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By Lawrence J. White
In January 2003, in response to the requirements of the Sarbanes-Oxley Act of 2002, the SEC released its “Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets.” Unfortunately, the report was an excuse for more delay in addressing the problem. Instead, the SEC should be pursuing solutions that would tear down these regulatory barriers.
Some Background
Credit-rating firms have been around since before the Civil War. In the late 19th century, R.G. Dun & Co. employed a network of correspondents who reported on the creditworthiness of companies and individual merchants throughout the United States. John Moody published the first public bond ratings, for railroad bonds, in 1909. Poor’s Publishing Co. followed in 1919; the Standard Statistics Co. began issuing ratings in 1922. The two merged to form Standard & Poor’s in 1941, and McGraw-Hill absorbed S&P in 1966. The Fitch Publishing Co. began its ratings in 1924. The business blossomed, and government regulation of the financial industry, from the 1930s onward, provided an extra push. As the capital markets developed over the course of the 20th century, the bond-rating firms came to occupy an important place in the investment world. Today, bond-rating firms like Standard & Poor’s and Moody’s primarily provide judgments about the credit quality of debt instruments like bonds, issued by companies and by governments. The information that the bond raters provide can be seen as part of the process by which lenders (bond buyers) try to gather information so as to pierce the “fog” of asymmetric information and determine to whom to lend (whose bonds to buy) and on what terms. The ratings can also be seen as part of the efforts by borrowers (bond issuers) to “tell their story” as to why they are worthy recipients of lent funds.
An Exclusive Category The SEC’s regulation of the bond rating industry began in 1975 with perfectly good intentions. As bank and insurance regulators earlier had done for their regulated institutions, the SEC wanted to use corporate bond ratings to set minimum capital requirements for broker-dealers. But the SEC realized – apparently, for the first time among regulators – that specifying the use of ratings also required specifying whose ratings could be used. After all, what would prevent a bogus rating company from awarding (for a suitable fee) “AAA” ratings to any corporation’s bonds? And in that instance, could the broker-dealers then use those “ratings” for regulatory purposes? Consequently, the SEC duly created a new regulatory category – “nationally recognized statistical rating organization” (NRSRO) – and immediately “grandfathered” the three major incumbent bond raters – Moody’s, Standard & Poor’s, and Fitch – into the category. For these firms, rating debt instruments has been a profitable business. Any company or institution that wants its debt held by regulated financial institutions needs to get a rating from one or more of the accredited agencies. What’s more, the three large firms have largely had the rating market to themselves. Why does the NRSRO designation matter? Almost all regulated financial institutions – banks, insurance companies, pension funds, etc. – must heed the NRSROs’ ratings in deciding which bonds they can hold in their portfolios. For example, banks cannot hold bonds that are below “investment grade.” Accordingly, any would-be bond rater that initially lacks the NRSRO designation would have great difficulties in getting the time and attention of bond issuers. The start-up entity’s rating would carry no weight in the portfolio decisions of banks and other regulated financial institutions. The NRSRO designation thus erects high barricades to entry into bond rating, providing a sinecure for the incumbents and putting a damper on the introduction of fresh ideas, methodologies, and technologies that entrants might otherwise bring.
Captive Audience In essence, the SEC has given the incumbents a captive audience: the entire U.S. bond market. In turn, the weight of U.S. capital markets on the global financial scene extends the influence of these few raters far beyond our borders. Further, the Basel Committee on Banking Supervision, under the auspices of the Bank for International Settlements and representing banking regulators around the world, has proposed expanding the regulatory influence of ratings to other countries. One of the Committee’s three proposed methods of determining banks’ minimum capital requirements would use the banks’ borrowers’ bond ratings (when available). There is an irony here: Public-sector financial regulators have long been using private-sector information (the ratings) to supplement their safety-and-soundness judgments. Regulatory critics have recently urged regulators generally to incorporate private-sector information into their judgments. Yet it is one thing to use impersonal market information (from, say, the Treasury bill market); it is quite another to require the use of private-sector rating information. The latter effort cannot avoid the “whose ratings” problem – and the potential abuses that can follow. This innovation question raises a larger issue: How could one tell if the incumbent bond rating firms currently meet a market test? With regulatory requirements that the incumbents’ ratings must be heeded, the capital markets have no choice but to heed them. The capital markets have no way of knowing or discovering whether there are better, more efficient and effective ways in which the capital markets might assess the creditworthiness of bond issuers – or whether there are better, more efficient organizations that could conduct those assessments. The efficiency of those markets themselves is potentially affected.
