Financial Market Regulatory Reforms and Due Diligence:

Lessons from Behavioural Science

Prof. Dr. Fabian Amtenbrink & Prof. Dr. Klaus Heine

Idea and outline

• Ongoing debate on how to (re-)regulate the credit ratings business -> debates in politics, economics, law

• In recent years insights of behavioural science have become prominent in economics (esp. behavioural finance) -> e.g. ‘Nudge‘ (Thaler/Sunstein 2008)

• Can findings from behavioral science inform us about how to regulate the market for credit ratings? More concrete: What can the European law maker learn from behavioral science for setting up an effective regulation of the credit ratings industry?

Problems of the market for credit ratings

• CRAs have ample experience in assessing creditworthiness and large research facilities -> economies of scale -> natural monopoly (reputation as sunk costs)

• Credit ratings are information. Provision of that information without additional marginal costs; exclusion of users of that information is difficult -> public good

• Business model: Issuer pays -> conflict of interest -> CRAs may provide sugarcoated ratings

• (Over-)reliance on ratings

• Oligopolistic market structure

Is there a need to regulate?

The European Union Approach

Aims of the EU regulatory regime (Reg. 1060/2009)

“The users of credit ratings should not rely blindly on credit ratings but should take utmost care to perform own analysis and conduct appropriate due diligence at all times regarding their reliance on such credit ratings.”(Reg. 1060/2009, Preamble No. 10)

“The emergence of new actors on the credit rating agency market should also be encouraged”

(Reg. 1060/2009, Preamble No. 55)

Towards certificed ratings?

‘… the objective of this Regulation, namely

to ensure a high level of consumer and investor protection by laying down a common framework with regard to the quality of credit ratings to be issued in the internal market…’(Reg. 1060/2009, Preamble No. 75)

“The proposed Regulation aims to improve the quality of credit ratings, but it does not relieve investors of the need to exercise judgment and due diligence in relying on ratings when making investment decisions…”European Commission, Explanatory Memorandum)

Registration

• Scope: This Regulation applies to credit ratings issued by credit rating agencies registered in the Community and which are disclosed publicly or distributed by subscription. (Artikel 2(1) Reg. 1060/2009)

• CRAs must apply for registration in order to qualify for recognition as external credit rating agencies as defined by Directive 2006/48/EC

• No central European supervisory authority

• Competent authority of home MS has to cooperate with authorities of other MS (so-called college of supervisors)

• Third-country CRA ratings can be endorsed by EU CRAs or certified by European Commission

Regulating CRA conduct

Introduction of legally binding organisational and operational arrangements, such as inter alia:

• Separat rating categories for structured financial products

• Avoidance of conficts of interest

• Transparency of procedures, methods and assumptions

• Definition of so-called ancillary services

•

Supervisory measures against CRAs

• Appropriate measures to ensure that credit rating agencies continue to comply with legal requirements of the Reg.

• Supervisory measures of the home MS authority

• Supervisory measures of the authorities of other MS

• MS must provide for effective, proportionate and dissuasive sanctions

Does the EU Regulatory Approach Enhance Due Diligence and/or

Competition?

European Commission v. expert opinions

Self-regulation based on voluntary compliance with the IOSCO code does not appear to offer an adequate, reliable solution to the structural deficiencies of the business. While the industry has come up with several schemes for self-regulation, most of these have not been robust and or stringent enough to cope with the severe problems and restore the confidence in the markets.

(European Commission, Proposal for a Regulation on Credit Rating Agencies, COM(2008) 704 final)

CESR and market participants believe that there is no evidence that regulation of the credit rating industry would have had an effect on the issues which emerged with ratings of US subprime backed securities and hence continues to support market driven improvement.(CESR’s Second Report to the European Commission on the compliance of credit rating agencies with the IOSCO Code and The role of credit rating agencies in structured finance’, May 2008)

“… full formal regulation may be counter-productive as it might be seen by users in the market place to imply a level of official endorsement of ratings which is neither justified nor feasible. “

(ESME’s report to the European Commission, June 2008)

… and what about market access?

Insights from Behavioural Science

Insights from behavioural science I

• So far discussion on credit ratings and CRAs by the help of prinicipal agent theory and industrial organisation

• Underlying assumption: Rational decision-making of individuals

• In the following relaxing the rationality assumption

• By now no literature, which integrates insights of behavioural science into the debate

• The following ideas have to be seen as a first step towards an integration of behavioural science into the debate -> conceptual framework -> open for discussion

Insights from behavioural science II

• Decision-makers are looking for advice, in order to improve their decisions. However, taking advice as a means to share accountability -> feeling more comfortable (Harvey/Fischer 2004)

• Investors may falsely and uncritically rely on credit ratings -> emotional “offloading”

• Quality of decision-making improves, if independent and uncorrelated information is acquired. However, decision-makers abandon recommendations, which are different (Harries/Yaniv/Harvey 2004)

Insights from behavioural science III

• Incumbent expert sources is attributed “expert power”; while information of new advisors becomes systematically discounted (Goldsmith/Fitch 1997)

• Investors may falsely and uncritically rely on credit ratings, if they are provided by incumbent CRAs

• In summary, the literature on the psychology of advice suggests that investors overconfidently rely on credit ratings

Insights from behavioural science IV

• The findings of the psychology of advice are in accordance with the so-called “lulling-effect”/”Peltzman-effect”

• Idea of the lulling-effect: Individuals overestimate the protective effect of regulations. Consequence: Individuals overly reduce their own measures against risk -> Individuals take (non-optimal) higher risk levels than without regulation

Insights from behavioural science V

• Propositions: – Tight public regulation of credit ratings and CRAs will make

investors to believe overconfidently in the information provided by CRAs

– Tight public regulation will overly reduce investors’ own efforts to evaluate the risk of debt securities

