Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Tue, 27 Jul 2010

SEC No Action Letter on Rating Non Disclosure

Updated July 27, 2010: Added link and corrected title of the Reform Act.

The US SEC issued a “No Action Letter” last week to negate a key provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act on the day that it came into force. The “No Action Letter” is self explanatory:

Items 1103(a)(9) and 1120 of Regulation AB require disclosure of whether an issuance or sale of any class of offered asset-backed securities is conditioned on the assignment of a rating by one or more rating agencies. If so conditioned, those items require disclosure about the minimum credit rating that must be assigned and the identity of each rating agency. Item 1120 also requires a description of any arrangements to have such ratings monitored while the asset-backed securities are outstanding.

Effective today, Section 939G of the Dodd-Frank Act provides that Rule 436(g) shall have no force or effect. As a result, disclosure of a rating in a registration statement requires inclusion of the consent by the rating agency to be named as an expert. We note that the NRSROs have indicated that they are not willing to provide their consent at this time. In order to facilitate a transition for asset-backed issuers, the Division will not recommend enforcement action to the Commission if an asset-backed issuer as defined in Item 1101 of Regulation AB omits the ratings disclosure required by Item 1103(a)(9) and 1120 of Regulation AB from a prospectus that is part of a registration statement relating to an offering of asset-backed securities.

This no-action position will expire with respect to any registered offerings of asset-backed securities commencing with an initial bona fide offer on or after January 24, 2011.

The relevant portion of Rule 436 is as follows:

(a) If any portion of the report or opinion of an expert or counsel is quoted or summarized as such in the registration statement or in a prospectus, the written consent of the expert or counsel shall be filed as an exhibit to the registration statement and shall expressly state that the expert or counsel consents to such quotation or summarization.

(g) Notwithstanding the provisions of paragraphs (a) and (b) of this section, the security rating assigned to a class of debt securities, a class of convertible debt securities, or a class of preferred stock by a nationally recognized statistical rating organization ... shall not be considered a part of the registration statement.

I can understand a “No Action Letter” that says that as an interim measure the identity of the rating agency need not be disclosed, but I am amazed to find that the SEC is allowing the entire “ratings disclosure” to be omitted. The fact that an issue is conditioned by a minimum rating requirement is I think a material fact.

Also, I do not understand why the SEC cannot simply state that the rating agency shall not be regarded as an expert and require the registration statement to make the same statement. Rating reports should be regarded as being in the same category as press reports and editorials. Ultimately, the SEC should simply abolish the whole category of nationally recognized statistical rating organizations (NRSROs).

I have blogged about rating agency regulatory reform several times in the last three years:

Posted at 15:03 on Tue, 27 Jul 2010     View/Post Comments (2)     permanent link

Wed, 21 Jul 2010

Time for a Financial Sector Appellate Tribunal

I wrote a column in the Financial Express today on why a Financial Sector Appellate Tribunal is superior to the bureaucratic solution created by last month’s ordinance to deal with turf battles between financial sector regulators.

The old saying that “your freedom to swing your fist ends where my nose begins” is as true of regulators as it is of individuals. In a regime of multiple regulators, the autonomy of each regulator is effectively limited by the autonomy of other regulators. What this means is that regulatory autonomy is a delusion and regulatory heteronomy is the reality.

The only real question is whether this heteronomy should be judicial or bureaucratic. I argued for the judicial option in these columns four months ago (‘Fill the gaps with apex regulator’, FE, March 19). Some degree of competition between regulators is a healthy regulatory dynamic, but ultimately any dispute between two regulators must be resolved in the courts.

My recommendation was based on the well-established proposition that the legislature frames laws, the judiciary interprets them and the executive implements the law as so interpreted. If there is a dispute about a law, the judiciary can step in and interpret the law or the legislature can step in and rewrite the law to eliminate the ambiguity. The executive has to await guidance from either of these two branches. I realise that this principle is perhaps totally old-fashioned in an environment where all three branches of the government are increasingly inclined to step on each others’ turf.

However, the judicial option at least had the advantage of being acceptable to the regulators. Three months ago, when the government suggested that the dispute between Sebi and Irda regarding the regulation of Ulips be resolved by the court, none of the regulators complained about loss of regulatory autonomy.

Last month, however, the President promulgated the Securities and Insurance Laws (Amendment and Validation) Ordinance, 2010, which not only settled the Ulips dispute in favour of Irda legislatively, but also provided a new bureaucratic arbitration mechanism for certain future disputes.

Most of the regulators are upset with this on the ground that it undermines their autonomy. This is not quite the correct way of looking at it because what it does is to replace judicial arbitration of disputes by bureaucratic arbitration. A better reason for scepticism is that, in general, bureaucratic arbitration is inferior in terms of process and in terms of outcomes.

The drafting of the ordinance itself is a good example of how bureaucratic processes tend to go wrong. The intention of the new section 45Y that has been inserted into the RBI Act is to ensure that future disputes can be resolved quickly. However, as one reads the section, one realises that this section is hopelessly inadequate.

