admission that they did not have the proper models to rate such securities during a time of stress.

The committee urged credit rating agencies to identify and manage conflicts of interest. Also, they must disclose conflicts of interest inherent in their business models that cannot be managed out. If they are unable to do so, cautioned the report, new regulation will be seriously considered. The report rejected the suggestion that investors pay for their own ratings, reasoning that investors who pay for their ratings may have an incentive to try to bargain down the ratings in order to maximize their returns. Further, the committee found that the credit rating agency market is not sufficiently competitive.

More broadly, the committee accepted the growing consensus that the bank originate and distribute securitization model is now irreversible and there will be no return to originate and hold. It then becomes a question of reforming the originate and distribute system. Ambiguity and confusion regarding the ownership risks of off-balance sheet vehicles has contributed to marker volatility. The FSA and international regulators must ensure that banks report their exposure to off-balance sheet vehicles appropriately.

Finally, the report concludes that some investors did not exercise sufficient due diligence on the products they bought and appear to have been overly-reliant on the credit rating agencies, often using ratings as a green light to invest. The committee therefore calls on investors to exercise greater responsibility for the future decisions they make.