Rating agencies pitch the case against regulation
US Senate Banking Committee investigates rating agencies role, while EU consults on the case for regulation
Described as dysfunctional by one critic, and under attack on both sides of the Atlantic, credit rating agencies are battling to ward off any move to impose intrusive regulation on their industry. In Washington, a rather hostile Senate Banking Committee held hearings on February 8 into the structure and operations of the rating agencies. The US Securities and Exchange Commission (SEC) is considering changing its 30-year old system, under which it gives formal recognition to some rating agencies - a system that is widely seen as anti-competitive and giving those recognised rating agencies an unfair advantage.
At the same time, the SEC is under fire for what is deemed, by some critics, to be inadequate oversight of the biggest ratings firms - Moody's Investor Services, Standard and Poor's and Fitch Ratings.
Meanwhile, in Europe, the European Parliament has also recently held hearings into the credit ratings industry, and the Committee of European Securities Regulators (CESR), which advises the EU Commission in Brussels on capital markets legislation, is looking at a spectrum of options that ranges from tough new regulation by a special authority, to codes of conduct and self-regulation. A CESR consultation paper generated more than 30 responses by the February 1 comments deadline, from investors, debt issuers and other participants in the capital markets, as well as the rating agencies.
Fiercest attack
One of the fiercest attacks on the leading credit ratings agencies (CRAs), at the Senate hearings came from Sean Egan, managing director of Egan-Jones Ratings, one of the smaller US ratings agencies, based in Philadelphia, Pennsylvania. The rating industry "is in crisis," he told senators. "At a time when the capital markets have become increasingly reliant on credit ratings, the ratings industry is suffering from a state that is hard to characterise as anything other than dysfunctional," he said.
Egan slammed the monopoly of Moody's and S&P, and drew attention to their inherent conflicts of interest, and the absence of any "downside" for the two dominant rating agencies when they made bad rating calls. Enron, the giant energy trading company was rated investment grade by the leading CRAs until four days before its bankruptcy in 2001, Egan said. The major rating agencies had also failed to warn investors about the serious credit problems at other large companies in recent years, he charged, including telecommunications companies WorldCom, Global Crossing, AT&T Canada, and Italian dairy firm Parmalat.
By contrast, Egan-Jones had given warnings about difficulties at Enron and some of the others that had run into trouble, Egan claimed. And he proposed several remedies, including a gradual end to the system where the big rating agencies were paid by bond issuers; a prohibition on these agencies receiving inside information; and greater recognition of rating firms (such as Egan-Jones) that "have succeeded in providing timely, accurate ratings..."
Key focus of complaint for several witnesses at the Senate Bank Committee hearing was the SEC's system of "nationally recognised statistical rating organisations" (NRSROs), for identifying rating agencies that are deemed to have wide market recognition and credibility. Four rating agencies are currently designated NRSROs - Moody's, S & P, Fitch and Canadian firm Dominion Bond Rating Service. This system, introduced in the mid-1970s, uses NRSRO ratings to provide benchmarks in federal and state legislation, as well as reference points in rules issued by other regulators, and in private financial contracts.
Catch 22
However, the process of NRSRO designation is far from transparent. Critics view it as anti-competitive. There seems to be a "Catch-22" because a firm cannot compete nationally without the NRSRO designation, but it cannot obtain the designation without a national reputation in the first instance, said Senator Richard Shelby, the banking committee's Republican chairman.
Egan proposed that the SEC should withdraw from providing NRSRO designation and "protecting the currently recognised firms from competition" if the commission could not rapidly implement the kind of remedies that he was advocating.
Another witness, Yasuhiro Harada, executive vice-president of Japan's Rating and Investment Information (R&I), described an unsuccessful decade-long attempt to get R&I and its predecessors (it is product of a merger) designated as an NRSRO. The largest Asian rating agency, R&I had sought the designation solely in respect to yen-denominated securities, in which it has a good deal of expertise.
