Credit Rating Agencies

Industry Inefficiencies and New Regulation

Daniel Elbaz New York University: Honors Seminar May 2011

Abstract Credit ratings of fixed income securities are used by a wide range of market participants. Accurate ratings of these instruments help in reducing information asymmetry and supply an independent measure of credit risk to investors. In recent years, there has been much concern over the deterioration of ratings performance attesting to an increase in volatility of ratings and a higher severity of downgrades especially for ratings of more complex structured finance products. Regulators have linked this deterioration of rating quality to various inefficiencies in the credit rating industry. The paper examines flaws in the current credit rating system including conflicts of interest, oligopolistic behavior, faults in the rating models for structured finance products (SFP) and the lack of accountability for poor ratings performance. The paper then discusses some new regulation imposed by U.S. regulators on CRAs and the effectiveness and limitations of these policies. Finally some regulatory policies are proposed that have not been formally covered by regulators but could help fill in the gaps by directly addressing several of the discussed flaws.

Table of Contents

INTRODUCTION...................................................................................................................................... 4 FLAWSINTHECREDITRATINGINDUSTRY .................................................................................. 5 COMPETITION ............................................................................................................................................................5 RegulatoryBarrierstoEntry...........................................................................................................................8 NaturalBarrierstoEntry .............................................................................................................................. 11 TwoRatingNorm.............................................................................................................................................. 13 CanTooMuchCompetitionbeDangerous? ........................................................................................... 14 CONFLICTSOFINTEREST ...................................................................................................................................... 14 IssuerPayModel................................................................................................................................................ 14 ConflictsofInterestsandStructuredFinanceProducts ................................................................... 15 RATINGSOFSTRUCTUREDFINANCEPRODUCTS .............................................................................................. 16 RatingsforTraditionalDebtvs.StructuredFinanceProducts ..................................................... 17 Unrealistic/FaultyAssumptions:ModelRisk......................................................................................... 19 LackofTransparency ...................................................................................................................................... 20 OriginatorRiskFactor .................................................................................................................................... 20 DifferencesinPerformancebetweenStructuredFinanceClasses ............................................... 21 ACCOUNTABILITY ................................................................................................................................................... 23 LegalAccountability......................................................................................................................................... 23 AccountabilityThroughReputationMechanism................................................................................. 23 NEWREGULATION ..............................................................................................................................24 THECREDITRATINGAGENCYREFORMACTOF2006 ................................................................................... 25 SECREGULATIONPROPOSALS ............................................................................................................................ 25 DODDFRANKACT ................................................................................................................................................. 26 LIMITATIONSOFEXISTINGREGULATION........................................................................................................... 26 REGULATORYPROPOSALS ...............................................................................................................27 INCREASECOMPETITION....................................................................................................................................... 27 RATINGSFORSTRUCTUREDFINANCE ................................................................................................................ 28 CONFLICTSOFINTEREST ...................................................................................................................................... 28 CONCLUSION .........................................................................................................................................29 REFERENCES..........................................................................................................................................30

Introduction
The SEC has been put under increasing pressure to heighten regulatory standards

on the CRA industry. Despite CRAs incontestable influence in the financial markets they are one of the least regulated industries in the financial world (Hassan and Kalhoefer, 2011). Before the Credit Rating Agency Reform Act of 2006 there has been very little regulation imposed on the industry as it was generally claimed that selfregulation was sufficient and the role of reputation would properly incentivize efficient behavior. Several notable events in the markets have signaled to many observers the need for increased regulation on the rating industry and the potentially devastating impact of an unregulated system. The first of these events is the East Asian financial crisis of 1997 in which the major CRAs failed to predict the emergence of the crisis. As a response to the increasing fear of sovereign default by these countries the CRAs became extremely conservative in their ratings leading to excessive downgrades of debt that were possibly unjustifiable. Several observers argued that this helped aggravate the situation by inflating borrowing costs for these countries (Ferri, Liu and Stiglitz, 1999). The Enron Scandal in 2001 also was a signal to many of the limits for these ratings. It was only four days before Enron declared bankruptcy that its debt was finally downgraded from investment grade. This could make what are essentially junk bonds appear to be investment grade, suitable for a conservative investor. After the recent subprime crisis CRAs were again put in the spotlight by regulators after a series of severe downgrades on many investment grade structured finance products. A broad range of mortgage backed securities (MBS) and collateralized

