Given the scale of the economic crisis and the pain it has inflicted, securities regulators were admirably restrained in proposing reforms in response to the failure of the Canadian asset-backed commercial paper market — although apparently not restrained enough for some.

Late last year, the Canadian Securities Administrators published a consultation paper outlining the results of its review of the collapse of the non-bank ABCP market and set out some possible regulatory responses.

The paper suggests that securities regulators should take jurisdiction over the credit-rating agencies; that the CRAs should be required to adhere to a code of conduct promul-gated by an international umbrella group of securities regulators; and that the reliance on credit ratings in securities regulation should be reduced. It also contemplates reforms for the exempt-market regime, including possible changes to the short-term debt exemption and the “accredited investor” exemption.

The credit crisis and its side effects, such as the freezing of the non-bank portion of the ABCP market in Canada, sparked some fears that such broad market failure would lead to a massive, intrusive regulatory response. Yet the CSA’s plans seem modest enough.

Rather than seeking to put the CRAs on a tight leash, the CSA simply suggests that the CRAs must comply with a code of conduct developed by the International Organization of Securities Commissions, or explain where their practices deviate from that code.

Some of the other reforms are presented only as possibilities. The paper raises the idea of requiring the CRAs to disclose the information they rely on in making their rating decisions for asset-backed securities, but it indicates that the CSA hasn’t decided whether to take this step. (The U.S. Securities and Exchange Commission is proposing a similar move.)

Despite the cautious approach, the paper has sparked a response from various factions of the securities industry. Not surprising, the four major CRAs commented on the CSA’s proposals; and while they are generally happy with the CSA’s strategy that simply requires them to “comply [with] or explain” their adherence to the IOSCO code, they are opposed to further interference from regulators and resistant to the notion that they could be forced to disclose the information they rely on in making their ratings.

The CRAs are particularly concerned about the possibility that securities regulators could seek to interfere with the ratings process, thereby compromising the independence and objectivity of their ratings. This is particularly acute in a system of provincial regulation.

In its comment on the consultation paper, Toronto-based CRA DBRS Ltd. argues that given the international nature of the ratings business, “13 individual securities regulators are not the appropriate authorities to be implementing” a regulatory framework for CRAs.

It points out that the CSA proposal seeks to harmonize its approach with other international regulators, such as the SEC, yet it allows for provincial variation. “This is at odds with any globally harmonized approach to regulation,” it notes, and calls for a national securities regulator to take up this job.

Whether a national regulator is ever achieved is obviously a question that goes far beyond a new regulatory regime for CRAs.

In the meantime, DBRS suggests provincial regulators co-ordinate their CRA oversight efforts with the Office of the Superintendent of Financial Institutions and that they lean heavily on the efforts of other major regulators.

Provincial regulators don’t have jurisdiction over the CRAs; this would require legislation in each province. DBRS recommends that the legislative regime should allow Canadian regulators to rely on others, such as the SEC, to provide oversight and compliance reviews.

If the CRAs are going to have to face intensified oversight, the last thing they want is the needlessly complex compliance challenges that the rest of the Canadian securities industry faces, in which firms must answer to a slew of different regulators that insist on maintaining slightly different rules and different interpretations of those rules for no discernible reason.

Meanwhile, some global players would rather face international regulation. New-York-based Fitch Ratings Ltd. says it believes the optimal solution is a “harmonized global system of oversight for CRAs, based on the IOSCO code.”

But it is unlikely the regulation of CRAs is going to stop at the IOSCO code. In the U.S., new rules are set to take effect later this year governing the interaction of issuers and CRAs that prevent the CRAs from providing advice to issuers on how to achieve a given rating, distancing the ratings personnel from the discussion of fees issuers pay and imposing a $25 limit on gifts that CRA analysts can receive, along with beefed-up record-keeping and disclosure requirements.

@page_break@Additionally, other disclosure rules have been proposed, and the SEC’s new chairwoman, Mary Schapiro, has singled out CRA regulation as one of her priorities. Specifically, she has pledged to address the inherent conflicts of interest the CRAs face because of their compensation models and to limit the impact of ratings on financial firms’ capital requirements.

In Europe, policy-makers appear to be in agreement that CRAs need greater regulation by virtue of their systemically important position in the financial markets. The theory is that, in the same way that the failure of a major bank or other counterparty can cascade through the financial system, wreaking havoc far and wide, a breakdown in the credit-rating process can have a similar effect because these ratings are so widely used and relied upon.

In late February, a group tasked by the European Commission to study the causes of the financial crisis and come up with reform recommendations released its report, which examines a wide range of issues, including the role of CRAs in the crisis. It found that the CRAs followed flawed rating methodologies, faced conflicts of interest that encouraged ratings shopping and that financial regulations requiring credit ratings increased their importance.

It concludes that CRAs’ pivotal role in the markets demands that they must be regulated “to ensure that their ratings are independent, objective and of the highest possible quality.” To that end, it calls for them to face registration and supervision by securities regulators; that regulators must reduce their reliance on credit ratings; and that structured products should have their own ratings category.

Moreover, the group says that a fundamental review of the CRAs’ business model must be carried out, including consideration of whether the industry should move from a model in which issuers pay for ratings to one in which users pay — and to look at how to separate CRAs’ ratings functions from their advisory services.

Some see the prevailing “issuer pays” business model, and the opportunity that creates for ratings shopping, as one of the core issues regulators must resolve. Although policy-makers have, in the past, sought to increase competition in the ratings business as a way of reducing the power of the Big Four CRAs, more players may actually aggravate the ratings shopping problem, a recent study suggests.

A paper published in January by Patrick Bolton, a professor at the New York-based Columbia Business School, and Xavier Freixas and Joel Shapiro, professors at Barcelona’s Universitat Pompeu Fabra, finds that competition in the credit-rating business may be less efficient than a monopoly: “This is because a
duopoly provides more opportunities for the issuer to shop and mislead naive investors.”

The paper examines various regulatory reform alternatives that could minimize the conflicts of interest and distort incentives that may compromise the ratings process. It concludes that these conflicts are best dealt with by regulatory intervention that requires up-front payments for rating services (before CRAs propose a rating to the issuer) and mandatory disclosure of any rating produced.

It remains to be seen whether any of these proposed reforms will be adopted by leading regulators in the U.S. or Europe, and whether the CSA sees fit to follow suit.

Speaking to the Standing Committee on Government Agencies in late February, David Wilson, chairman of the Ontario Securities Commission, indicated that the OSC will be assessing the comments it received and will then develop its final proposals.

One idea the CSA will consider, beyond compliance with the IOSCO code, is the possibility of adopting a disclosure requirement that would oblige the CRAs to ensure the information they use in rating an asset-backed security is publicly disclosed. This idea is meeting resistance from the CRAs and other market players.

“The potentially adverse consequences of such a disclosure requirement cannot be overstated,” warns Moody’s Investors Service Inc. It cautions that requiring this disclosure may deter issuers from providing adequate information to CRAs to avoid public disclosure. It suggests that it could also hurt the securitization business and, therefore, the availability of credit. And it worries that it could contribute to ratings shopping. IE