No scrapping of NRSROs
Yet, while most witnesses - whether rating agency chiefs or other market participants - want changes in the NRSRO system, few suggest it should be scrapped altogether. And, there appeared to be little support for more extensive regulation of credit rating agencies.
For example, Micah Green, president of The Bond Market Association, said the criteria adopted by regulators for approving NRSROs "should be flexible enough to allow increased competition between a large number of entities, while ensuring that designated rating agencies have the expertise to produce accurate ratings." He said rating agencies should publish information on the historical accuracy of their rating assessments. But his association did "not believe that regulation of the credit rating process is necessary or desirable, since government regulation would tend to result in less diversity of option and would be less responsive to new product developments."
A clearly defined recognition criteria for NRSRO designation is also wanted by James Kaitz, president of the Association for Financial Professionals, a body representing corporate treasurers and finance officers, many from companies that issue debt securities. This recognition criteria should be based on whether a credit rating agency can consistently produce credible and reliable ratings over the long term, he told the Senate Banking Committee.
The SEC must also improve its on-going oversight of the rating agencies to ensure that they continue to merit NRSRO status, he said. Despite ten years of examining the role and regulation of credit rating agencies, the SEC has not taken any meaningful action to address the concerns of issuers and investors, according to Kaitz. These concerns included the reliability of credit ratings, conflicts of interest and abusive practices in the rating process.
Not only has the SEC bestowed a significant competitive advantage, it has failed to exercise any meaningful oversight of the recognised agencies, Kaitz told Senators. He called on the Senate Banking Committee to hold the SEC accountable and said it should demand that the commission took immediate action. What was needed was a "reasonable regulatory framework that minimises barriers to entry."
Among CRA bosses, only Moody's President, Raymond McDaniel, explicitly said he would not oppose the scrapping of the NRSRO system if it was seen to limit competition.
Fitch chief executive Stephen Joynt said the SEC should "formalise the process by which it recognises rating organisations." He suggested that the application process, specific recognition criteria and timeframes for action on all applications should be specified in appropriate regulations. Public comments should be solicited on applications and an appropriate appeal process should be put in place.
Echoing the calls for greater transparency in the NRSRO process and the need for more competition, S & P president Kathleen Corbet expressed great concern about the adverse consequences of any intrusive supervision of CRAs that might emerge. She said such supervision could compromise the independence of rating agencies, reduce diversity and innovation in credit analysis, create the impression that rating opinions have governmental approval, and encourage issuers to provide less information.
Strongly defending the historical accuracy of their credit ratings, the leading rating agencies all insist that they are happy to be judged by the marketplace. Market discipline is preferable to regulation, they argue.
Receptive SEC ear
The almost universal calls for a more open NRSRO process looks likely to be given a receptive ear by the SEC. In an interview with Global Risk Regulator in January, Roel Campos, an SEC commissioner, said: "my goal is to make the NRSRO process more open and transparent, allowing agencies with specialities to get the designation." Whether this would go far enough to satisfy the Senate Banking Committee - which is planning more hearings on the matter - remains an open question.
Meanwhile, on the other side of the Atlantic, there is also strong opposition among capital markets participants to intrusive regulation of CRAs. Responses to the CESR consultation paper mostly support self-regulation and the adoption by the rating agencies of the code published in December by the International Organisation of Securities Commissions (IOSCO), the Madrid-based umbrella body for than 100 securities regulators around the world.
This Code of Conduct Fundamentals for Credit Rating Agencies, covers all the controversial areas of rating agency operations - the quality and integrity of the rating process, the avoidance of conflicts of interest and CRA responsibilities to the investing public and issuers. It requires CRAs to comply with the code or explain why they can't.
Self-regulation, based on compliance with the IOSCO code would provide the "correct framework for CRAs," says the Brussels-based European Banking Federation, in a typical response to the CESR consultation paper. But "the CRAs should not under any circumstances become regulated bodies," says the federation's secretary general, Guido Ravoet, in his comment letter.
Not a scientific process
"Putting a regulatory framework in place for rating agencies would lend a legitimacy and credibility to ratings that, in our view, would be both inappropriate and dangerous. Credit rating is not a scientific process," he said.