debt obligations (CDO) that held MBSs were greatly affected by the unexpected decline of the housing market. These structured finance products were found on the balance sheets of a large range of market participants who were all affected by substantial writedowns. Rating agencies have been severely criticized by regulators for their role in facilitating the rapid expansion of the structured finance market, and the origination of an enormous amount of low quality loans that were then packaged and given misleadingly high ratings. There was much speculation into the factors leading up to the huge failure of the ratings as regulators in both the U.S. and Europe targeted several inefficiencies within the industry to set out to solve them. Because there still remains a need for a standard, simple measure of credit risk it is likely that CRAs will continue to play a significant role in the financial world. Therefore, a detailed understanding of the industry and problematic issues is key in developing proper regulation that insures financial stability in the markets.

FlawsintheCreditRatingIndustry

Competition A main aspect of the credit rating industry that regulators seem to be paying closest attention to is the industrys abnormally high market concentration. The big three players in the ratings market, Standard and Poors, Moodys Investor Service and Fitch Group dominate the market with a three-firm concentration ratio (CR3) equal to about 97% of all outstanding ratings across all asset categories (Wolters Kluwer , 2011). Regulators and market participants have linked this high level of market concentration to

anti-competitive behavior among the agencies, which could ultimately lead to poor rating quality. One indicator used in industrial economics to determine if a firm is exercising significant market power is to analyze profitability. Unusually high profits could signal a firms ability to exercise monopoly power. Table 1 displays the net profit margin of Moodys Corporation from 2008 to 2010 derived by dividing total revenue by net income after taxes. (Moodys was used as an example as Standard and Poors is owned by The McGraw Hill Companies and Fitch Ratings is privately held).

Year Revenue Net Income Net Profit Margin

2008 1,755,400 457,600 26.1%

2009 1,797,200 402,000 22.4%

2010 2,032,000 507,800 25.0%

Table 1: Profitability, Moodys Corporation, USD in thousands Source: Morningstar, Authors Calculations

Moodys profit margins were higher than the margins of any other company in the S&P 500 for five consecutive years during the early 2000s (Thakker, 2008). Net profit margins of 22% - 26% seem above the norm especially when compared to other firms in the financial services industry. Table 2 compares Moodys margins to the margins of other firms in the industry.

Ticker Morgan Stanley Goldman Sachs JP Morgan Dun & Bradstreet MS GS JPM DNB

Revenue 31,622,000 39,161,000 102,694,000 1,676,600

Net Income 4,703,000 8,354,000 17,370,000 252,100

Net Margins 14.9% 21.3% 16.9% 15.0%

Comparison of profitability, USD in thousands Source: Morningstar, Authors calculations

Although these other major financial services institutions (Morgan Stanley, Goldman Sachs and JP Morgan) are very different in nature, comparing profit margins serves in putting Moodys high profitability in perspective. It is clear that Moodys margins are extremely high compared to its industry. It would be beneficial in our understanding of the industry if the analysis could extend to compare the profitability of larger CRAs with smaller ones, seeing if larger firms have an advantage. However, this would be rather difficult since not many of these ratings firms are publicly held. However a close competitor to the big three rating agencies is the credit research and credit rating firm Dun & Bradstreet (DNB). DNBs net profit margins, shown in Table 2, are significantly lower than that of Moodys, signaling that Moodys does indeed have a competitive advantage. This can be explained by two reasons. Firstly, Moodys unlike DNB, retains the NRSRO designation (Nationally Recognized Statistical Rating Organization) by the SEC meaning that their ratings can be used for regulatory purposes. Secondly, economies of scope may have a significant impact as well. While DNB exclusively issues ratings and credit research on

corporations, Moodys and the other big CRAs cover the corporate debt market as well as sovereign debt and the structured finance market. Regulators have attributed the particularly high market concentration that exists in the industry to several factors. Both regulatory and natural barriers to entry have effectively limited new entrants into the market. In addition, although smaller CRAs do exist in the industry they make up a minute percentage of the market and have historically been unable to compete with the big three and gain significant market share.

