Learn about the regulation of credit rating agencies (CRAs) with CFA Institute. Credit rating regulations are necessary to encourage high-quality ratings.
Effective regulation of CRAs is necessary to encourage high-quality credit ratings and increased accountability for CRAs. A CRA is a company that assigns credit ratings, which rate a debtor's ability to pay back debt by making timely interest payments and the likelihood of default. The “big three” CRAs are Standard & Poor’s, Moody’s Investors Service, and Fitch Group.
Before the passage of Dodd-Frank, securities regulations required funds to maintain certain ratings supplied by nationally recognized statistical rating organizations, which is the formal designation regulators have given CRAs. Many believed this led to a “captive market” in which the issuer-pay business model of traditional CRAs created potential conflicts of interest. Many critics believe these conflicts led to credit ratings that were intended to please issuers—in return for higher revenues—rather than an accurate assessment of credit and default risk.
Regulation
In the United States, Dodd-Frank took a number of steps to address these concerns:
- Made CRAs liable for faulty ratings
- Removed statutes and regulations requiring use of credit ratings
- Created Office of Credit Ratings within the SEC
- Increased oversight of internal controls
- Increased transparency about ratings methodologies and performance
In Europe, the focus has been on many of the same issues as in the United States.
CFA Institute Viewpoint
CFA Institute supports the elimination of requirements in statutes and regulations to use credit ratings, which gave CRAs a captive market and insulated them from the consequences of poor ratings. Credit ratings can be useful benchmarks, but we do not believe it is prudent to require investors, institutions, and regulators to rely on the ratings of these agencies given the poor quality of their past work. We therefore support the Dodd-Frank provision to subject CRAs to liability for conflicted ratings as a means of holding these firms accountable for such ratings.
We do not believe that public bodies could provide a better alternative to private credit ratings, as no evidence suggests that public ratings would be subject to even greater conflicts of interest than private ratings. Rather, authorities should lower the barriers to entry to the credit ratings industry and provide a level playing field to enable meaningful private competition.
Firms using an investor-pays business model are limited in the scope of their coverage. This would make important macro information about debt markets unavailable to investors.
We support increased transparency about conflicts, ratings performance, and methodologies to help investors compare and contrast the accuracy and approaches of competing CRAs.
Provide a Reasonable Bases for Ratings
CRAs should refrain from rating new structured products until the statistical data are sufficiently robust to produce a defensible rating. Credit rating analysts should have a reasonable and adequate basis, supported by appropriate research and investigation, for any ratings they issue. New structured products rarely have sufficient performance data to enable rating agencies to have an adequate basis for a rating. Only after sufficient data are available to help the analyst recognize how these instruments will function in different circumstances should a rating be given.
Prevent Ratings Confusion
Policymakers and regulators should refine or otherwise eliminate the concept of “investment grade” wherever possible to reduce the incidence of misconception about the purpose of the CRAs’ ratings. The statutory and regulatory references to credit ratings have had a number of negative effects on the markets. First, they have given the rating agencies a captive market independent of the quality of their analyses and ratings. Regulatory and statutory requirements for institutional investors to rely on these ratings also has reduced the need for investors to conduct their own due diligence on securities and rating agencies. Second, the term “investment grade” has given many investors a false sense of security about the purpose of the rating and the quality of the rated instrument. To prevent these misperceptions, we believe the term “investment grade” and the related reliance on credit ratings should be removed.
Provide Notification of Pending Debt Rating Action
Companies should have to immediately disclose to the market when they are notified by a rating agency of any initiation, withdrawal, or change in credit rating, including guaranteed or contingent obligations.
A credit downgrade can affect not only the price of a company’s debt securities, but also the value of its equity securities.
Use Rating Terms
Rating agencies should use rating nomenclature or categorization that distinguishes structured products from corporate and commercial paper ratings to help investors recognize the differences. Some rating agencies use alternative nomenclature to distinguish between different asset classes, such as traditional debt and commercial paper. Because of the different payment mechanisms and issue structures, these instruments need a different nomenclature to help less-sophisticated investors recognize that these are different from traditional sovereign securities.
Prohibit Notching
CRAs should develop global best practices on prohibiting the practice of “notching.” Notching occurs when a CRA unilaterally issues a rating on an entity or structure to punish an issuer who has chosen a different rating agency.
Notching has the potential to give the market conflicted signals. To prevent confusion, CRAs should not issue an unsolicited rating to punish a company that has declined to hire the agency. This, however, would not prevent small ratings firms from issuing ratings on specific companies or securities for the benefit of their clients but without issuer approval.