BLUEPRINT for an EUROPEAN RATING AGENCY

Brussels, October, 2011

Contents

1 2 3 4 5 6

Vision and executive summary Current setup of the rating industry Suggested solution The European Rating Agency Investor-based revenue platform Approach/next steps

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Vision, mission and strategic goals of a European rating initiative

VISION

Strengthening and maintaining financial market stability and reducing systemic risks rooted in the current setup of the rating industry

MISSION

Promoting effective and efficient rating information, facilitating more open and competitive European capital markets, improving investor information, and ensuring the public's trust in the capital markets

STRATEGY Establishing a European Rating Agency based on a new operating model, designed to address the inherent weaknesses and conflicts of interest of the current setup; creating an investor-based revenue platform
Source: Roland Berger BLUEPRINT EUROPEAN RATING AGENCY.pptx 3

STRUCTURAL PROBLEMS OF THE RATING INDUSTRY

Executive summary The case for a European Rating Agency

Situation: The commercial credit rating agencies (CRAs) acted as catalysts in the global financial crisis Diagnosis: This role was triggered by a set of wrong microeconomic incentives and problems in the current setup of the rating industry that can be summarized as follows: Monopolistic structure: Systemic concentration risk and monopolistic pricing Conflict of interest I: Revenue model Conflict of interest II: Provision of additional services Liability gap: Rating defined as an "opinion" Quality problems in methodology and processes/approach Cyclicality mismatch/rating philosophy Regulatory mismatch Ratings form basis for regulation but are unregulated themselves "Home bias": Rating approach is based on US model Conclusion: These issues justify an initiative to reshape the industry to create more transparency and market efficiency, to reduce systemic risk and to remove the monopolistic rates currently paid by capital market participants (issuers and investors) Suggested solution: Establish a globally operating European Rating Agency in the form of a foundation created by the financial sector, based on an extremely transparent operating concept and introduce a new investor-based revenue system to eliminate the conflict of interest I (revenue model)

Source: Roland Berger analysis

BLUEPRINT EUROPEAN RATING AGENCY.pptx

STRUCTURAL PROBLEMS OF THE RATING INDUSTRY BACKUP

The current status of the rating industry has exposed a range of problems (1/2)
Current situation in the rating business
Monopolistic structure Moody's, S&P and Fitch rating agencies dominate, with 95% global market share 80% is held by the US institutions Moody's and S&P with overlapping shareholder structures Conflict of interest I Revenue model Rating services are paid by those whose products are rated (issuer-based revenue model) CRAs are private firms Conflict of interest II Provision of additional services CRAs offer a range of non-rating services, including transaction structuring Liability gap Rating is defined not as a product but as an "opinion" shielded from liability by the US Constitution (1st Amendment) Due to this business model, the CRAs cannot be held accountable, even in cases of intent or gross negligence, shielding them from legal intervention and product liability claims
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Implications for the market

Concentration risk and lack of competition have a negative impact on the quality of credit ratings Monopolistic pricing reflected in 40% return on revenues Incentives for inflated ratings, in particular for mortgage products Insufficient incentives to achieve highest-quality rating CRAs rate products that they structured themselves: Arbitrary structuring until the required rating is achieved

Source: Roland Berger analysis

STRUCTURAL PROBLEMS OF THE RATING INDUSTRY BACKUP

The current status of the rating industry has exposed a range of problems (2/2)
Current situation in the rating business
Quality problems Lack of consistency in rating methodology and substantial gaps in know-how Unsatisfactory level of transparency Cyclicality mismatch/rating philosophy US-based CRAs aim at constant ratings over the business cycle ("through-the-cycle rating") Undifferentiated ratings lead to untimely downgrades ("cliffhanger downgrades") exaggerating market volatility Deviation from "fair and true" ratings

Implications for the market

Rating errors/methodological weaknesses and lack of rating transparency led to misallocation of capital resources amounting to approx. USD 3 trillion in the structured finance market

Regulatory mismatch Although CRAs are largely unregulated, their ratings form the basis for financial sector regulation (banks, investors) "Home bias" Two of the top three CRAs are US-based firms with an Anglo-Saxon approach to credit analysis CRAs primarily take a US investor's perspective They face criticism for showing a lack of understanding of European specifics
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Rating errors and quality problems lead to suboptimal decision making in financial institutions and regulatory authorities

Source: Roland Berger analysis

STRUCTURAL PROBLEMS OF THE RATING INDUSTRY

Monopolistic structure? Three CRAs control 95% of the global market, 80% is held by two US institutions (Moody's and S&P)
Global sales development
Total: approx. USD 5 bn REGULATORY entry barriers
Since 1975, the SEC1) has been responsible for granting NRSRO2) status. Despite many applications for NRSRO status, only one new general-purpose CRA was approved by the SEC between 1975 and 2002 Originally there were 3 NRSRO agencies: Moody's, S&P, Fitch. Four more (one general-purpose CRA as mentioned above, three specialist CRAs) joined them in the period up to the early 1990s, but were bought out by the original three (especially Fitch) Rating agencies without NRSRO status are ignored by investors and thus have no market

