Not only does the credit crisis present financial markets and the global economy with unprecedented challenges, it also poses once-in-a-lifetime tests for policy-makers. Although Canada has weathered the crisis fairly well, the Canadian Securities Administrators are contemplating regulatory reforms in response.

So far, the financial services industry in Canada has been spared the worst of the credit crunch. The problems, which originated in the U.S., have hit U.S. firms hardest. Several Canadian banks have taken large writedowns and the domestic asset-backed commercial paper market did seize up, but in both cases, the reason was exposure to U.S. subprime mortgage securities. There has been very little homegrown turmoil here.

Even so, Canadian investors have suffered, particularly as a result of the crippling of the non-bank ABCP market. Regulators and policy-makers, therefore, must consider whether the crisis has exposed fundamental weaknesses that need to be fixed.

Such consideration has been underway for some time, and the first concrete result in Canada is a CSA consultation paper that contemplates changes to the regulatory system as a result of the failure of the non-bank portion of the domestic ABCP market. In the CSA paper, the regulators focus on two main issues: the role of credit rating agencies and the function of the exempt market.

Regarding the former, the CSA recommends taking jurisdiction over CRAs, establishing a framework for their regulation and, at the same time, reducing the role of credit ratings in securities regulation.

While the CSA is proposing to bring CRAs under its oversight, its plans are fairly modest. It would simply require CRAs to comply with the code of conduct that is issued by the umbrella organization for securities regulators, the Madrid-based International Organization of Securities Commissions. Or, in areas in which CRAs don’t comply, they would have to explain why.

IOSCO revised that code of conduct this past spring, largely in response to the credit crisis. The new code aims to ensure the quality of the ratings process; it addresses the issue of CRAs’ independence and the avoidance of conflicts of interest; and sets out CRAs’ responsibilities to issuers, investors and market participants.

The changes proposed in IOSCO’s latest publication include, among others: prohibiting CRA analysts from advising companies on how to structure products to obtain high ratings; ensuring the information on which analysts rely is good enough to support a rating; establishing a process for reviewing their rating models; ensuring analyst proficiency and examining their compensation methods; requiring adequate resource allocation; and providing structured finance ratings through different symbols.

As part of the CSA’s proposed framework for CRA regulation, the regulators are also considering requiring CRAs to disclose publicly the information on which they have relied in rating an asset-backed security. While this is potentially more controversial than the requirement to comply with the IOSCO code — a similar requirement is being proposed by the U.S. Securities and Exchange Commission — the CSA is taking a cautious approach to the notion. It is throwing the issue out for discussion, but hasn’t conclusively decided to demand this disclosure.

Toronto-based rating agency DBRS Ltd. says that it has been in talks with regulators and was aware that this proposal was in the works. It expects further discussions with regulators, and plans to submit a comment letter.

To implement this new regime, however, regulators still have to get their local legislators onside. The CSA doesn’t have the legal authority to adopt its proposed framework. So, regulators will require legislative amendments to introduce this new system. Notwithstanding the rather modest proposal for CRA oversight, the fact that regulators require legislative co-operation injects an additional element of uncertainty into the CSA’s plans.

As for reducing reliance on credit ratings in securities regulations — which the CSA does have the power to do unilaterally — the CSA is considering whether to delete references to credit ratings or whether it can arrive at a suitable substitute in situations in which credit ratings play a role in regulation.

Currently, there are instances when the existence of a sufficient credit rating can lead to favourable regulatory treatment. For example, “highly rated” short-term debt can be distributed without a prospectus and can be purchased by money market funds by virtue of its rating.

The rationale for reducing the reliance on credit ratings, as the CSA paper notes, is that this practice of using credit ratings to determine regulatory treatment may give the impression that regulators are endorsing these ratings. Moreover, it adds value to the ratings, and boosts the rating agencies’ market power. Similar issues are under consideration by the SEC in this area, too.

