Industry comments on Japan's new ratings rule

Japan''s Financial Services Agency released its second proposal on bank capital requirements at the end of March. Here S&P discusses the proposals.

The Financial Services Agency's (FSA) second proposal, as with its first proposal released on Oct. 31, 2004, prohibits banks from using un-requested ratings, excluding those on central governments, under the standardized approach. FSA's explanation of its rationale for this proposal is that there is a concern about the possibility that External Credit Assessment Institutions (ECAIs) could use un-requested ratings to pressure issuers to request ratings.

Standard & Poor's believes the exclusion of ratings assigned without the request of the issuer creates an incremental potential for a most favorable ratings bias among issuers, and among banks implementing the standard approach. In-built incentives for both issuers and banks to engage in "rating shopping" could result in pressure on ECAIs to compromise on quality to win business, eroding the sound credit culture in Japan. The exclusion does not adequately reflect the contribution of un-requested ratings to transparency and market discipline, and the beneficial role such ratings play as a safeguard against undesirable arbitrage in the broader market.

The comments below were submitted by Standard & Poor's to the FSA.

Comment 1: Concerns Over Misuse Of Un-requested Ratings Unnecessary

FSA confirmed on March 31, 2005 its intention to prohibit banks from using un-requested ratings in the standardized approach because of its concerns about the potential for ECAIs to use un-requested ratings as a tool to pressure issuers to request ratings. However, Standard & Poor's still believes there is no need for regulators to be concerned about the possibility that Standard & Poor's would use un-requested ratings in such a manner. The rationale behind this opinion is detailed in our report: "S&P's Comments to Japan's Financial Services Agency on Proposed Capital Requirements" published on Dec. 1, 2004. Standard & Poor's encourages the FSA to review our polices and procedures related to ratings assigned without the request of the issuer, and notes that other regulators, as reflected in the IOSCO code, generally have acknowledged the contribution of such ratings to the marketplace.

Comment 2: Regulatory Arbitrage By Banks

If only ratings that are confirmed as requested by ECAIs or issuers can be used under the standardized approach, banks may have an undesirable incentive to conduct regulatory arbitrage by not attempting to confirm the existence of a request for ratings that require a relatively high risk weighting. Standard & Poor's believes this type of regulatory arbitrage by banks would undermine the sound credit culture and market transparency in Japan.

According to FSA's statement on March 31, 2005, under the standardized approach, banks can use only ratings that are confirmed as requested by either the ECAI or the issuer.

If two ECAIs, X and Y for example, have ratings on a particular issuer, if X's rating requires a higher risk weighting than Y's rating, and if X does not disclose whether each of its ratings is requested or make this information readily available, then the bank is likely to have an incentive to avoid the higher risk weight required by X's rating, simply by not making efforts to confirm with the issuer whether or not the rating from X was requested.

Comment 3: Regulatory Arbitrage By Issuers

If only ratings that are confirmed as requested by ECAIs or issuers can be used under the standardized approach, it could give issuers an undesirable incentive not to confirm the existence of a request for ratings that require a higher risk weighting than other ratings. Standard & Poor's believes such regulatory arbitrage by issuers would undermine the sound credit culture and the market transparency in Japan.

According to FSA's statement on March 31, 2005, under the standardized approach, banks can use only the ratings that are confirmed as requested by either the ECAI or the issuer.

If two ECAIs, X and Y for example, have ratings on an issuer, if X's rating requires a higher risk weighting than Y's rating, and if X does not disclose whether each of its ratings is requested or make this information readily available, then the issuer may have an incentive to tell the bank that X's rating is un-requested or not to provide any information about X's rating, while clearly stating to banks that Y's rating is requested.

This problem cannot be overlooked, as it is practically difficult to provide a definition of "request" that leaves no scope for interpretation.

Comment 4: Market-Oriented Discipline

Standard & Poor's believes that the market, not bank regulations, should be the mechanism for imposing discipline on ECAIs. Standard & Poor's current policy in Japan is to identify a rating that is not based on a company request by inserting a disclaimer in reports on that rating. By doing so, we hope the market can examine whether un-requested ratings are comparable with requested ratings in terms of rating levels, quality, and frequency of ratings reviews, and confirm that ratings are not influenced by any conflicts of interests at Standard & Poor's. If bank regulators try to achieve the same outcome by simply prohibiting banks from using un-requested ratings, rather than utilizing market mechanisms, this could result in rating arbitrage by both banks and issuers as described above, as well as causing market confusion and adding costs related to unnecessary procedures required to confirm the existence of a rating request. In-built incentives for both issuers and banks to engage in regulatory arbitrage or "rating shopping" could result in pressure on ECAIs to compromise on quality to win business, eroding the sound credit culture in Japan. The exclusion of un-requested ratings does not adequately reflect the contribution of un-requested ratings to transparency and market discipline, and the beneficial role such ratings play as a safeguard against undesirable arbitrage.

Comment 5: Use Of Rating Split Data

For FSA to determine tables to map each ECAI's ratings to risk weighting buckets, it is desirable not only to compare default rates published by various ECAIs, but also to look at the actual "rating split" data. (Rating split refers to the difference in ratings assigned on the same issuer by different rating agencies.)

According to FSA's statement on March 31, 2005, the Minister for Financial Services will determine the mapping between each ECAI's ratings and risk weighting buckets based on qualitative and quantitative criteria, with the latter consisting solely of historical default rates. While Standard & Poor's acknowledges the application of default studies to the mapping exercise, it is practically difficult to compare default rates across ECAIs because of differences in the definition of default, in methodologies to calculate default rates, and in the period of time over which ratings performance is measured. While FSA's statement is largely in line with the Basel Committee's proposal in June 2004, the method of adjusting for these differences was not fully discussed by market participants or among regulators. Standard & Poor's encourages the FSA to consider existing rating splits that prevail in the market, and the extent to which they should also be reflected in the mapping process. A mapping exercise which does not acknowledge existing rating splits may encourage a bias toward the use of the most favorable ratings as the basis for measuring regulatory capital requirements. In reality, it is difficult for FSA to justify any mapping solely through the comparison of default rates on Japanese companies disclosed by various ECAIs with different methodologies.

At the same time, domestic market participants are fully aware that the average difference between ratings from different ECAIs can be significant, sometimes greater than three notches. In Japan, it is common practice for credit organizations, fixed income analysts, and non-profitable research organizations to analyze such rating gaps in various ways such as by industry, by ECAI, and in time series. Therefore, if FSA ignores actual rating split data and uses default rates as the only quantitative criteria to determine mapping rules, it is likely to result in unrealistic regulation. Standard & Poor's does not believe the Basel Committee's proposal in June 2004 prohibits local banking supervisors from examining quantitative information other than default rates. Rather, we believe the overall intention of the Basel Committee's proposal is to make the capital requirements reflect the economic reality.

[The article is an abstract from RatingsDirect, Standard & Poor's Web-based credit research and analysis system (www.ratingsdirect.com).]