Regulatory Barriers to Entry

NRSRO Designation and High Regulatory Reliance on Ratings: In 1975 the SEC created the NRSRO (Nationally Recognized Statistical Rating Organization) designation among credit rating agencies. This designation was created to differentiate which rating agencies ratings could be used in determining capital requirements. Today much SEC regulation refers to the use of credit ratings by NRSROs. In addition, very few agencies have been given this NRSRO status. Up until recently there have only been three agencies (the big three) with NRSRO designation however as of April 2011, ten CRAs hold the label (SEC, 2011). There is a large amount of regulation that limits many financial institutions, including money market and mutual funds and insurance companies, from only holding investment-grade, high quality assets. This regulation calls for NRSROs ratings to be used in assessing the riskiness of such assets. In addition there is still a growing need for regulators to determine the credit quality of banks assets through standard measures. For

example the Basel II banking laws and recommendations issued by the Basel Committee on Banking Supervision, encourages the use of recognized rating agencies in determining a banks net capital requirements. Requiring the use of only designated CRAs gives these firms a large advantage over other non-NRSRO agencies by increasing the demand of their ratings by a large range of market players.

NRSRO Requirements Initially the SEC did not publish specific standards in determining whether a rating agency can be designated as a NRSRO, instead it was done on a case by case basis. The SEC later published a list of criteria that a credit rating agency must have in order to be considered an NRSRO. These requirements were meant to standardize the application process of becoming NRSRO certified however it brought about several new issues. The following are the basis for NRSRO recognition:

1. Whether the rating agency is nationally recognized in the United States as an issuer of credible and reliable ratings by the predominant users of securities ratings

2. Whether the organizational structure of the credit rating firm allows for credible ratings

3. The sufficiency of the rating organizations financial resources (to determine whether it is able to operate independently of economic pressures or control from the companies it rates)

4. The size and quality of the rating organizations staff

5. The rating organizations independence from the companies it rates

6. The agencys rating procedures (to determine whether it has systematic procedures designed to produce credible and accurate rating)

7. Whether the rating organization has internal procedures to prevent the misuse of nonpublic information and whether those procedures are followed

(SEC, 2003)

Although the criteria are designed to formalize a way of determining qualified agencies, it noticeably favors larger, more established firms and creates a barrier for smaller firms to enter the market. Smaller firms are unlikely to be nationally recognized or have a workforce size comparable to an established CRA. This creates a catch-22 situation in that smaller entrants can not become widely recognized without NRSRO designation although it is impossible for them to gain the status without being first widely recognized. In addition to smaller firms, it creates another disadvantage to foreign firms by requiring recognition in the United States although foreign CRAs may be equally or more qualified than U.S. rating firms.

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Natural Barriers to Entry Network Externalities The existence of network externalities in the industry is a critical factor limiting the entry of new firms and keeping a controlling market share for the big agencies. The ratings of S&P, Moodys and to some extent Fitch are widely accepted amongst market participants and are the standard, go to agencies. Issuers may be hesitant to use ratings from lesser known CRAs (even with an NRSRO designation) as investors demand a standard, well known rating system that allows them to easily compare similar securities. Therefore, some market participants dont see a need for additional rating agencies as it could complicate such comparisons.

