Rating Agencies in the Face of Regulation

Opp, Christian C.; Opp, Marcus M.; Harris, Milton

doi:10.2139/ssrn.1540099

Cited by 120 publications

(130 citation statements)

References 41 publications

(52 reference statements)

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“…My findings are more consistent with the "regulatory arbitrage" hypothesis, according to which investors readily buy ABS as long as inflated ratings sufficiently relax regulatory constraints (Acharya and Richardson, 2009;Calomiris, 2009;Efing, 2014;and Opp, Opp, and Harris, 2013). My findings are less consistent with the "investor naivety" hypothesis according to which investors simply lack the expertise to understand the complex design of ABS and do not anticipate ratings inflation (Blinder, 2007;Skreta and Veldkamp, 2009;and Bolton, Freixas, and Shapiro, 2012).…”

supporting

confidence: 59%

Arbitraging the Basel Securitization Framework: Evidence from German ABS Investment

Efing

2014

SSRN Journal

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Reproduction permitted only if source is stated.ISBN 978-3-95729-207-0 (Printversion) Non-technical summary Research QuestionThe 2007-2009 financial crisis has raised fundamental questions about the effectiveness of the Basel II Securitization Framework, which regulates bank investments into asset-backed securities (ABS). The Basel Committee on Banking Supervision (2014) has identified "mechanic reliance on external ratings" and "insufficient risk sensitivity" as two major weaknesses of the framework. Yet, the full extent to which banks actually exploit these shortcomings and evade regulatory capital requirements is not known. This paper analyzes the scope of risk weight arbitrage under the Basel II Securitization Framework. ContributionA lack of data on the individual asset holdings of institutional investors has so far prevented the analysis of the demand-side of the ABS market. I overcome this obstacle using the Securities Holdings Statistics of the Deutsche Bundesbank, which records the on-balance sheet holdings of banks in Germany on a security-by-security basis. I analyze investments in ABS with an external credit rating to uncover risk weight arbitrage on the demand-side of the ABS market. ResultsThe analysis delivers three main results. First, I provide security-level evidence that banks arbitrage Basel II risk weights for ABS. Banks tend to buy the securities with the highest yields and the worst collateral in a group of ABS with the same risk weight (and, therefore, the same capital charge). My findings corroborate the hypothesis that institutional investors bought risky ABS to some extent for motives of regulatory arbitrage.Second, banks operating with low capital adequacy ratios close to the regulatory minimum requirement are found to arbitrage risk weights most aggressively. From a financial stability perspective this finding is troubling as it implies that the presumably more fragile banks are also most pervasively optimizing the very capital regulation designed to constrain them.Third, banks with tight regulatory constraints buy riskier ABS with lower capital requirements than other banks. The ABS bought by banks that arbitrage risk weights, promise an as much as four times higher return on required capital than the ABS bought by other banks. Arbitraging the Basel Securitization Framework:Evidence from German ABS Investment * Matthias Efing Swiss Finance Institute & University of Geneva AbstractThis paper provides evidence for regulatory arbitrage within the class of assetbacked securities (ABS) based on individual asset holding data of German banks. I find that those banks operating with tight regulatory constraints pick the securities with the highest yield and lowest collateral quality among ABS with the same regulatory risk weight. This ABS selection allows banks to increase the return on the capital required for an ABS investment by a factor of four.

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confidence: 59%

Arbitraging the Basel Securitization Framework: Evidence from German ABS Investment

Efing

2014

SSRN Journal

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“…This variation produces the systematic bias in the disclosed ratings even with agencies' estimates of the asset's true quality. Finally, Opp, Opp, and Harris (2013) consider the higher costs of obtaining all necessary information in order to rate more complex securities. In this case, CDOs have inflated tranche ratings due to the unwillingness of rating agencies to spend the necessary resources to fully understand the collateral.…”

Section: Hypothesismentioning

confidence: 99%

A Re-Examination of Rating Shopping and Catering Using Post-Crisis Data on CDOs

Owlett

2016

SSRN Journal

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“…This has come to be known as the phenomenon of ' infl ated ratings ' (cf. Opp et al , 2011 ). The emergence of structured fi nancial products (such as asset-backed securities) in particular led to the CRAs earning vast amounts of money.…”

Section: Introductionmentioning

confidence: 99%

The quality of credit ratings and liability: The Dutch view

Duffhues¹,

Weterings²

2011

Int J Discl Gov

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Credit rating agencies (CRAs) such as Standard & Poor ' s and Moody ' s have existed since the beginning of the twentieth century. Their main objective is to increase the effi ciency of the fi nancial markets, by producing ratings expressing the creditworthiness of companies with respect to loans and credits. The intermediary position of CRAs places high demands on the effi ciency of the rating process and the avoidance of confl icts of interest. In practice there is some doubt as to the realism of these objectives and hence the usefulness of ratings even though, paradoxically, they do enjoy broad acceptance. This article discusses the question of whether the criticism that investors and companies have of CRAs is always justifi ed, and what action should be taken when that criticism is justifi ed. Reference is made to the objectives of CRAs and the doubts about their effi ciency and effectiveness that have arisen in many national and international publications. This article provides an insight into how CRAs operate and how this is judged within a society. CRAs have an information transformation function, and the existence of dual information asymmetry might have a negative impact on this. Holding CRAs liable is one of the possible solutions. Legal measures, such as breach of contract and negligence, may offer CRAs incentives to make every reasonable effort to prepare adequate credit ratings and to update ratings in a timely manner. It is nonetheless diffi cult (in the context of liability) to make an objective assessment because CRAs, too, must work under uncertain relationships.

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Rating Agencies in the Face of Regulation

Cited by 120 publications

References 41 publications

Arbitraging the Basel Securitization Framework: Evidence from German ABS Investment

Arbitraging the Basel Securitization Framework: Evidence from German ABS Investment

A Re-Examination of Rating Shopping and Catering Using Post-Crisis Data on CDOs

The quality of credit ratings and liability: The Dutch view

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