Source: www.breakingviews.com is Europe’s leading financial commentary service.
Date: May 2003
Ratings agencies are under the regulatory spotlight. Moody’s and Standard & Poor’s were criticized for their role in the equity bubble: not spotting the likes of Enron in time. And now they are being criticized for their role in the post-bubble era: tipping companies over the edge by junking them too rapidly. In recent weeks a US congressional sub-committee has held hearings on the agencies, while the SEC published a consultation document on the industry. The implication of this activity is that the agencies need more regulation. But that’s exactly the wrong conclusion – they need less.
This is not to say that the agencies have an unblemished record. Far from it. They have been slow to spot trouble. And they suffer from a big potential conflict of interest: the fact that their income comes from the companies they rate.
But what is the best way of improving the situation? Arguably to cut the red tape and expose the agencies to a more competitive market.
A big problem with the current set-up is that the agencies are viewed as private-sector regulators. This, in turn, has two negative consequences. They themselves have to be regulated, which erects big barriers to entry. And they have to be responsible, which means they can pull their punches.
This quasi-regulatory role has many manifestations. Most obviously, the agencies fall under a special SEC category – the nationally recognized statistical rating organization (NRSRO). Getting this status is tricky. Until February, only three firms had it: Moody’s, S&P and Fitch IBCA. And Fitch is a comparative minnow. Now there’s a fourth – Dominion Bond. But that’s hardly a competitive market.
This special category affords certain privileges. Most important, an NRSRO is allowed privileged access to inside information. The SEC’s Regulation Fair Disclosure is supposed to ensure that all market participants are treated equally. But the agencies have an exemption. And once they get this privileged information, what do they do with it? They work it into their ratings but can’t reveal it. Possessing inside information that is of interest to investors without being able to disclose it is awkward, to say the least.
Then there’s the ratings agencies’ role in banking regulation. This is a moveable feast, as the international regime for regulating banks is currently being revised. But there’s currently a proposal – under what is known as Basle II – to use the ratings produced by the agencies to determine how much capital banks need to set aside when they make loans. In other words, a loan to an AAA credit would require less capital than a loan to a BBB credit. If the proposal is accepted, the agencies will become further entrenched as part of the regulatory structure.
Finally, there’s the way the agencies’ ratings have come to offer reference points for private contracts. What has come to be called the ratings trigger is a notorious example. A bank loan, for example, might contain a clause forcing the borrower to repay the money early if it is downgraded to junk. That was one of the nails in Enron’s coffin.
Another example is the way fund managers behave. Some are often explicitly prevented from investing in junk bonds, a category defined by reference to the agencies’ ratings. This distinction, in turn, creates an artificial cliff. If a company’s bonds are junked, investors desert it, pushing the bonds down further.
So what, one might ask? Isn’t this rigidity the price one has to pay for simplicity and order?
No. Imagine the same thinking was applied to financial journalism. Let the SEC create a new category – the nationally recognized financial reporting organization (NRFRO). Give this badge to two big media organizations – say Bloomberg and the Wall Street Journal – and two small ones. Allow them to receive inside information from companies on the condition that they don’t publish it.
Imagine, too, that these NRFROs were paid by the companies they reported on rather than their readers. Would we really think this was a good way of ensuring a free flow of information? Hardly.
The quasi-regulator model for agencies is wrong. It would be far better to view them as providers of independent research. And the way to achieve this is to cut the barriers to entry, not to add more.
Increased competition should spawn greater variety, higher quality and maybe even new revenue models. The best agencies might even be able to get investors to pay for their service. Now that really would be radical.
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