Regulating the Rating Agencies
54 Pages Posted: 4 Mar 2005
Until four days before Enron declared bankruptcy, its debt was still rated investment grade by the major credit rating agencies. Clearly, four days before Enron declared bankruptcy, its debt was highly speculative. The furor over Enron, WorldCom and other recent debacles has led to calls for regulatory change in a number of industries; the rating agency regulatory regime is being revisited as part of this effort.
The regulatory regime requires or encourages many investors to buy debt securities highly-rated by a rating agency which has been designated by the SEC as a Nationally Recognized Statistical Rating Organization (NRSRO); at present, only 4 such agencies exist. There is even more market concentration in the rating agency industry than the existence of only 4 NRSROs suggests. Two of the agencies, Moody's and Standard & Poor's, dominate the market; it is the norm for most issuers to get ratings from both agencies. The regime does not impose substantive oversight over rating agencies.
Some critics blame the market concentration and the rating agencies' poor performance in Enron (and, they say, more generally) on the regulatory regime. These critics argue that ratings agencies are selling favorable regulatory treatment rather than information. Such critics favor largely scrapping the regulatory regime. I argue that ratings do provide information, albeit probably of lesser quality than they might provide if the industry were more competitive. I argue, too, that while the present regulatory regime probably ought to be scrapped eventually, doing so immediately might have an opposite effect to the one intended, further entrenching Moody's and Standard & Poor's.
No matter what regulatory changes are made, it won't be easy for a new rating agency to be established or gain a significant presence in the market. Market and institutional forces might have dictated market concentration even in the absence of the regulatory regime. A long-standing reputation is of considerable value as well, especially since the rating agency can't feasibly offer monetary guarantees of the caliber of its work. Moreover, agents who make the investment decisions, as well as the firms purchasing ratings, have every incentive to stick with the tried, true, and court- and market-vetted rating agencies.
Recognizing that the market may still remain quite concentrated, regulatory reform should encourage rating agencies to be more responsive to the needs of market participants. One promising suggestion contemplates creation of a public forum in which market participants would comment on rating agencies' performance. Less promising are suggestions to begin substantive oversight of rating agency business operations, and to increase the ability of investors and others to sue rating agencies. Finally, conflicts of interest may become a significant problem, especially if the market becomes much less concentrated - an annual certification by rating agencies that they are operating in accordance with procedures to guard against conflicts may be desirable.
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