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Confronting Credit Rating Reform Confronting Credit Rating Reform A “Public Good” Approach

Jin-Chuan DUAN Risk Management Institute National University of Singapore (July 2010)

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Background

• Credit rating agencies have been heavily criticized

in the 2008-09 financial crisis.

• Credit ratings are:

(1) referenced in regulatory frameworks that affect capital requirements; requirements; (2) used in commercial contracts to set collateral requirements; and (3) employed to determine eligibility of debt instruments in, say, pension portfolios.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Background (continued)

• Because major CRAs are for-profit, they need to

keep rating methods proprietary which can hinder methodological developments.

• Major CRAs have been reluctant to downgrade a

firm in distress (e.g., Enron, Lehman) firm in distress (e.g., Enron, Lehman)

• The business model of CRAs is based on the issuer-

pay principle. This could lead to moral hazard and rating shopping.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Objectives:

NUS-RMI’s credit rating initiative sets out to

• Advance scientifically sound credit rating

methodologies.

• Provide alternative, not-for-profit ratings on 1000
• r more Asian firms, representative of 12
• r more Asian firms, representative of 12

economies.

In addition to contributing to the infrastructure of the world financial system, we strive to

• Promote NUS-RMI as a global credit risk research

center.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Conceptual foundation

• Credit ratings (sell-side) are really a “public good”.
• The current debate on credit ratings focusing on

regulatory changes seems to miss this “public good” aspect.

• Providing this “public good” not-for-profit seems to
• Providing this “public good” not-for-profit seems to

be an obvious alternative.

• NUS-RMI will advance credit rating methodologies

and offer credit ratings on a not-for-profit basis. In short, treating credit ratings as a “public good”.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

A unique approach

• RMI builds the rating research and production

infrastructure – a comprehensive data base, and advanced IT system and a team of support staff.

• Researchers have been invited from around the world

to take part in the rating model development. Being not-for-profit, researchers will be able to keep their IP. not-for-profit, researchers will be able to keep their IP.

• Researchers will share the common research

infrastructure but compete to get their models adopted for the RMI ratings.

• The RMI rating model will remain current,

evolutionary and organic, responding to continual suggestions and/or challenges.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

A unique approach (continued)

• We count on voluntary contribution of ideas, skills

and time from individuals all over the world, which is much like Wikipedia, a timely amalgamation of the best ideas.

• RMI will perform quality control, such as model
• validation. Hence, our approach is really a selective
• validation. Hence, our approach is really a selective

Wikipedia.

• A global call for proposals has been conducted, and

the 11 winning research teams plus an RMI internal team are currently working on their different rating

• models. More teams have expressed interest in

joining this undertaking.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

A unique approach (continued)

• RMI maintains the research infrastructure: (1) a

comprehensive database of over 20,000 currently listed Asian firms and around 5,000 delisted firms which include over 1,600 defaulted or bankrupt firms since 1990, and (2) both grid and parallel computing capability. computing capability.

• RMI provides financial support to those who

require it to travel to Singapore to spend an extended period of time for model development.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

A unique approach (continued)

• Being a not-for-profit rating undertaking, the RMI

rating methodology will be non-proprietary and completely transparent.

• Human judgment is naturally an integral part of any
• research. Errors may also occur unintentionally in a

research process. The selected rating model will be research process. The selected rating model will be independently validated.

• Our rating model implementation will be free of ad

hoc human judgment, apart from dealing with

• ccasional data errors that are expected from time

to time.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

A unique approach (continued)

• There will be no conflicts of interest since we will

not be accepting fees or funding from the firms we

• rate. Neither will we charge users for using the

ratings.

• The model selection will be based on the commonly

accepted scientific principle – statistically superior accepted scientific principle – statistically superior

• n a common dataset.
• Operational factors, such as data availability,

frequency of updates and information content of rating results, will also be factored into the selection.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Governance

• RMI has set up an internal management process to

sign off responsibilities in order to ensure data integrity and implementation accuracy.