There is, however, one further complicating factor in any ultimate decision over the degree of future CRA regulation. The new Basel accord regulating bank capital, and the Capital Requirements Directive that transposes the accord into EU law, both stipulate some form of recognition process for rating agencies. This is because, where banks rely on external credit ratings to calculate their credit exposure and capital levels, they may only use the ratings of "recognised" agencies. Consequently, there will have to be some "recognition" mechanism for what are known in the new Basel accord and the directive as External Credit Assessment Institutions (ECAIs), which includes institutions such as export credit agencies, as well as rating agencies.
Compliance with the IOSCO code should be the basis for "recognition" as an ECAI for the purposes of the new bank capital rules, argues the European Banking Federation in its comment letter. It would be "nonsensical" to have separate registrations for compliance with the IOSCO code and "recognition" as an ECAI, says the federation.
Taking a similar line, the British Bankers Association throws its weight behind option 6, in the CESR consultation paper. The six options spelt out in the paper range from the most onerous regulatory regime (option 1), involving registration with a central European authority - which would effectively license the rating agency and police compliance with the authority's rules - to doing nothing at the moment (option 6), and simply monitoring the results of self regulation under the IOSCO code. This latter option would also involve a recognition process for the purposes of the Basel accord and the Capital Requirements Directive.
Other options (options 2-5) involve various combinations of regulation and registration, with greater and lesser degrees of oversight and onerousness.
The Bond Market Association, in its comment letter to CESR describes option 6 as the "only viable option." The "enforcement of the IOSCO code by the market offers the strongest, most cost-efficient and most immediate answer to current regulatory concerns, the association says.
Allowed to bed in
The European Association of Corporate Treasurers, and both the British and French associations of corporate treasurers, say in comment letters that the IOSCO code should be allowed to bed in for a couple of years before consideration is given to any further regulation proposals.
And, in a joint comment letter, five associations representing investment bankers, securities dealers and primary market participants, similarly conclude that: "self regulation by CRAs, based on adherence to the IOSCO Code wherever practical, validated by external audit and supported by pressure from users of ratings, is the best way to enhance standards and promote competition." The EU should refrain from extending official recognition requirements beyond what is necessary under the Capital Requirements Directive, the five associations say.
Moody's, S & P, and Fitch all vehemently reject, in their comment letters, any form of intrusive regulation. Moody's wants CESR to recommend a "wait and see" approach. CESR and the EU Commission should observe the implementation of IOSCO code, and the adherence of the ratings agency industry to it. Later, the EU Commission can make an informed assessment of whether the need exists for additional regulation. Backing option 6, Moody's describes options 1-5 in the consultation paper as "redundant."
S & P says no case has been made to justify new legislative or regulatory initiatives in the CRA arena. There is no evidence of a fundamental market failure of a kind that would justify the intrusive regulatory options considered in the CESR consultation paper, it says.
Harm investor protection
Most particularly, S & P is opposed to any regulation that attempts to influence, directly or indirectly, the methodologies or processes used by rating agencies to arrive at their rating opinions. Any form of registration or regulation that sought to influence particular rating opinions or dissuade credit rating agencies from particular rating actions could damage, rather than enhance investor protection and the integrity and stability of the financial system, S & P said.
Fitch, in its comment letter, argues that the "introduction of a regulatory regime of any type will, by definition, increase barriers to entry," and restrict competition. The lighter touch approach is, therefore, the most appropriate. Backing option 6 in the consultation paper, Fitch notes that this option has received overwhelming support - from issuers, investors and ratings advisers - at CESR's recent public hearing in Paris.
Having robustly made the case against intrusive regulation, the rating agencies must now wait until CESR makes public its advice on the matter. This technical advice is due to be submitted to the European Commission by April 1. The Commission is required, in turn, to submit to the European Parliament by July 31, "its assessment of the need for appropriate legislative proposals to deal with" the issue of the CRAs.
