When regulations lead to improved transparency and greater competition in the market, good things happen. This is exactly what has happened with credit rating agencies (CRAs) over the last decade. The latest Securities and Exchange Commission (SEC) report on CRAs shows significant improvement in compliance, transparency and competition in the industry. This is good news for consumers, investors, and regulators alike. But some in Congress would like the SEC to consider untested and unprecedented reforms, rather than reform that would build upon what’s already working in the industry.
The 2010 Dodd-Frank Act charged the SEC with improving CRA performance by increasing oversight, toughening sanctions and developing the new SEC Office of Credit Ratings.
The report states that CRAs have "appropriately addressed" all of the SEC's previous recommendations. According to Thomas J. Butler, director of the SEC’s Office of Credit Ratings, "...the examination report shows that the SEC’s vigilant oversight is improving compliance at CRAs, while the SEC Annual Report to Congress depicts an industry that is growing more competitive and transparent."
Transparency protects against "ratings shopping," builds competition, and empowers investors. SEC Rule 17g-5 (the anti-ratings shopping rule) became effective in 2009, requiring CRAs to put all information used to determine a rating into a database that is accessible by the entire industry. Now smaller CRAs can use this data to provide unsolicited ratings for securities to show how their analysis might differ from a competitor's. In 2013, Morningstar did just that, accessing the data and providing unsolicited ratings for 13 securities. Morningstar's unsolicited ratings prove 17g-5 can be a powerful tool for reducing "ratings shopping" going forward.
With new entrants and increased unsolicited ratings in recent years, the CRA industry has also become much more competitive. For example, Kroll, a smaller CRA, did not rate mortgage-backed securities (MBS) in 2011, but rated over 40 percent of all rated MBS just two years later. Moreover, according to data from Commercial Mortgage Alert, smaller agencies are gaining an edge in commercial mortgage- backed securities (CMBS), with Kroll rating 50 percent of rated CMBS, while Morningstar and DBRS each rated 18 percent. More competition in the MBS market will make sure markets impose better discipline on CRAs.
With the impact of the SEC’s enhanced oversight now clear and improved industry competition, the regulatory framework for CRAs is having a positive effect. That’s why I find it puzzling that some members of Congress are pressuring the SEC to further increase the government's role in the ratings process. If they get their way, a government-sponsored organization would hand select which CRA gets to rate a given structured finance security.
Such an approach would lead to poor outcomes for two reasons. One, having a government assignment system would reduce the incentive to innovate and provide competing analyses and increase the barrier to entry for smaller agencies. That would undue much of the recent progress made on competition. Two, an assignment system could lead investors to equate selection with government seal of approval, an outcome that runs counter to the Dodd-Frank goal of reducing moral hazard and reliance on ratings.
It’s clear to me the wisest course of action is for the SEC to stay the course, see how the recent reforms continue to work in action, and if necessary build on what is already working. One such improvement that would further deter ratings shopping and improve competition, is to enhance the anti-ratings shopping rule to incentivize more CRAs to produce publicly-available, unsolicited ratings.
To suggest the CRA industry is less compliant, competitive, or transparent ignores the facts and the SEC’s own annual report on the industry. Let's build on the reforms of the last decade by Congress and the SEC, rather than scrap it for an untested and non-competitive system likely to lead to poor outcomes for investors and taxpayers.
Campos, a former SEC commissioner, is currently a senior partner at the national law firm of Locke Lord LLP, whose clients include financial institutions and rating agencies.