First of all, section 45Y deals only with instruments. It essentially says that if any difference of opinion arises as to whether a certain instrument is a hybrid or composite instrument and falls under the jurisdiction of RBI, Sebi or Irda, then such difference of opinion shall be referred to a joint committee consisting of the finance minister, two top finance ministry officials and the key financial regulators.

Because the Ulips dispute was about a certain instrument, the government created a statute to deal with disputed instruments. What happens if the next dispute is about institutions and intermediaries? For example, RBI may want to regulate as an NBFC an entity that Sebi regulates as a capital market intermediary. Section 45Y is helpless to deal with this dispute because the dispute is not about instruments.

The second problem with the statute is that it says: “The Joint Committee shall follow such procedure as it may consider expedient and give, within a period of three months... its decisions thereon to the Central Government.” One would have liked to see an explicit provision of decision making by majority or qualified majority. The fundamental problem with the existing HLCC is its quasi-consensual and secretive procedure and its unwillingness to rely on transparent voting. The joint committee inherits this fatal weakness.

The third problem is that the ordinance provides that the decision of the joint committee shall be binding on the regulators—RBI, Sebi, Irda and PFRDA. It does not say that the decision is binding on anybody else. In particular, it is not binding on any of the regulated entities.

Suppose, for example, the joint committee decides that a particular product offered by a bank is actually a security that falls under the jurisdiction of Sebi. If Sebi then imposes a penalty on the bank, the latter could well go to court challenging the jurisdiction of Sebi. Neither the bank nor the court is bound by the decision of the joint committee. The decision is binding on RBI, but surely RBI cannot impose a penalty for violation of a Sebi regulation.

I remain convinced that when we have swinging regulatory fists and bleeding regulatory noses, a judicial solution is far more viable and sensible than section 45Y. The time for a Financial Sector Appellate Tribunal is now.

Posted at 05:04 on Wed, 21 Jul 2010     View/Post Comments (4)     permanent link

Fri, 09 Jul 2010

RBI on India and the Global Financial Crisis

The Report on Currency and Finance 2008-09 published by the Reserve Bank of India this month is on the “Global Financial Crisis and the Global Economy.” Well over two-thirds of this 380 page report is about the global crisis itself and does not contain anything new. But about a hundred pages are devoted to the impact of the global crisis on India and to the policy responses in India.

There are a number of interesting empirical analyses in these two chapters of the report. Well, there is an occasional piece of silly econometrics like the regression in levels between trending variables in footnote 9 on page 277; the absurdly high r-square of 0.9981 should have alerted the authors to the possibility (near certainty?) that this is a spurious regression. However, most of the empirical analyses do appear to be sound econometrically.

A few results that I found interesting:

Posted at 09:10 on Fri, 09 Jul 2010     View/Post Comments (3)     permanent link

Fri, 02 Jul 2010

Drunken trading and risk limits

The Financial Services Authority of the UK put out an order last month regarding a drunken broker (Steven Perkins) who bought $520 million of crude oil futures sitting at home at night with his laptop (hat tip Finance Professor).

I find it amazing that somebody sitting at home with a laptop between 1:00 am and 4:00 am can execute over 2,000 buy trades worth over half a billion dollars when his broking firm is essentially an execution only oil brokerage, and Perkins himself (and almost all other brokers in the firm) were barred from doing proprietary trading.

What does it say about the risk management and control systems at the brokerage firm (PVM)? The FSA explicity says that it “makes no criticism of PVM”:

Mr Perkins’ behaviour was contrary to PVM’s policies and procedures and the FSA makes no criticism of PVM in this notice. Mr Perkins was immediately suspended by PVM on 30 June 2009 and his employment later terminated.

I would however think that there are issues of risk management that cannot be wished away. The Telegraph reports that the transaction caused a loss to PVM of $9.8 million and resulted in the brokerage reporting a loss of $7.6 million for the year. The implication is that the normal profits of the firm were $2.2 million. A drunken broker supposed to execute only client transactions lost in a single night an amount which was more than four times the normal annual profits of the entire brokerage firm!

I think that financial firms need better risk management systems and need to think carefully about operational risk. When Perkins lied to his company that the trade was for a client, he did not claim that it was for large oil company, he said that it was for a “local trader” which is how independent oil traders are referred to. There should have been some counterparty risk controls kicking in when a half a billion dollar trade is made at the dead of night for a client who is a small time local trader. Some alerts should have been trigerred when the purchases by a single broker during the three hour window was more than 17 times the average daily volume of the entire market for this period of the night.

Interestingly, PVM is owned by senior brokers themselves and the poor risk management cannot be attributed to corporate governance issues. I think it reflects the failure of systems and processes at many financial firms to adjust to the modern reality of round-the-clock high-speed electronic trading.

Posted at 06:06 on Fri, 02 Jul 2010     View/Post Comments (4)     permanent link