US senators criticise rating agency reform proposals

Senators and industry experts have criticised US Treasury proposals to keep tabs on credit rating agencies in relation to competition, conflicts of interest and the quality of ratings.

The remarks came during a hearing of the Senate Committee on Banking, Housing and Urban Affairs on August 5.

The Obama administration’s proposals, which were sent to Congress on July 21, aim to protect investors by tightening oversight of rating agencies and increasing transparency around the process of handing out ratings.

The measures would establish a dedicated Securities and Exchange Commission (SEC) office for supervising rating agencies and ensuring they follow their own procedures when assigning ratings. Agencies would undergo mandatory registration and have to document their procedures for determining ratings.

But the plans do not require agencies to use all the information at their disposal to rate products – something questioned by Chris Dodd, the committee’s Democratic chairman.

In response, assistant secretary for financial institutions Michael Barr said the Treasury’s plans were designed not to impinge on the process of assigning ratings. “We’ve tried to be clear the government shouldn’t be in the business of designing the methodologies for the rating agencies or validating them in any way,” he said.

However, the proposals require rating agencies to provide disclosures on the limitations of their analysis with each rating, such as the reliability of data and the sensitivity of ratings to changes in assumptions. They would also be required to use different ratings symbols for structured credit and plain vanilla bonds.

During the hearing, some senators and panellists lashed out at the ideas, saying they created new barriers to entry in the market and entrenched the position of the three main rating agencies. In his testimony, Lawrence White, professor of economics at New York University’s Stern School of Business, said tighter rules would discourage competition. Meanwhile, they might not even achieve the goal of better regulation for existing rating agencies, he added. “It could be a fool’s errand, and it will most likely increase the protective barrier around the three major rating agencies,” he said.

As part of the administration’s changes, existing financial regulations would be reviewed to identify instances in which references to ratings could be removed. White suggested these references should be eliminated altogether, along with the legally enshrined status of nationally recognised statistical rating organisation (NRSRO).

A number of the administration’s proposals are aimed at staving off potential conflicts of interest – a frequently cited problem arising from the fact major rating agencies are paid by the issuers whose debt obligations they rate. These include banning firms from undertaking consulting work with companies whose bonds they are rating, as well as disclosing any conflicts of interest arising from the way rating agencies are paid, and revealing the remuneration earned from issuers in each rating report.

If employees of rating agencies are subsequently hired by issuers they have previously analysed, the agencies would be required to conduct a review of any ratings issued to that firm to ensure they were appropriate. Each rating agency would also have to appoint a compliance officer, who would not be allowed to engage in any ratings-related activity and report directly to the board or senior management. This officer would be required to submit an annual report to the SEC.

But the changes do not seek to alter the issuer-pays model employed by the main rating agencies, which was criticised heavily during the committee hearing. Stephen Joynt, chief executive of London- and New York-based Fitch Ratings, said the agency would be willing to consider such a proposal, as long as it applied to all the major rating agencies. In his testimony, Joynt noted Fitch had already made a number of changes to the way it worked in the wake of the financial crisis, during which agencies have been blamed for failures in rating subprime-linked securities.

Elsewhere, a number of the administration’s proposed measures appear similar to those that have already been taken by the biggest rating agencies. New York-based Standard & Poor’s has hired an ombudsman and external auditor to look for conflicts of interest at the firm, for example, while New York-based Moody’s Investors Service has bolstered its ratings with additional information about the uncertainty of the underlying assumptions on which they are based.

The administration's plans also target the practice of ratings shopping by issuers – seeking ratings from different agencies in order to select and use the highest available. This would be discouraged by requiring issuers to disclose all preliminary ratings they received from other agencies before the final rating, enabling investors to see how many were sought, as well as any discrepancies between them. Meanwhile, the administration is strongly supporting moves by the SEC that would force issuers to share information given to one rating agency with others – a move it believes will allow them to assign more unsolicited ratings, increasing transparency in the market. The agency would also like to see NRSROs disclose full histories of ratings that have been paid for by issuers on a delayed basis.

The role of rating agencies has received intense scrutiny from global regulators since the subprime collapse began in mid-2007. In April, the European Union adopted a new code of conduct for the agencies, which will come into force in 2010. During the Senate committee’s hearing, chairman Dodd noted it was the sixth time it had looked into the issue of rating agencies over the past three years. It was unlikely to be the last, he suggested.

See also: Calpers lawsuit tests ratings agency liability in defaults
CESR: Rating agencies still not following rules on structured products
EU presses ahead with tougher regulation of rating agencies
S&P creates ombudsman role
SEC votes to tighten rules on rating agencies