The SEC Receives Renewed Calls for Credit Rating Industry Reform, but Will it Act?
The meeting of the SEC’s Investor
Advisory Committee took place on the 21st May, virtually –
recording available here.
In the afternoon, a panel was convened that was made up of: Professor Frank
Partnoy of the University of California, Berkeley; Marc Joffe of the Reason
Foundation, Yann Le Pallec who is the Head of Global Rating Services at
S&P; Van Hesser who is the Chief Strategist for Kroll Bond Rating Agency;
and Professor Joe Grundfest of Stanford University. Van Hesser addressed the
Committee first, noting that increased business in the past few years indicates
that KBRA is progressing in the market. The point was made that KBRA aimed to
offer a differentiated experience for the industry in the wake of the Crisis,
and that this recent and consistent upturn in their fortunes was an indication
of that model being accepted by the marketplace. In discussing the pandemic,
Van Hesser mentioned how there are a wide range of factors that affect credit
ratings, and that the current situation is very fluid and, in many ways, unprecedented.
Professor Frank Partnoy then followed with a succinct overview
of the industry’s regulation and some of the issues that have emerged since the
Crisis. One of which was the fact that, despite some successes, a number of regulatory
initiatives have failed. One such failure is with regards to the attempted to
reduce ‘regulatory reliance’, which is based on a concept Partnoy developed
known as the ‘regulatory licence’. Partnoy noted how a number of pieces of
legislation, and ensuing regulation that dictated that references to ratings
should be entirely removed, simply have not been implemented. This is on top of
the behavioural difficulties in removing reliance on the ratings. As potential
solutions to such issues, Partnoy suggests a number of approaches. First, he
suggests that financial entities, such as banks, should have to disclose what
they are holding if they are using rated investments, and preferably on a
granular level. Also, as he has long since championed, a number of other more
market-based approaches to understanding creditworthiness should be utilised by
the market. He then turned his attention to the way in which the SEC actually
provides details of its investigations and examinations. A point of issue has
been that the SEC will not ‘name names’ when it comes to providing information
on who it has found to be transgressing – it will often say things like ‘we
found that a mid-sized agency did not…’, which Partnoy suggests affects the
regulatory capital in this area; he argues that there is a benefit in the
market knowing who has been found to be falling below the standards set. Finally,
he discusses the issues with regards to aspects such as the protection being
afforded to the agencies via the exemption of the application of Section 11, which
was repealed in the wake of the Crisis to expose the agencies to liability,
something which has never taken hold.
Marc Joffe then followed, and addressed issues regarding the
negative effects of increased competition i.e. increased rates of ‘ratings
shopping’. He followed this with a discussion around higher CMBS ratings, which
appear to be inconsistent with the push by the Dodd-Frank Act to implement ‘universal
ratings’ which would increase transparency and clarity in the area. Joffe then
produced a number of interesting proposals, including insightful declarations
of the alternatives to credit ratings that exist within the marketplace (he
cited analytics firms/ regulator-developed methodologies/ the incorporation of
Universities [he cited the work at the NUS in Singapore] and non-profits/ and
open-sourced methodologies) as well as a number of distinct policy recommendations.
Those included avoiding the use of NRSROs in standards, eliminating the concept
of NRSROs altogether, enforcing the 17g-5 program better, and potentially
incorporating machine-readable financial disclosures into the financial system
more.
Following on from Joffe, S&P’s Yann Le Pallec introduced
the viewpoint of one of the ‘Big Two’, and discussed a number of elements and initiatives
that S&P have undertook. He mentioned how S&P have invested heavily in
a number of safeguards to prevent, or at least reduce the impact of a number of
recognised conflicts of interest. This was adjoined to the interesting point
that the company deals with more than 20 regulators worldwide, perhaps hinting
at the need for more joined-up regulatory thinking. He then detailed how
S&P has invested heavily in its compliance functions, although this has
been noted in the literature (not just related to S&P) as being a negative
outcome of the regulatory era i.e. simply moving to a tick-box culture as
opposed to focusing on the underlying causes of such failures. In addition to
this, Le Pallec discussed how new training initiatives and standards have been
developed. To address some of the more obvious criticisms of the rating
industry, he concluded by discussing how both S&P has long since supported
the reduction of regulatory reliance, and that every remuneration model in the
rating industry comes with conflicts and that, ultimately, the responsibility lies
with the investor to utilise the information they have available to them responsibly.