First Mover Advantage The big rating agencies have enjoyed the benefits of being some of the first firms in the credit rating industry as they experienced a rather substantial first mover advantage. The advantage comes from the compensation an issuer must receive in order to take the risk of switching to a new CRA with unknown ratings quality. This compensation is generally in the form of price discounts. Although first entrants also had to provide this discount to compensate their customers, later entrants must provide even more of a discount. If an issuer is already comfortable using the ratings of a particular CRA it needs sufficient incentive to switch raters otherwise it is likely to remain with the current agency.

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Economies of Scale There is some debate on whether or not there exists substantial scale economies in the production of credit ratings. Rating production can be defined as human capital intensive and therefore contain no significant lumpy inputs that generally bring about large economies of scale (Thakker, 2008). However there are major economies of scale in the production and maintenance of reputation. Reputational capital is an important asset that established CRAs retain. Generally speaking, to initially gain reputation a new ratings firm must suffer an initial loss of investment upon entering the market (by offering discounts when they have little or no reputation as incentive for issuers to switch agencies) only to be rewarded later when this reputational capital is built up. In addition the cost of maintaining this reputation can be very costly. Assuming low quality ratings would damage reputational capital, there must be a high level of effort exerted, which is associated with higher costs.

Economies of Scope and Diversification Risk In the credit rating industry there seems to exist scope economies that would make larger firms, offering a variety of ratings for different asset classes, more profitable. This phenomenon may be attributed to the fact that the production of ratings, for any type of fixed income security (i.e. sovereign debt, corporate debt or securitized products), have similar inputs. These shared inputs generally include access to databases, subscriptions and highly educated and trained analysts (human capital), which are all necessary in the ratings process for any security.

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In addition to economies of scope, CRAs who produce ratings for a broader range of security types benefit in their minimization of diversification risk. Diversification risk is the risk of having a substantial hit to overall profits, via the reputation mechanism, due to market participants perceiving the agencys ratings as ill quality. CRAs that offer a variety of ratings would have lower diversification risk. A series of severe ratings downgrades can be brought about by either an agencies exerting lower than expected quality or a false perception of bad quality invoked by a systemic event that affects the rated instruments. Regardless of the cause, either would have an effect on an agencies reputation and profit. In the credit rating industry, the larger firms generally issue ratings for a variety of securities while smaller agencies tend to specialize, focusing on their niche. Therefore diversification risk is perceived as having an inverse relationship to firm size.

Two-Rating Norm For major international debt issuers a two-rating norm has developed when assigning security ratings (Dittrich, 2007). This is the common practice of receiving both S&P and Moodys ratings for each debt issuance. This development can be attributed to several factors. First, investors demand more than one rating in order to supply additional information. Even though this additional information value is not very high investors do not directly carry the additional costs (Dittrich, 2007). Another argument for this emergence is certain SEC regulatory requirements for two NRSRO ratings. A final reason is the desire for issuers to publish two or more ratings for their debt to increase confidence amongst investors, thereby lowering borrowing costs.

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Can Too Much Competition be Dangerous?

If competition in the market were to increase it may bring up certain issues dealing with conflicts of interest. This has been the fear of some observers who advise against increased competition (Becker and Milbourn, 2009). New firms entering the market may engage in competitive laxity; the action of offering inflated ratings in order to attract issuers and compete with the bigger CRAs. In addition it may promote ratings shopping where issuers would have greater incentive and ability to choose the agency that offers the highest ratings for their debt. While these arguments are worthy of noting, sufficient regulation preventing conflicts of interest between issuers and CRAs should make these dangers minimal.

ConflictsofInterest Issuer-Pay Model When rating agencies first existed they followed a subscriber-pay business model whereby investors would pay a fee for a series of ratings. Much has changed now with the emergence of the issuer-pay model that exists for the major rating agencies. With this new business model issuers pay the rating agencies to rate their own debt, naturally having a higher inclination for such conflicts of interest.

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For issuers who desire high ratings in order to lower borrowing costs, there is financial incentive to shop for ratings. In addition, credit rating agencies may have incentive of keeping customers or attracting new issuers by inflating their ratings.