• There is no plan to set up an independent

governance committee. Instead, quality assurance relies on millions of eyes watching much like relies on millions of eyes watching much like Wikipedia.

• RMI will not apply for any officially sanctioned

credit rating agency status. It will remain as a scientific pursuit, advancing rating methodology and offering alternative credit information. No one will be compelled to use the RMI ratings.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Coverage

Countries/Economies covered in RMI’s database

Economy Exchanges

Firms*

Australia ASX 1875 China SSE, SZSE (A, B, SME & ChiNext) 1905 Hong Kong HKEX, GEM 1372 India NSE, BSE 5235 India NSE, BSE 5235 Indonesia IDX 407 Japan TSE, OSE, OSE-Hercules, JASDAQ, NSE, SSE, FSE 3821 Malaysia Bursa Malaysia (Main, ACE) 979 Philippines PSE 252 Singapore SGX (Mainboard, Catalist, Catalist-NS) 775

• S. Korea

KRX, KOSDAQ 1849 Taiwan TWSE, GreTai (Securities, Emerging) 1568 Thailand SET 565

* Number of listed firms as of 2010-04-27

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Can we do better?

• Moody’s, S&P and Fitch are all very large
• perations. Through their relationships, they have

access to proprietary data.

• Is it possible for a much smaller-scale operation to

do better, with only publicly available data?

• Duffie, Saita and Wang (2007) were able to achieve

an accuracy ratio for default prediction of 88% in the period 1993-2003 using a purely quantitative model.

• This compares favorably to Moody’s accuracy ratio
• f 65% in the period 1999-2003.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

If we could hire Paul, the oracle octopus .....

Can we do better? (continued)

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Yes, we can

• Duan, Sun and Wang (2010) proposed a forward

default intensity approach to generate the term structure of default probabilities.

• They demonstrated that the forward default

intensity method works well for the US data. We applied it to the RMI database and obtained good applied it to the RMI database and obtained good results.

• The beta version of the RMI rating system will be

based on the forward default intensity method.

• Just like Wikipedia, this credit rating method is

meant to be challenged and improved.

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Yes, we can (continued)

Default prediction performance for US (DSW, 2010)

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Yes, we can (continued)

Default prediction performance for US (DSW, 2010)

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Yes, we can (continued)

Default prediction performance for Japan

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Yes, we can (continued)

Default prediction performance for Japan

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Timeline and milestones

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Project organization

Project lead: Prof DUAN Jin-Chuan Deputy lead: Dr Oliver CHEN Ops lead: CHUA Beng Yan ACR Coord. Editor: Dr XU Weiwei

Project Leads Validation Team Market Monitor Team Asian Credit Review Leads Data Collection Model Implementation Logistics Team Modeling Teams

NUS internal teams and many external teams

Review Database

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Asian Credit Review

• Orientation: a professional magazine for finance

professionals, policy makers and academics.

• Content: reports on the data, models and results of

the credit rating initiative. Also, coverage of credit

Information dissemination

• Content: reports on the data, models and results of

the credit rating initiative. Also, coverage of credit market developments and policy issues.

• Tentatively set to release two issues per year.

Web portal: www.rmi.nus.edu.sg/cri

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Screenshots of Web Portal

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Screenshots of Web Portal (continued)

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

Screenshots of Web Portal (continued)

JC Duan (07/2010) Confronting Credit Rating Reform – A “Public Good” Approach

• We believe that valuable soft credit information rests

with credit analysts. Conducting periodic surveys is a good way to assemble such information to improve credit analysis.

• RMI has begun to conduct such surveys. The survey

results are made available to all participants. In the

Credit analyst survey

• RMI has begun to conduct such surveys. The survey

results are made available to all participants. In the longer run, we believe that the survey statistics can be used to improve the performance of credit rating models.

• We need more participants and would appreciate

your suggestion of credit analysts. Email: rmisurvey@nus.edu.sg

Thank you! Thank you!

For more information, go to: www.rmi.nus.edu.sg/cri Feedback and enquiries: rmiratings@nus.edu.sg