Professor Grundfest then followed, with the initial part of
his segment addressing the view that the stable duopoly in the sector produces
very little innovation. He then clarified that, in his view, the issuer-pays
remuneration model is the only realistic model for agencies who are the largest
in the industry. He then discussed an idea that he has championed. This is the ‘Buyer-owned and
Controlled Rating Agency’, or BOCRA. Essentially, the idea is that these
entities would be owned and operated by some of the larger investors, with the
concept being that the entity would have ‘strong incentives to promote an
investor’s point of view in the rating process’. The financial support for such
entities would be gained from a partnering arrangement whereby every time an issuer
pays for an NRSRO’s rating, they would have to pay for a rating from a BOCRA.
Grundfest suggests that there would be no limit on the amount of BOCRAs, but
that in reality only two would likely emerge and that the market would dictate
its prices. This approach contains many more details - available in the link
above – but Grundfest did begin with acknowledging that it is slightly ‘controversial’.
The section concluded with some interesting Q&As, with
one in particular (from JW Verret of George Mason University) raising the issue
of the Office of Credit Ratings being particularly underfunded in relation to
other bodies in other industries that have similar mandates (like PCAOB).
Then, on June 1st, the Credit Ratings Subcommittee
of FIMSAC announced
that it was recommending
a number of proposals with regards to the regulatory needs within the rating
sphere. In its recommendations, that were based on a number of months of
research and testimony, the subcommittee focused on three elements in
particular: the need for increased NRSRO disclosure; the need for enhanced
levels of issuer disclosure; and a mechanism for bondholders to vote on the issuer-selected
NRSROs.
On the first point, the recommendation is that NRSROs should
provide more in-depth information about their models and how the models differ
by industry. Furthermore, if there are any inputs that effect a model, for
example any qualitative inputs, then these should also be declared publicly. With
regards to deviations from stated methodologies – which is not allowed unless
expressly declared and with good reason – the subcommittee suggests that
additional summary statistics on how often, and to what extent NRSROs have
deviated would be useful for further research.
With regards to increased disclosure from issuers, the subcommittee
first finds that for corporate issuers, the process of how NRSROs are
selected should be more transparent, and to this end they suggest that the SEC should
work alongside trade groups so that ‘best practice’ in this area can be
identified and replicated. For securitised issuers, the same selection process is
of interest to the committee, with it suggesting that more transparency is
needed. In addition to a similar establishment of ‘best practices’ in this
area, the subcommittee also suggests that any time a rating agency is selected
but the rating not subsequently published, then this should be made public so
that investors can be aware of any potential instances of ‘rating shopping’.
Finally, in relation to the bondholders voting on the
selection of NRSROs, the subcommittee suggests that, like public auditors, the
bondholders should be able to vote on whether to ratify, or simply to confirm
confidence in the NRSRO selected to develop the rating for the bond. The
subcommittee argues that this may provide for additional discipline on the
rating agencies. The report concludes with a number of acknowledgements
regarding the issues with such policy recommendations, with the most prominent
being that the current regulatory framework may prevent some or all of the
policies being implemented.
The thing to note is that there is certainly no shortage of
proposals with regards to what may be done to ‘fix’ the rating arena. If we
proceed on the basis that this ‘fix’ is desired, which in certain points I
suggest is not actually the case – my forthcoming research on ‘rating addiction’
argues that the system is addicted to ratings quite simply because they fulfil
a number of purposes – then the issue is whether such policies are reasonable.
A number of the above are reasonable, but some of the above may need a lot of
regulatory capital, or better still ‘regulatory will’ to eventually succeed. Whether
this ‘will’ exists is, perhaps, truly the question. I have argued in the past,
and will no doubt argue in the future, that the real question is ‘who does the
current system serve?’ I believe that the answer to this question dictates how
much regulation, and by that I mean truly impactful/altering regulation, will
be implemented. Partnoy noted in his section that a number of elements of
Dodd-Frank have not been adopted – the question then becomes ‘why not?’ If it
is because the proposed regulations were not workable within the current
regulatory framework, then the issue is that either the legislators are out of
touch, or that the framework is not fit for purpose and needs to be changed.
Perhaps on the back of these currently proposed policies, the actions of the
SEC will be telling.
Keywords – CRAs, regulation, @finregmatters
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