5% 16% 47% 32%

ECONOMIC entry barriers

Economies of scale and product standardization Benefits of experience and special industry expertise Reputation high level of acceptance by issuers and investors High startup costs Monopolistic structure is among the root causes of the problems

S&P

Moodys

Fitch

Other

1) U.S. Securities and Exchange Commission 2) Nationally Recognized Statistical Rating Organization
Sources: 2009 financial reports of The McGraw-Hill Companies, Fimalac Group, Moody's, Roland Berger BLUEPRINT EUROPEAN RATING AGENCY.pptx 7

STRUCTURAL PROBLEMS OF THE RATING INDUSTRY

Monopolistic structure? S&P and Moody's are ultimately controlled by the same investor groups
Oppenheimer & Co, Inc. Majority owned by Mass. Mutual Life Insurance X% Fidelity founder: Johnson family 49% Warren Buffet 4.86% Gates Foundation 8.73%

Oppenheimer Funds Inc.

Northern Trust Corp.

Capital Group Companies

Vanguard Group Inc.

State Street Corp.

T. Rowe Price Associates

Fidelity Investments

Black Rock Inc.

Bank of New York

Massachusetts Financial Services

Davis Selected Advisers

Berkshire Hathaway Inc.

Morgan Stanley Bank

Direct & Indirect shareholding 1.32% 21.98% 3.97% 3.91% 3.98% 8.15% 6.89% 2.25% 0.62% 7.55% 12.13% 3.50%

2.95%

1.75%

16.15%

4.44%

4.41%

3.90%

1.27%

4.59%

1.23%

0.21%

40.91%

Shareholders in both organizations

76.25%

The McGraw-Hill Companies (US)

100%

38.0%

53%
Moody's Corporation (Delaware)

Standard & Poors (New York)

S&P
Shareholders in both organizations Cross shareholdings

Moody's

Sources: Bloomberg data of December 2010, websites of shareholders and CRAs

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Suggested two-pillar solution: European Rating Agency and an independent investor-based revenue platform
European Rating Agency Investor-based revenue platform New platform in cooperation with stock exchanges and independent of the European Rating Agency Open to all licensed independent rating providers Paid for by investors with robust price competition Regulatory adjustments required to avoid the free rider problem

Maximum independence through private nonprofit foundation with a strong academic council Additional competition by breaking up the monopolistic structure Cost efficiency through "Basel II+" operating model Global market entry/ full-service provider Public monitoring via a "super-transparent" rating agency

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THE CASE FOR A EUROPEAN RATING AGENCY BACKUP

Cornerstones of the concept What is new?

TOPIC Institution

WHAT IS NEW?
Nonprofit foundation, public support in the startup phase Independent foundation Maximizing public information Investor based

OBJECTIVE
Allows fast setup and creates credibility in the market Permanent link to political institutions is not desirable in order not to jeopardize the agency's independence Minimize third-party influence, ensure independence Ensure CRA control by all stakeholders through timely disclosure Turn away from the issuer-based revenue model to avoid current conflict of interest Allocate rating costs to investors different models are possible (volume charge, exchange-based fee, etc.)

1. Legal form &

ownership

2. Governance 3. Transparency 4. Revenue model

Operations

5. Organization 6. Processes 7. Services and

products

Basel II a. banks as benchmarks Significantly reduce costs by using an efficient model Maximizing transparency Comprehensive coverage, but with complexity control Ensure CRA control by all stakeholders through timely disclosure Concentrate know-how, ensure competitiveness through efficient operations and limiting costs Don't offer any products whose complexity cannot be modeled Gradually cover products, starting with country and bank ratings, followed by corporate bonds, structured fin., etc. Avoid undifferentiated ratings, prevent untimely downgrades ("cliffhanger downgrades") that could exacerbate a crisis

8. Methodology

State-of-the-art quantitative methods, implementing early warning elements and "through-the-cycle rating"

Source: Roland Berger analysis

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FOUNDATION CONCEPT

Focus on members with the fewest possible conflicts of interest

Strong Possible members of the ERA

Issuers

Potential conflicts of interest

Risk of bloated ratings due to agencies' financial interest in doing more business with issuers Too close to issuer ("inherited conflict") Influence on country ratings and related costs of public debt Too close to government and thus "inherited conflict" regarding country ratings Possible interest in country ratings of member states

