Credit rating agencies: The current system and how it can be improved

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Deserved or not, credit rating agencies have power. They can make politicians tremble, as Fitch did on October 15, 2013, when it suggested that the United States could lose its AAA credit rating because of the ongoing government shutdown. Standard & Poor’s had already dropped the U.S. to AA-plus in 2011. These corporate agencies rate everything from rural U.S. counties to global financial behemoths such as JPMorgan Chase, and there are real-world consequences. For example, in November 2013 Fitch downgraded Chicago’s debt, an action that can raise the future costs of borrowing and make it harder for the city to meet its financial obligations.

The role of such ratings is to “provide global investors with an informed analysis of the risk associated with debt securities,” as the Council on Foreign Relations puts it in a useful primer. The major players are Standard & Poor’s, Moody’s and Fitch, known collectively as the Big Three, and together they control more than 95% of the market for creditworthiness ratings. Seven smaller agencies make up the remainder. All such agencies must be certified by the U.S. Securities and Exchange Commission and are known as “nationally recognized statistical rating organizations,” or NRSROs.

The agencies’ immense clout has been accompanied by substantial controversy. Their “issuer pays” financial model has led to charges that, when necessary, agencies adjust criteria to boost their own bottom line. This accusation is central to an ongoing lawsuit on the 2007 failure of Bear Stearns — it cites emails in which Standard & Poor’s personnel admit that high-quality ratings they provided on risky mortgage bonds were a “sham.” Investors lost more than $1 billion when the bonds collapsed, in part sparking the subprime crisis. And in Europe’s ongoing sovereign-debt crisis, the agencies have been accused of increasing market volatility and grading more on economic ideology than facts.

The Credit Rating Agency Reform Act, signed into law in 2006, was intended to increase competition in the credit-rating market by reducing barriers to entry and improving transparency, but the Big Three have maintained their lock on the vast majority of the market. The Dodd-Frank Wall Street Reform and Consumer Protection Act, adopted in 2010, includes provisions for improved oversight of ratings agencies, but many of the specifics remain to be worked out. Concern remains that agencies will outflank new rules, including those intended to reduce their inherent conflicts of interest.

A 2013 study from the Stern School of Business, New York University “Credit Rating Agencies: An Overview” looks at the past and the potential future of credit rating agencies (CRAs). The researcher, Lawrence J. White, summarizes the current state of academic knowledge about the agencies and offers insight into potential regulatory changes.

The study’s findings include:

  • “The SEC had an unfortunate history of being a substantial barrier to entry, with the consequence that only the major three CRAs were present as NRSROs during the crucial early years of the 2000s, when private-label securitization was expanding rapidly.” The current quasi-monopolistic system limits competition between ratings firms and the result can be “higher prices and/or worse-quality performance.”
  • With the current “issuer pays” system, the potential impact of more competition on ratings quality is ambiguous: “If investors are naive (or credulous), or they are mandated by regulation to rely on ratings, or lax prudential regulation motivates them to ‘reach for yields,’ more competition by CRAs will offer more opportunities to shop around for issuers and/or for investors and thus lead to higher (more optimistic) ratings.”
  • Neither an “investor pays” model — often suggested as a solution — nor a completely new financial model can eliminate all flaws of the current system. (A 2012 report by the General Accounting Office assesses seven possible alternatives.)
  • Efforts to increase industry transparency and reduce conflicts of interest constitute a focus on ratings inputs rather than outputs — the ratings themselves and their reliability. This focus is understandable, the author writes, but “competency in creditworthiness assessments may be quite difficult for a regulatory process to measure well…. The focus on inputs is, at best, an indirect method for achieving what is needed if prudential regulation continues to mandate the use of ratings.”
  • The author questions why bonds are treated differently than other financial instruments that do not require ratings, but are instead regulated through a process of examination and supervision. If mandatory reliance on ratings were eliminated, such a process could be introduced for bonds, he argues, and regulation of credit-ratings agencies would become unnecessary.

“There is a deep irony that is embedded in the current trend of CRA regulation,” White concludes. “Although the regulation is an expression of public unhappiness over the roles that the major CRAs have played in the financial crisis and in Europe, a likely consequence of this regulation is that the major CRAs could become even more important in the market for creditworthiness information.” Still, the author finds that there is potential for change: “If more vigorous efforts were made … to pursue the safety-and-soundness goals of prudential regulation without the mandatory use of the CRAs’ ratings — then regulation of the CRAs could also cease.”

Keywords: nationally recognized statistical rating organization (NRSRO), financial regulation, financial crisis, subprime crisis, Dodd-Frank Act.

    Writer: | Last updated: November 13, 2013

    Citation: White, Lawrence J. “Credit Rating Agencies: An Overview,” Annual Review of Financial Economics, 2013, 5:93–122. doi: 10.1146/annurev-financial-110112-120942.

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