The Path to Reform Clearly, the public policy goal should be to improve competition and to increase the potential for innovation in the ratings business. How can we get there from here? There are two sensible routes. By far the best is for the SEC, and other financial regulators, to cease delegating their safety judgments to a handful of protected bond raters. In essence, the regulators should make the same safety-and-soundness judgments about bonds that they currently make about loans and other financial assets.
The SEC could then withdraw the NRSRO designation. The financial markets would then be free to make their own decisions as to which rating companies – incumbents or entrants – offered the best judgments about the relative safety of a company’s bonds. Or they could decide that rating companies might no longer be needed in the 21st century, given the information revolution of the past few decades. Also, if rating firms are still valued, the markets could make new judgments as to what business model is most appropriate. Should the raters earn their revenues from fees charged to the rated companies, as is currently the case for the four incumbents? Or should they charge investors, as was true prior to the 1970s and as a few small non-NRSRO raters still do? If the removal of the NRSRO designation is too radical, there’s Plan B: The SEC must cease barricading entry and must permit qualified firms to attain the NRSRO designation. This means that the SEC must assess an entrant’s track record of bond failure predictions. The agency must also assess incumbents’ performances – which it has never done. However, the SEC’s tentative criteria for assessing a NRSRO, which the Commission proposed in 1997 but never finalized, should be scrapped. Those criteria focused on measuring inputs to the rating process rather than on a firm’s rating performance (i.e., a bond rater’s track record of accuracy with respect to bond defaults). Measuring inputs could be fatal to a rating firm that might employ innovative methodologies and that might not use traditional inputs. Those 1997 criteria also would create a “Catch 22”: To receive the NRSRO designation, a rating organization would have to be “recognized as an issuer of credible and reliable ratings by the predominant users of ratings in the United States.” Of course, if an organization is not already an NRSRO, recognition as a credible rater by the “predominant users of ratings” would be extremely difficult (if not impossible). Instead, sensible criteria should focus on the accuracy, efficacy, and competency of rating firms – incumbents, as well as prospective entrants – with respect to bond defaults. Of course, if such assessments are beyond the SEC’s capabilities, there’s always Plan A: Cease the safety delegations to the bond raters, and eliminate the NRSRO category. The possible paths are clear. The time for action is now. Instead of studying the issue further, the SEC should start tearing down the regulatory barriers that protect incumbent credit-rating agencies at the expense of potential competitors – and at the expense of investors. Lawrence J. White is Arthur E. Imperatore Professor of Economics at NYU Stern. |
he U.S. Securities and Exchange Commission (SEC)
currently has its hands full dealing with the corporate governance
mess. But as it grapples
with the fallout from Enron, WorldCom, and Global Crossing, the agency
faces another problem that may well have as much importance for the
efficient operation of the United States’ financial markets:
the bond-rating industry’s obscure but nearly impervious regulatory
barriers to entry.
n the 17 years between 1975 and 1992, the SEC
bestowed the NRSRO designation on only four new entrants. However,
by the end of 2000, mergers among
them and with Fitch had reduced the field to just the original three.
Between 1992 and February 2003, the SEC did not designate a single
new NRSRO, even though several firms applied for such status. After
a protracted process, and a month after the SEC’s January 2003
report that promised more study of the state of competition in the
ratings business, the SEC admitted a new member to the rating agency
club. It extended the NRSRO designation to Dominion Bond Rating Service,
a Canadian firm. As of today, then, there are only four NRSROs.