Credit Rating Reform, Part I: The State of Credit Rating Reform

Since the Dodd-Frank Wall Street reform bill became law in 2010, government efforts to cure what ails the credit rating industry have completely stalled in some areas, while inching ahead in others. In recent months, the Department of Justice initiated a lawsuit against Standard & Poor’s, accusing it of inflating its ratings and misleading investors, and the SEC convened a roundtable to contemplate the industry’s future. Yet aside from these events, the silence of the last three years has been deafening.

The core issue remains conflicts of interest.  This refers to the incentives generated by the industry’s pay structure, in which issuers compensate the agencies to rate their securities. Multiple agencies may submit ratings, but in the end, issuers select – and pay -- only one firm to grade their deals. Consequently, agencies have a huge incentive to relax their standards and submit favorable ratings to gain business, especially during a fight for market share. During the boom years leading up the 2008 financial crisis, issuers would frequently pressure the rating firms to influence outcomes.

“It would be like a figure skater bribing the judges, and they’re all giving 10s,” said Sen. Al Franken, Democrat of Minnesota.

Franken’s clearinghouse model, which is the main alternative to this way of doing business, involves creating an independent supervisory board to randomly assign and rotate work among agencies. Over time, however, performance and accuracy would determine which agencies received more work in the future.  That idea got a very cool reception at the roundtable, where some participants, including regulators and financial executives, were reticent to overhaul the system and failed to reach consensus on the pay structure question. Critics argued that a clearinghouse would run counter to the government’s objective of reducing investors’ reliance on credit ratings, and that random assignments would overlook the contours of each deal as well as each firm’s area of expertise. The view that it would infringe on the agencies’ First Amendment rights was also aired.

The lone area of regulatory progress seems to be the SEC’s effort to dismantle institutional reliance on rating agencies such as S&P, Moody’s, and Fitch (e.g. formally known as nationally recognized statistical rating organizations, or NRSROs). In the 1930s, and again in the 1970s, regulators shaped the industry’s landscape for decades to come by mandating that institutional investors must rely on the NRSROs’ ratings. Now, removing references to credit ratings from the regulatory infrastructure is intended to weaken that linkage and encourage investors to conduct additional, independent due diligence and credit analysis.

Although Franken’s proposal has become mired in a web of indecision, efforts in this area continue to plod ahead. And the SEC has not been alone in its undertaking: The Federal Reserve, the Treasury Department, and the Federal Housing Finance Agency have all proposed and adopted rules to remove references to NRSROs. This takes rulings on the industry full circle – regulators are now trying to transform what they created long ago.

One factor limiting the SEC’s ability to implement Dodd-Frank, a complex and comprehensive law, has been its chronic understaffing at all levels. Reformers also doubt the ability of recently appointed SEC Chairwoman Mary Jo White, a former Wall Street defender, to lead the process forward. The SEC “embraced the classic D.C. strategy of kicking the can down the road,” law professor Jeffrey Manns of George Washington University said about the slow progress. “The concern would be that the longer the SEC takes, the less political will there would be to see this through. The sense of urgency is not as pronounced as it has been.”

Although the SEC sometimes uses this tactic to delay rules that it considers poorly designed, the clearinghouse model deserves timely consideration. The conflict of interest issue, which Franken’s plan is designed to address, is fundamental, inescapable, and relatively self-evident compared to other problems in the financial industry, so working around its edges is a strategy that falls short. Other ideas, such as improving NRSRO governance, paring back reliance on ratings, increasing disclosure, and lowering the industry’s barriers to entry, are relevant but secondary. The longer regulators chase those half-measures, the more they risk missing the issue that truly matters.

As Sheila Bair, the former FDIC chairman, remarked during the Dodd-Frank approval process: "This stuff doesn't get any better with time.  The longer you wait to finalize the rules, the more they get watered down, the more exceptions that get built in, people's memories about the crisis start to fade, and the pressure isn't there."