Credit Rating Agency News Updates

In the second update today, this post will look at two recent stories regarding the credit rating industry. The first update relates to a story we looked at in August which was based on an article I wrote for the Journal of Business Law. The second update relates to the development of a Dodd-Frank era plan that the Wall Street Journal has recently turned its attention to in a particularly scathing manner.

Dagong Re-Enters the Chinese Market

Last year, one of China’s largest agencies was banned by the China Securities Regulatory Commission from producing ratings for securities for a year, and also from making any changes to its senior management structure for the same period. Additionally, the National Association of Financial Market Institutional Investors suspended Dagong from rating debt instruments for non-financial firms. The agency was criticised for being too close to the rated entities via its consultation services, and also for poor internal management, unqualified management and assessment committee members, and missing modelling data.

Now, a year on, the agency has been allowed to resume its rating operations. In a statement yesterday, the agency stated ‘the company has fully restored credit rating business for non-financial corporate debt financing instruments in the interbank market, and securities credit rating business since November’. To enable this return, the agency has undergone internal restructuring, as demonstrated by the inclusion of China Reform Holdings Corp Ltd. Which is a centrally administered and state-owned investment firm and who now have acquired a 58% stake in the company – essentially, the agency can be said to have been nationalised.

There are two clear problems facing Dagong. First, the company has had its reputation obliterated by way of its banning, but also now by its apparent nationalisation – how a rating agency can declare independence with this ownership structure is difficult to see. Second, since it was banned S&P have entered the domestic marketplace, with it bringing an authority that Chinese rating agencies simply do not have. The culmination will likely mean a rough re-entry for Dagong.

WSJ Turns its Attention to the Failure of the Rule 17g-5 Amendments

In 2008, the SEC proposed a number of new rules that it hoped would make a mark on the inherent conflicts of interest that exist within the modern credit rating industry. One of those amendments was to ‘Rule 17g-5’, which as an amendment dictated that an Nationally Recognised Statistical Rating Organisation (NRSRO) that is hired to determine an initial rating for a structured finance product must disclose to non-hired NRSROs that a. the arranger (issuing entity) is in the process of seeking a rating and b. to confirm from the arranger that they will provide the same information provided to the NRSRO to conduct the rating to the non-hired NRSRO. Simply translated, this means that when an issuer is seeking to have its issuance rated by an agency, it must provide the same information to a non-hired rating agency that requests the information for the purpose of generating an unsolicited rating that would, in effect, act as a benchmark to the paid-for rating. The SEC added to this the restriction that the non-hired NRSRO must only access the information to produce an unsolicited rating (as opposed to for commercial gain). In furtherance of this, Regulation FD was amended so that ‘the disclosure of material non-public information to an NRSRO regardless of whether the NRSRO makes its ratings publicly available’ would be legal. However, 11 years on, there has been enough time elapsed to assess whether this plan was a success or not.

Cezary Podkul, writing for the WSJ, starts by stating that ‘a decade later, the verdict on that plan is in: the program was a failure’. The article consults reflections from agencies, trade associations, and the SEC themselves who all admit that there have been very few unsolicited ratings produced via this mechanism. The SEC have stated that after a ‘thorough search’ of their records they cannot find any instances of a NRSRO utilising the programme, whilst Moody’s, S&P, Fitch, Kroll, DBRS, and Morningstar (now merged) have all declared they have not utilised the programme. Podkul makes the obvious connection that the reasoning for this is that the agencies do not get paid for unsolicited ratings and, to add to that, are at risk of upsetting future clients if they rate them lower via the unsolicited mechanism. Furthermore, rating agency bosses have made the good point that, as this only applies to structured finance products, the work involved in coming to a rating decision within that particular area is extensive, and becomes inefficient very quickly – as a senior executive at Fitch noted: ‘we have other work to do’. Podkul goes on to make the point that a later plan to develop an oversight committee, as part of the Franken-Wicker amendment, was rejected by the SEC on the basis that this 17g-5 amendment would work. Mr. Franken is quoted as saying that the failure of the programme was ‘very predictable’, and it is difficult to disagree with him.

The failure on the SEC’s part comes from a misunderstanding, for whatever reason, of the dynamics of the rating industry. It is the paid element that has frustrated this particular effort. For example, in my very first article back in 2016, I argued that the programme could actually work if a. non-profit rating agencies were allowed to be included in the programme and b. they were adequately, and independently funded. That the programme failed is not entirely because of the lack of consideration of this proposal, but it is an important point to make – one must fully understand the market if one is to regulate it. It is either the case that the regulators do not understand the market, which I highly doubt, or that they were under pressure to do something and, as a result, rolled out an ill-thought out programme which has both not worked and prevented the idea from being promoted again, based on its failure. This programme can be probably be chalked off as a massively missed opportunity, unfortunately.

Keywords – credit rating agencies, business, @finregmatters