Conflicts of Interests and Structured Finance Products The recent emergence of the structured finance market has exacerbated such issues, as conflicts of interest may be more likely to exist in ratings for such products (H. Langhor, P. Langhor, 2009). This phenomenon can be accredited to the greater differences in the ratings of structured finance products, vs. corporate debt, between different rating agencies. Although the ratings of traditional corporate debt is more straight forward, the models and assumptions used by the agencies to rate structured finance products varies slightly more so. This may promote a greater incentive for ratings shopping and inflated ratings on the part of the agencies. Additional conflicts that have arisen with the ratings of structured finance is the occurrence of structuring advice in the securitization process; the practice of using the knowledge or the assistance of CRAs to structure the product to a desirable rating. Originations of these products at least involve arrangers using rating agency models to pre-structure deals (Committee on the Global Financial System, 2005). Therefore the agencies may not be fully independent of the securities they rate. This issue is significantly less likely to occur in the ratings for corporate debt in that it is difficult for a corporation to easily and quickly alter their business to improve credit quality in order to obtain a higher rating.

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RatingsofStructuredFinanceProducts Structured finance involves the bundling of assets into pools and the selling claims to cash flows backed by these assets. In addition, there is often a tranching of liabilities whereby the cash flow from the underlying is diverted to different tiers. The different levels of tranches each contain different risk levels where the highest has first priority of payments. The structured finance market has grown significantly over recent years but has been severely hurt after the financial crisis. Ratings of structured finance products have historically experienced more severe downgrades on average than that of ratings for more traditional debt (H. Langhor, P. Langhor, 2009). Ratings for these complex instruments have been put in the spotlight after many highly rated securities turned sour during the recent financial crisis. The inaccuracies of the ratings of structured finance products could have systemic consequences if they make these volatile instruments seem safer than there true risk. The failure of these ratings was especially true for CDO (collateralized debt obligations) backed by various asset-backed securities. Graph 1 illustrates the substantial failure of these ratings. It shows the percentage of every originally rated AAA ABS CDO rated by S&P that were downgraded. Only 10% of these AAA rated CDOs retained their highest credit ratings while almost 60% of them were rated below B. Almost 80% of these securities were put into junk bond or non-investment grade categories (according to S&Ps ratings system, securities below BBB are considered non-investment grade).

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Graph 1: S&P rating distribution of 2005-07 issued U.S. AAA-rated ABS CDOs Source: Standard and Poors

Regulators have pointed out several inefficiencies in the ratings for structured finance products. The following outlines several of these flaws.

Ratings for Traditional Debt vs. Structured Finance Products All financial instruments that the big-three rate are subject to a common rating process and are ultimately mapped into an alphanumeric scale that is benchmarked to the historical performance of corporate bonds (Bank for International Settlements, 2005). Although the rating for SFPs and corporate debt have a similar ratings process and rating scale, there are crucial differences between the nature of the two instruments. The performance of corporate bonds is almost entirely dependent on the credit risk of the company, which is relatively easier to assess. Structured finance products however are highly exposed to systemic risk (i.e. changes in the macro-economic conditions) and structural risks as well. Structural risks in securitized products arise with the creation of 17

tranches and differing claims to cash flows from asset to asset. Therefore certain bonds will react differently than others to changes in market conditions. Therefore, different bonds/tranches will be exposed differently to interest rate risk, exchange rate risk and prepayment risk (the risk of early repayment of principal on a loan), none of which have significant effects on the credit quality of a corporation. It is clear that the nature of the performance of SFPs is quite different from that of corporate debt. Despite this phenomena, rating agencies have been using the same ratings scale for both types of fixed income securities. This may appear to investors that the inherent risks of these bonds are similar. It is interesting to note that empirical evidence shows that historically, corporate debt has the same or even greater likelihood of a ratings downgrade compared with SFPs; this is likely due to the diversification of loans in the asset pool (H. Langhor, P. Langhor, 2009). However, SFPs on average are subject to more than one notch downgrades than corporate debt. Graph 2 shows the relative frequency of multi-notch downgrades of SFPs vs. corporate debt. There is clearly a significantly greater frequency of more than one notch downgrade for SFPs especially for below investment-grade rated instruments.

