Congress demands ratings report from SEC after no-show at hearings

WASHINGTON, DC - The chairman of a House of Representatives subcommittee that held early April hearings titled "Rating the rating agencies: the state of transparency and competition," sent a strongly-worded letter to the chairman of the Securities and Exchange Commission (SEC) in mid-April demanding a long-awaited concept paper on the rating agencies by June 4.

The letter was written by Richard Baker, chairman of the subcommittee on capital markets, insurance, and government-sponsored enterprises, to William Donaldson, chairman of the SEC. The letter said, "I am deeply troubled by the process by which the NRSRO (nationally recognised statistical rating organisation) designation is granted and by the potential conflicts of interest that exist under the current structure. Moreover, I question whether the current structure serves the interests of investors and the markets, given the track record of the rating agencies that failed to adequately warn investors of the significant bankruptcies in the recent past."

The SEC had originally promised to produce the concept paper by the end of March on the challenges faced by the rating agency industry, but failed to produce one in time for the Congressional hearing. The concept paper follows on from a January report that was requested as part of the Sarbanes-Oxley Act in the US — lawmakers feel that rating agency industry structure needs to be overhauled to improve corporate governance. Rating agencies came under intense criticism worldwide for their failure to predict the downfall of companies such as Enron and Worldcom, and legislators worry that the protected nature of the industry, through the NRSRO designation, is to blame. In addition, most of the rating agencies now have consulting arms, and there is concern that this presents the same type of conflict-of-interest problems that accounting firms in the US ran into. In the background is the fact that under the credit risk provisions of the Basel Accord revisions, banks will be able to use credit rating agency data to calibrate their internal credit risk models — regulators fear that the credit rating agency information may not be up to scratch, creating substantial model risk.

Many were surprised that the SEC did not produce the concept paper by the March deadline. "It disturbs me that the Commission has studied this issue for more than a decade without reaching any firm conclusion," said Paul Kanjorski, the ranking Democratic member of Baker’s subcommittee. He noted that in 1994, the SEC solicited public comment on the role of ratings agencies, and this led to a rule proposal in 1997 that was never finalised. However, the SEC says it has continued to examine the subject, and held hearings in November 2002 on the credit rating agencies. The January report was derived in part from those hearings, and the SEC was supposed to produce a concept paper 60 days later, but failed to meet that deadline.

Annette Nazareth, director of the division of market regulation at the SEC, defended her organisation at the April hearings. She outlined a number of areas that she said the SEC was exploring further for its concept paper, but did not give an indication of the kinds of policy changes or recommendations that the SEC might be considering.

Lawrence White, a profession of economics at the New York University Stern School of Business, delivered a particularly tough address to the hearings. White called the January SEC report "an excuse for more delay in addressing the problem" of regulatory barriers to entry into the rating agency business, in the form of the NRSRO designation. Many who advocate the removal of the NRSRO designation believe that a more competitive rating agency industry — free of the protective NRSRO designation — would result in ratings that were more responsive to changes in underlying creditworthiness of companies covered.

The fact that the US agencies will be playing a wider role in the Basel Accords was also in the back of the minds of those testifying. In an article that White appended to his testimony, he wrote, "the Basel II proposals would explicitly expand the rule of bond rating firms in the safety-and-soundness regulation of banks in the US and simultaneously expand that infiltration to bank regulation around the world." As a result, the question of how the rating agencies should be regulated becomes one that supervisors around the world will have to address.

Representatives of both Moody’s and Fitch were present at the hearings, and Standard & Poor’s submitted comments to the committee after the hearings. In those comments, agencies defended the NRSRO designation and the ways in which they had structured their businesses.

The SEC’s January report can be found at:
www.sec.gov/news/studies/credratingreport0103.pdf.

Prepared testimony from the April Congressional hearings is at:
www.financialservices.house.gov/hearings.asp?formmode=detail&hearing=201Operational Risk