– Investors will purchase more risky debt securities than without public regulation

• Conclusion: Tight public regulation of CRAs may be well intended to improve the quality of credit ratings, but the market outcome is worse than without regulation

Insights from behavioural science VI

• Evidence from neuroeconomics; recent study by Engelman/Capra/Noussair/Berns (2009): Expert financial advice neurobiologically ‘offloads’

• While undergoing ‘functional Magnetic Resonance Imaging’ participants of an experiment had to made financial decisions

• Significant impact of expert advice on decision-making: Probability weighting functions of test persons were shifted in the direction of the financial advice -> offloading

Insights from behavioural science VII

Engelman/Capra/Noussair/Berns 2009, p. 4

Policy Conclusions I

• Preventing the offloading of valuation mechanisms in the brains of investors

• In general, two ways for improving the quality of decisions of investors:– Making investors more aware of the inherent risks of credit ratings

(debiasing)– Improving the quality of credit ratings

• Two generic policy measures:– Reinforcing competition between CRAs– Due diligence

Policy Conclusions II

• Reinforcing competition between CRAs• Not a simple task, given the market failures on the market

for credit ratings (natural monopoly, public good)• Instead of simple deregulation, competition enabling

institutions• Proposed policy measures (to be extended):

– Transparency of applied rating methods and underlying data -> Investors can more easily evaluate the quality of ratings -> third parties can criticize methods and data set -> Transparency makes it more salient for investors that the quality of credit ratings not only depends on the reputation of CRAs but also on methods and data

– No licensing of CRAs by government agencies -> Licensing suggests a competence that CRAs do not have (strong trigger of the lulling-effect )

Policy Conclusions III

• Due diligence– Obligation that CRAs make deep own investigations into the

creditworthiness of issuers– Decrease of the informational asymmetry between issuer and

investors– Lulling-effect will decrease, because of the provision of

better/more differentiated rating information– Law suits of investors against CRAs will provide salient

information for investors and will be helpful to overcome in the future deceived investment decisions

• Is there a need/use for a European CRA?

Recent developments and the road ahead

• September 2009 EU package initiatives to strengthen financial market supervision

• The future European Securities and Markets Authority (ESMA)– Centralised registration– Centralised oversight (e.g. on-site inspections)

• The June 2010 Commission proposal– Amending Reg. 1060/2009 to recognise new ESMA– New obligation: access to all information used in ratings of

structured finance instrument to competing CRAs – ESMA has the power to propose periodic penalty payments. BUT:

decision on application rests with European Commission

THE END

Insights from behavioural science II

• Delete: Small literature on herd behaviour and credit ratings (Ferri/Morone 2008)

• Herding: Agents follow each other, although it would be better, if agents would rely more on their own expertise -> socially non-optimal equilibrium

• CRAs disseminate public information, which may prevent socially non-optimal herding -> debiasing (Ferri/Morone 2008)

• Delete: However, Ferri/Morone (2008) assume that CRAs provide correct information

• Shorten this point Herding of issuers to release only AAA debt securities, because investors use heuristics to classify securities -> AAA is seen to be risk free -> too many AAA debt securities on the market, because of the demand driven herding of issuers (Barberis/Shleifer 2003, Benmelech/Dlugosz 2009) -> overconfidence of investors

Insights from behavioural science VIII

• Findings of fMRI:– In case of giving advice other regions of the brain were activated

than in case, when no advice was given -> financial advice is neurally not an “additional information” complementing already available information -> financial advice is an information treated apart from the original decision problem

• Activation patterns of brain regions:– No financial advice: Brain regions which are associated with

decision-making under uncertainty and in which elements of expected utility are processed (orange) -> Deactivation of these regions, when financial advice was given

– Financial advice: Brain regions which are associated with judgements of true and false beliefs that other individuals may hold; assessing the trustworthiness of trading partners in economic games (blue)

Deleate whole sheet and provide highlight during talk

Insights from behavioural science X

• Activation pattern in case of nonconforming with financial advice:– Activation of ‘right amygdala’– Region is associated with

negative emotional states

->feeling uncomfortable when not

following others (experts!)– Activation of ‘anterior insula’– Region is associated with encoding

of negatively valued affections of risk

->assessing the risk to (do not) follow

the financial advice

• In summary, neuroeconomics supports the proposition, that credit ratings lead to a mental “offloading” -> no critical evaluation of the received information -> lulling

interesting but there is no tile for this so deleat for this presentation!!!

Policy Conclusions III

– No contractual obligations for asset managers to purchase debt securities of a certain rating level or of a licensed CRA -> Prevention of offloading the accountability for investment decisions by investors and asset managers

– No central regulatory authority for CRAs on the EU or world level -> Availability of different regulatory approaches prevents investors to believe in the existence of an optimal regulatory standard (trigger of lulling-effect) -> investors will have to consider not only the rating but also the quality of the regulation behind the rating

– The issuer pays model seems to be the only viable business model. However, improving competition and preventing shopping around by paying CRAs upfront and mandatory disclosure of ratings -> Investors will bcome more aware how reliable an issuer is -> how often has an issuer earned a top-level rating and when has an issuer withdrawn a debt security?

– Do we really need this slide as well??? Maybe we better delete it given time restraints

– Transparency of applied rating methods and underlying data -> Investors can more easily evaluate the quality of ratings -> third parties can criticize methods and data set -> Transparency makes it more salient for investors that the quality of credit ratings not only depends on the reputation of CRAs but also on methods and data

– No licensing of CRAs by government agencies -> Licensing suggests a competence that CRAs do not have (strong trigger of the lulling-effect )