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Graph 2: The percentage of ratings subject to more than one notch downgrade during the year Source: S&P

Unrealistic/Faulty Assumptions: Model Risk Unlike ratings for corporate debt, structured finance products are rated using mostly Monte Carlo simulation and scenario modeling approaches. This is due to the inherent nature of structured instruments being almost entirely exposed to systemic risk. The securitization of loans leads to great diversification of non-systematic risks (borrower default) but still leaves the instruments performance largely linked to changes in macro-economic conditions. While company-specific risk is generally easier to determine (i.e. analyzing financial statements and historical performance) modeling systemic risk of an asset is largely based on various assumptions about interest rates, movements in asset prices, global demand etc. (Fender, Kiff, 2004) Many of the models used by the big three CRAs for rating SFPs underestimated default correlations amongst loans. Therefore they assumed that with proper loan diversification correlation would be rather low. However the occurrence of a systemic event, the housing bubble burst, affected most of these loans. In addition, CRAs underestimated the impact changing housing prices would have on the performance of 19

these products. This risk of assigning the wrong model specification/assumptions (due to insufficient historical data or the inherent analytical challenges) is known as model risk. Although model risk exists in the ratings of other instruments, it is more pronounced in ratings of SFPs as the ratings are very sensitive to model assumptions, namely correlations and recovery rates. Regulators have claimed that the CRAs had insufficient data to properly specify models for certain SFPs and since the ratings for these products relied heavily on quantitative models, there was significant errors in the models. If investors rely on ratings for their CDO investments, this model risk is among the principal risks these investors are exposed to (Fender, Kiff, 2004).

Lack of Transparency Due to the elevated complexity of securitized products, it is difficult for many investors to assess credit risk on their own. This can lead to the over-reliance and misuse of such ratings where investors and financial institutions almost entirely export risk management to the CRAs. Not understanding the model assumptions and methodologies used, investors may not be aware of the reliance of these models on certain underlying assumptions.

Originator-Risk Factor A deterioration of underwriting standards by banks after the emergence of securitization has been noted among regulators. The new originate to distribute model allowed banks to underwrite loans and sell them by means of securitization while no

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longer retaining the credit risk on their balance sheets. Many CRAs did not take into account the correlated risk of the loan being originated in the same pool. Since the loans in a pool are generally only originated by a few firms, there is a correlated risk among these loans with respect to loan quality and underwriting standards (Bank for International Settlements, 2008). The subprime SFP downgrades that characterized the recent financial crisis are concentrated on four firms signaling the significant differences in underwriting standards. After the crisis many CRAs have recognized this additional risk factor and have taken steps in reducing it. For example in October of 2007 Moodys started categorizing originators into three separate groups based on loan quality (BIS, 2008).

Differences in Performance between Structured Finance Classes Although there has been high ratings volatility in many types of SFPs, certain instruments tend to have much more severe downgrades than other. The Graph 3 illustrates the estimate of the loss rate over 5 years for six different types of securities all with initial Baa ratings. There seems to be significant differences amongst expected losses despite similar ratings. For example, CDOs have almost ten times the expected loss of that of residential mortgage backed securities (RMBS). Substantial differences amongst these products can be attributed to increased leverage that the process of tranching creates. Tranche thickness plays a role in the leverage of the instrument as well. The thickness of a tranche refers to the percentage of the total securitization that a given tranche comprises. Relatively low tranche thickness means that it takes fewer loan defaults to affect the cash flow of that tranche.

