The Senate's passage of its version of the financial regulatory reform bill, like its House of Representatives' counterpart (H.R. 4173), presents a mixed bag of reforms for the role of the credit rating agencies in the debt markets of the U.S. Both bills instruct financial regulators to cease relying on ratings in their prudential regulation of banks and other financial institutions. This is all to the good. It is the near-deification of the three large rating agencies, as a consequence of over 70 years of such regulatory reliance on ratings, that greatly magnified the disastrous consequences of their over-optimism with respect to the creditworthiness of subprime residential mortgage based securities.
But both bills also pile on new regulatory requirements on rating agencies, which will surely add to the costs of being a credit rating agency and will discourage entry and thus discourage new ideas, new methodologies, new technologies, and new business models. Because the large incumbents are better able to absorb these costs, an ironic consequence of these requirements is that the three incumbents could well become more important, not less. Do the authors of these provisions realize this?
Finally, the Senate bill contains the "Franken Amendment", which instructs the SEC to create a clearinghouse board to which issuers of RMBS that sought a rating would apply. Though the issuer would continue to pay for the rating, the "shopping around" by the subprime RMBS issuers would be eliminated, since the clearinghouse would select the rater. If this provision survives the reconciliation of the two versions of the bill, it will be crucial for the clearinghouse to maintain high standards of rating quality and to be open to innovation in ways of determining the creditworthiness of bonds.