@page_break@In addition to addressing the credit-rating process, the CSA contemplates tackling a couple of issues that emerged in the exempt market regime as a result of the ABCP mess. The CSA proposes revising the short-term debt exemption so that it can’t be used to issue asset-backed debt, including ABCP; and, it proposes a review of the “accredited investor” exemption.

Of these, the review of the accredited investor exemption is potentially more interesting. As the CSA consultation paper notes, the accredited investor exemption presumes that investors who meet this definition don’t require prospectus-level disclosure because they are sophisticated enough to make investment decisions without that much disclosure or, at least, rich enough to bear the loss if their investments turn sour.

The credit-market turmoil has called this conclusion into question. It appears, however, that the CSA is questioning only the financial thresholds at which someone can be considered an accredited investor ($1 million in financial assets or $200,000 in annual income, among other things) — not the premise that wealth can is a reliable proxy for investment knowledge and sophistication.

Hopefully, the policy review will go further than simply raising the financial thresholds for accreditation and considers alternative tests of investor savvy. But for now, it appears the CSA is planning only to look at the former. Erez Blumberger, manager of corporate finance with the Ontario Securities Commission in Toronto, indicates that this review will begin once the comment period on the paper is complete.

In addition to these two major issues, the CSA paper also considers whether changes are needed to the rules governing money market funds and their purchases of ABCP. Primarily, the CSA is looking at restricting portfolio concentrations, and if rules about what money markets funds can hold need to be revised. The CSA paper notes that U.S. money market funds are subject to a 5% limit on holding any single issuer. The paper proposes to revisit Canada’s 10% limit to determine the correct level for ensuring money market funds remain diversified, low-risk investments.

The CSA is also considering whether to restrict these funds from investing in ABCP and other such assets. And, the CSA paper asks, do fund managers need more guidance in determining the factors they should consider in setting their asset mix?

While the CSA paper mentions the role of dealers and advisors, it indicates that the CSA is waiting for the results of a review by the Investment Industry Regulatory Organization of Canada into that part of the crisis. IIROC indicates that its report will be released by mid-October.

According to the CSA, IIROC’s review so far has found that about 2,500 retail investors purchased $372 million of the non-bank ABCP that was subsequently frozen. About 95% of these investors were clients of just five dealers.

The CSA also reports that, according to IIROC, about $320 million of ABCP (both bank-sponsored and non-bank) has already been repurchased by dealers (affecting 600 investors, both retail and corporate). Another 1,800 investors are expected to have about $180 million in non-bank ABCP repurchased by their dealers as part of the restructuring that was arranged by the committee headed by Purdy Crawford.

While IIROC is handling the retail investor/dealer angle, the CSA is conducting its own reviews of issuers that hold significant quantities of non-bank ABCP, focusing on whether the firms are properly accounting for their exposure, and whether this is adequately explained in the management discussion and analysis portion of their financial disclosure. The CSA report indicates that these reviews will continue until the non-bank ABCP restructuring is complete.

So far, the CSA paper reports, as a result of these reviews, a handful of issuers were required to restate their financials because their valuation writedowns were inadequate and their ABCP was not properly classified on the balance sheet.

Also, according to the latest report detailing the results of the past year’s continuous disclosure reviews, a number of other issuers were asked to beef up their ABCP-related disclosure in future filings. The regulators’ directive concerned both the methods and assumptions used to determine fair market value, and the impact of the holdings on issuers’ ability to meet their cash needs and planned growth objectives. (See page 14.)

The other disclosure issue the CSA is examining is whether the banks are providing enough insight into their use of off-balance sheet entities, the risks inherent in these vehicles and the banks’ valuation practices for illiquid securities.

Overall, the CSA report says, its reviews indicate that disclosure is improving. So, it is not proposing any changes to disclosure requirements as a result of the turmoil.

This low-key response is indicative of the CSA’s overall approach to the credit-market turmoil. It contemplates a new but modest effort at CRA regulation. It imagines a series of other important but fairly technical tweaks to the existing system. This reaction seems in proportion with the level of turmoil in Canada, which has been unpleasant but not severe. IE