Investment banks State/government Regulatory authorities Supranational institution (EU Commission) Credit institutions Stock exchanges Investors

Conflict of interest if issuer is also a borrower Virtually no conflict of interest Conflict only possible under very special conditions Focus for forming the foundation consortium

Conflict of interest: Weak

Source: Roland Berger analysis BLUEPRINT EUROPEAN RATING AGENCY.pptx 11

TRANSPARENCY CONCEPT

Transparency could be greatly improved at existing rating agencies

Low 1 Transparency 10 High

S&P
1. Aggregated only 2. To be determined from other sources 3. Aggregated only 4. Detailed description 1. Against fee-based subscription 4 5 3 8 4

Moody's
1. Detailed chart 2. To be determined from other sources 3. Detailed 4. Rough description 1. Description of markets and industries available, no parameters 1. Current and historical grades with explanations 2. Analysis, creditworthiness reports, comments only on subscription 3. No data 9 5 9 6 7

Fitch
1. 2. 3. 4. Detailed chart Main shareholders Detailed description Chart of the rating process 9 7 9 9 3

Organization 1. Organizational structure 2. Members/owners 3. Legal form 4. Procedures Methodology 1. Models used, criteria for rating factors, parameters Rating results 1. Rating grades 2. Rating reports 3. Minutes of rating committee meetings

1. Brief description of methodology by sector, no examples

1. Current and historical grades 2. Sometimes available for a fee 3. Not available

8 7 1

10 6

1. Current grades, historical 6 data only for a fee 2. Some industry and 5 country research available, issuer data only for a fee 3. No data 1 1. Issuer profile, financial reports for a subscription fee 5

Input data 1. Financial and qualitative data Median

1. Sometimes available for a subscription fee

1. Issuer profile, financial 5 reports for a subscription fee

4.5

6.3

6.0

Source: Roland Berger analysis based on data from the agencies, Bloomberg

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4 METHODOLOGY AND COST EFFICIENCY

Basel II gives us the methods, and banks are the benchmark for cost efficiency
Basel II gives us a technological leap in rating methodology and the option of producing credible, scientifically verifiable rating results in a short time on the basis of publicly available empirical data Cost structure of banks for internal ratings (Basel II models plus credit department analysis) is 10 times less than the cost structures of the agencies Banks are the cost benchmark for the European Rating Agency Costing base for the ERA after saving up risk capital for liability purposes without aiming for profit reduces target price by another 40% (agencies' current return on sales)

Summary: New and credible model is beneficial to capital market players from a cost perspective too

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MARKET COVERAGE

ERA will cover all segments worldwide

Regions North America South America/ Caribbean Europe Middle East Africa Emerging markets

Market segments Corporates Financial institutions Structured finance Sovereign & public finance Subsovereign Infrastructure & project finance Structured finance products Asset-backed securities (ABS), e.g. credit card receivables, car loans, student loans, equipment loans & leases, etc. Structured credit: Collateralized debt obligations (CDO) Collateralized loan obligations (CLO) Commercial mortgage-backed securities (CMBS) Residential mortgage-backed securities (RMBS) Asset-backed commercial paper (ABCP)
Project finance across industries Industrial infrastructure & projects (energy, chemicals, building materials, transportation, telecom services, etc.) Utilities infrastructure & projects (gas, electricity, water, waste disposal, etc.) Social infrastructure (airports, ports, hospitals, etc.)

Source: Roland Berger analysis

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Investor-based revenue model can avoid the free rider problem

All credit transactions outside the banking system above a defined limit must be guided through a central platform. This applies to bonds as well as to OTC credit transactions Issuers are instructed by prospectus regulations to publish all rating-related data according to the given standards in a central platform. The data must be published in due time before placement Each rating agency has the right to equal access. This applies to presentations and Q&A sessions Each rating agency that is (a) licensed and (b) independent is allowed to produce a rating on an unsolicited basis and publish it on the platform Investors are bound by (pan-European) regulations to buy a rating when buying a tranche in the primary market from this selection or be able to carry out a rating themselves. This must receive regulatory approval (Basel II IRB advanced approach ) Investors do not buy the rating information, but compliance, as ratings have already been published Secondary market portfolios do not require ratings to be bought if one was bought for them in the primary market. This will lead to passing back the costs to the issuers via a price adjustment in the primary market through arbitrage, as the price including rating costs is equal to the price of a similar bond on the secondary market Investors act as contracting partners of the rating agency, which enables suitable product liability regulations (via terms & conditions of the rating product)

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How the investor-based revenue platform works

Issuer Prospectus regulations

Bond

Investor Buys Investment regulation

Publishes

Selection of ratings

Data

AA

A+

AA-

Central credit platform

Pays to agencies Rating agencies Rating results

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