TCS Daily


Cartel to Competition

By Alex Pollock - July 18, 2006 12:00 AM

The outlook for the future structure of the credit rating agency sector improved greatly on July 12th, when the House of Representatives passed the "The Credit Rating Agency Duopoly Relief Act" with a solid majority.

Ratings on bonds and other credit instruments produced by rating agencies have become an essential part of the way fixed income markets function and are regulated. Unfortunately, the sector has become a government-sponsored cartel, or as the title of the House bill suggests, a duopoly -- with market dominance by Standard & Poor's and Moody's. Since it is common for securities issues to need ratings from two firms, it can be argued that "shared monopoly" is actually a better term.

This reflects, as least in part, the way the Securities and Exchange Commission has administered its "NRSRO" designation. To be granted NRSRO ("Nationally Recognized Statistical Rating Organization") status by the SEC staff became an extremely valuable franchise, since numerous regulations and regulators require financial and investment companies to use credit ratings, but restrict them to using those produced by agencies with the NRSRO designation. Thus the regulatory regime has simultaneously expanded demand and restricted suppliers.

No surprise: the profits of the dominant agencies became remarkably high. Doubtless it was never the intent of the SEC to create a cartel and the related cartel profits, but this has been the consequence of its actions since inventing the "NRSRO" label in the 1970s, and also its inaction when the resulting problems became obvious over the last decade.

Congress has appropriately grown impatient. The House-approved bill would move the sector from the current SEC-sponsored cartel toward greater competition, disclosure and market discipline. The Senate Banking Committee has also taken up the issue, and if the basic pro-competitive approach is adopted by the Senate and enacted, the credit rating agency sector will have the chance to become more efficient and innovative, with greater customer choice and lower cartel profits.

A serious technical problem faced by the Congress in designing its approach is that the term "NRSRO" has become imbedded in very large numbers of investment and capital regulations for securities firms, mutual funds, banks, thrifts, insurance companies, and government-sponsored enterprises, issued by numerous regulators -- as well as in various statutes. All of these became subject to the (as it turned out) anti-competitive decisions of the SEC staff; on top of that, the SEC never formally defined the criteria by which the NRSRO designations were made.

The House bill cuts this Gordian knot of regulation in what seems to me a brilliant and elegant way: it redefines by statute what "NRSRO" shall mean. It thereby changes the entire concept from an anti-competitive designation regime to a pro-competitive registration and disclosure regime.

The bill defines an NRSRO as a credit rating agency that, having been in business at least three consecutive years, makes the appropriate registration with the SEC. The registration must notably include statistics addressing the performance of its ratings. Other required disclosures would include its procedures and methodologies for determining its ratings, its policies for protecting privileged information and controlling conflicts of interest, and its organizational structure. It will also file its own financial statements with the SEC on a confidential basis.

The registration would be voluntary. Nobody would make a credit rating agency register as an NRSRO if it chooses not to. But registration would allow it to compete to have its ratings used for regulatory purposes by financial and investment companies, and their respective regulators, on the merits of their case. Investors and other financial actors would have the ability to make informed choices among more competitive providers.

Enhanced competition would undoubtedly produce innovations and improvements in the performance of ratings. Of particular importance, it would allow the two contrasting models of the credit rating agency business to be available to the regulated users of ratings, instead of only the one which is dominant today.

The dominant model is that the issuers of securities which are being rated (that is, the borrowers) pay for the ratings of their own credit quality. The alternative model is that the investors pay for the ratings on a subscription basis. It may seem natural that the alignment of incentives is better if the rating agencies are working for the investors -- indeed, this was the original model of the business, subsequently displaced in the practice of the dominant firms.

In the "Duopoly Relief Act," no choice is made between models. Both could be offered in the NRSRO market and compete for investor preference, leading to a more robust marketplace of ratings ideas. Having both models represented among NRSROs would be a distinct improvement over the status quo.

A Senate Banking Committee spokesman recently said the committee hopes to make progress on a credit rating agency bill before the August Congressional recess. There seems to be a chance for real reform.

Alex J. Pollock is a resident fellow at the American Enterprise Institute.

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