Through a glass darkly

aksaroya —  1 May 2013 — Leave a comment

The weaknesses of the credit ratings system are only too clear, but finding a way to address the conflict of interest issues without generating new problems is anything but straightforward, says Ramona Dzinkowski, economist and business journalist

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Since the Dodd-Frank Act of 2010, the US Securities and Exchange Commission (SEC) has had a multitude of objectives aimed at improving investor security in the US. One of the most important is to recommend a better system for rating securities to eliminate the potential conflict of interest between issuers and agencies while also taking measures to possibly eliminate investor reliance on the agencies altogether.

The crux of the matter is the issuer pays model, which is used by the vast majority of credit rating agencies. An agency is paid by an issuer for rating its security and the issuer generally then makes its credit rating publicly available for free. According to many observers, this creates an incentive on the part of the agencies to issue favourable ratings or delay possible downgrades. Ultimately, it’s seen as one of the many related problems underlying the financial crises of 2008.

In its December 2012 report to Congress on assigned credit ratings, the SEC reviewed a series of possible payment options for the agencies, including a model proposed by Congress whereby the SEC acts as middleman between issuer and agency. In other words, securities issuers will no longer be able to select their own rating agencies. The possible outcome of such a system has been the subject of much debate. For some, removing the choice of agency is a simple solution to the conflict of interest problem. However, others see it as a much more complicated issue, an affront to the free enterprise system as we know it, and a possible violation of the First and Fifth Amendments.

Meanwhile, the SEC is a long way down the road of removing requirements and references to rating agencies in its rules in an effort to eliminate the reliance on external agencies. The December 2012 SEC report declares: ‘Reducing reliance on credit ratings could mitigate conflicts of interest to the extent that it causes investors to use factors other than credit ratings to make investment decisions. If credit ratings are no longer used in statutes and regulations to confer benefits or relief, the incentive to obtain credit ratings that meet these requirements should be eliminated.’

For me, taken together, this presents an intellectual dilemma. On the one hand, Congress has taken measures to minimise the reliance on rating agencies by requiring the SEC to remove references to them in its rules; on the other, it proposes to increase their perceived or ‘endorsed’ credibility by having the SEC independently assign agencies to rate new issues. What is the policy direction here?

Also, there’s the lingering question of how these assignments would be made, given the annual SEC review of the agencies. Would the best agency win, all the time, resulting in a preferred agency with better compliance results being assigned a greater number of new issues, on average? Would this ultimately improve agency performance, or boost the market power of one of them in an already monopolistic industry? In addition, how many new SEC personnel would be required to administer the new system with its potential thousands of new complex releases every year?

There are still more questions than answers here. The SEC is currently organising a public roundtable to invite discussion from supporters and critics of the possible alternatives.

This article first appeared in Accounting and Business, International Edition, April 2013

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