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Graph 3: Estimate of the Baa-rated 5-year Loss Rate by Investment Type Source: Moodys Investor Service, 2006

In addition, differences in granularity of a loan pool can account for further performance differences. Granularity refers to amount of loans contained in one pool. The less granularity (fewer effective loans) there is in a pool the more substantial small changes in individual loans will account for in the performance and cash flow of the security. CDOs tend to be more lumpy (exhibiting less granularity) and generally contain a relatively small number of assets compared to more traditional ABSs. This can help explain the greater expected loss rate of CDOs versus other SFPs within the same ratings category.

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Accountability There is much debate in existing literature about the sufficiency of accountability that credit rating agencies have for their ratings performance. Accountability is important in suppressing incentives for moral hazard and should ultimately lead to the exertion of a high level of effort and high quality of ratings. While some argue that the reputation mechanism is sufficient in creating this accountability others say that agencies should be held directly liable for poor performance.

Legal Accountability The Securities Act of 1933 gave individual investors an express right of action for damages . . . when a registration statement contains untrue statements of material fact or omissions of material fact (Clinton, 2004). However CRAs have until recently, enjoyed immunity from this liability. In addition, several court cases brought up over poor performance on CRAs have been ruled almost entirely in favor of the agencies. These cases have concluded that ratings of securities should be considered as opinions and not factual information.

Accountability Through Reputation Mechanism Although the reputation mechanism can potentially create this accountability, several market factors may disrupt its effectiveness.

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Insufficient competition, a prevalent factor in the industry, can limit the value of reputation if it encourages firms to behave anti-competitively. If agencies know there are few other firms issuers can go to if they produce low quality ratings, then there is less incentive to maintain this quality (assuming high quality is associated with cost of effort). In addition, due to the probabilistic nature of credit ratings it is very difficult for users to determine whether ratings are of high or low quality. If for example several high quality rated securities default, it is hard to differentiate between faulty ratings or the occurrence of the small probability that a high rated security defaults. To further exacerbate problems, there exists a tendency among issuers to stick to a certain credit rating agency despite changes in performance. This phenomenon can be attributed to several causes. First, there are so few other firms (especially NRSROs) that issuers can flock to in the case of poor performance. In addition, if issuers change rating agencies it could arouse suspicion amongst investors of ratings shopping. Finally, it may be costly to switch between agencies in order to adjust to new systems or break existing contracts.

NewRegulation
Up until recently there has not been significant regulation on CRAs due to the generally accepted notion that self-regulation was sufficient in incentivizing proper behavior. However, after the recent financial crisis the CRAs have been put in the spotlight and regulators over the world have imposed and proposed new regulation on the

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industry. The main goal of this post-crisis regulation is to gain efficiency in the market as well as returning confidence to investors of the reliability of these ratings.

TheCreditRatingAgencyReformActof2006 The main purpose of the act was to standardize the registration of NRSROs. It created a list of criteria for agencies that seek the designation of NRSRO. In addition is gives the SEC new oversight over NRSROs and requires the commission to make annual reports about new registrations and new regulatory actions imposed.

SECRegulationProposals After the recent financial crisis the SEC set out to establish certain proposals that aim at solving certain flaws in the ratings industry. The proposals covered:

Disclosure of Conflicts of Interest: Required NRSROs to disclose their net revenue attributable to the 20 largest customers. This would signal to ratings users of potential conflicts of interest.

Annual Compliance Reviews: Require NRSROs provide to the SEC an annual report describing their compliance reviews for the most recently completed fiscal year.

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 Disclosure of Credit Rating Reviews: Require NRSROs to disclose to all other NRSROs when they are in the process of determining the credit rating of a structured financial product for an arranger. (Ali, 2009)

DoddFrankAct The Dodd Frank Wall Street Reform and Consumer Protection Act required the examination and study of NRSROs and has lead to an ongoing effort to impose further regulation. These reports cover conflicts of interests, ratings of structured products and the structure of the major NRSROs. In addition the act requires the SEC to adopt a number of rules covering: internal controls, conflicts of interests in sales/marketing, disclosure of credit rating methodologies and analyst training and testing. A major recent regulatory change the SEC has adopted on behalf of the DoddFrank Act is the elimination of NRSROs immunity from legal liability. This gives users of ratings the right to take legal action and demand compensation for damages due to poor ratings quality.

LimitationsofExistingRegulation Although some of the new regulation that has been implemented serves in increasing transparency of ratings methodologies and lowering conflicts of issues there has been very little done to effectively increase competition in the industry. It seems

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unlikely the SEC will substantially remove references to ratings in regulation, leaving up barriers to entry. The new liability that the NRSROs now carry due to the Dodd-Frank Act can bring up several new problematic issues. If there is strict liability imposed on agencies, it may create a moral hazard for investors using ratings to invest recklessly in securities without doing their own research. This could potentially raise dependence on ratings by investors, which is the very thing regulators are trying to limit. In addition, due to the probabilistic nature of ratings, it would be very difficult to determine if these ratings were in fact poor quality.

IncreaseCompetition One way to increase competition in the industry would be to reduce regulatory reliance on CRAs and eliminate the NRSRO designation completely. This would give smaller, non-NRSRO firms the ability to compete and gain market share. The complete elimination of the NRSRO status may prove difficult in implementing, as there is a need for a standard measure of the credit quality of assets in regulation. A possibly more efficient way of improving market concentration may be to adjust the NRSRO requirements and to allow more firms to be given this designation. The call for national recognition could be eliminated from the requirements to allow smaller firms and foreign firms to gain the status. It is clear however that this requirement was designed as a measure of performance and reliability of these rating agencies and

RegulatoryProposals

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therefore a new measure would be necessary. Regulators could instead view historical ratings performance (by comparing ratings issued vs. probability of defaults) as a means for assessing the firms credibility.

RatingsforStructuredFinance Although some CRAs have recently decided to use different rating scales for structured finance, it is not yet an official regulatory requirement. By requiring CRAs to differentiate between ratings of corporate and structured finance, users of the ratings can be alerted of extra risks associated with these products. Agencies can use different numerical values or symbols and disclose additional warnings to investors of higher ratings volatility.

ConflictsofInterest Although it has already been proposed to require CRAs to list customers that account for a large percentage of revenues, they could be required as well to limit a certain percentage of their revenue from coming from a single issuer. If an agency has a narrower source of income (from only a few customers) there is a larger incentive to inflate ratings to keep these customers from switching agencies. This started becoming an issue at the peak of the structured finance market where a large part of CRAs structured finance business came from only a few large issuers.

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Conclusion
The Credit Rating Industry remains to be very important in the financial world as

a wide range of market participant use ratings to assess credit risk. In addition, it is difficult to find a replacement for ratings in regulation as it provides a standard measure of credit risk of assets. Although an over-reliance on ratings by investors could be potentially devastating, ratings could be used effectively to supplement independent risk management. Since credit ratings have an important and influential role in the markets it is crucial that the agencies that issue them operate efficiently. In addition, it has been argued that CRAs have a pro-cyclical role in the markets, in that there ratings can affect cost of borrowing for issuers. By analyzing the industry as a whole it is clear that there exists many flaws that could potentially cause CRAs to act undesirably and issue poor ratings performance. It is for this reason that regulation on the credit rating industry is extremely important to preserving financial stability. There is an ongoing effort to impose greater regulatory standards on the industry to reduce some of these inefficiencies. However, as of yet there has been little regulation to properly deal with the lack of competition in the market as well as issues in the ratings for structured finance. Overall, the rating industry has been known as one of the least regulated players in the financial markets despite a great deal of influence. However, the key to creating a well-functioning rating industry is not to over-regulate as well. This could potentially hamper the CRAs rating processes and may ultimately lead to poorer performance. Therefore regulators must be precise in imposing new regulation and fully understand the unique characteristics of the industry.

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References
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