Rule 17g-5(c)(1) (the “Rule”) of the Securities Exchange Act of 1934 addresses nationally recognized statistical rating organization (“NRSRO”) conflict of interest concerns by prohibiting an NRSRO from issuing a credit rating where the person soliciting the rating was the source of 10% or more of the total net revenue of the NRSRO during the most recently ended fiscal year.  As noted by the Commission, this prohibition is necessary because such a person “will be in a position to exercise substantial influence on the NRSRO” and, as a result, “it will be difficult for the NRSRO to remain impartial, given the impact on the NRSRO’s income if the person withdrew its business.”  The Commission also recognized that the intent of the prohibition “is not to prohibit a business practice that is a normal part of an NRSRO’s activities,” and that the Commission may evaluate whether exemptive relief would be appropriate. 
Posts Tagged ‘Ratings agencies’
In our paper, The Economics of Solicited and Unsolicited Credit Ratings, forthcoming in the Review of Financial Studies, we develop a dynamic rational expectations model to address the question of why rating agencies issue unsolicited credit ratings and why these ratings are, on average, lower than solicited ratings. We analyze the implications of this practice for credit rating standards, rating fees, and social welfare. Our model incorporates three critical elements of the credit rating industry: (i) the rating agencies’ ability to misreport the issuer’s credit quality, (ii) their ability to issue unsolicited ratings, and (iii) their reputational concerns.
I strongly support the Commission’s effort to evaluate ways to improve our credit ratings system. Effective oversight of Nationally Recognized Statistical Rating Organizations (“NRSROs”) is critical to ensuring accurate ratings and promoting investor confidence.
As an SEC Commissioner, I have focused singularly on how the SEC can best serve the needs of investors. It is clear that the role played by credit rating agencies can have an impact on the integrity of our markets and investor confidence. 
Today’s roundtable and the Commission’s December 2012 Report to Congress on Assigned Credit Ratings are direct outgrowths of industry practices that permitted inaccurate ratings to undermine the securities market and the integrity of the credit ratings industry. 
Triggered by the recent financial crisis, the regulation of banks has gained new traction among academics, regulators, and politicians. One of the key challenges in effective regulation is time inconsistency of regulation. While a regulator would like to commit not to bail out banks in order to set the right ex-ante incentives, this threat is generally not credible since the government does not follow through in the event of a crisis. Banks therefore have an incentive to expose themselves to risk that is partially insured by the government.
To mitigate this problem, regulators attempt to reduce the likelihood of banking crises by regulating both banks’ asset side and liability side. While there has been a recent push to focus on the liability side by mandating higher equity capital requirements, the very nature of a deposit-taking institution implies that leverage is an integral part of the business model of banks, unlike for other firms. In this paper, we therefore focus on the regulation of banks’ asset holdings. The starting point of our paper is the natural assumption that a regulator cannot directly observe the riskiness of assets, but needs to rely on an external (private) assessment of risk. Since the introduction of the Basel I framework, credit ratings have played an important role in bank regulation as “objective” measures of credit risk. This role has been confirmed in the Basel III (2011) guidelines, which still rely on credit ratings as measures of creditworthiness.
The Federal banking agencies have recently issued three notices of proposed rulemaking (and applicable related guidance) in connection with the implementation of Section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Section 939A generally requires that all Federal agencies remove from their regulations references to and requirements of reliance on credit ratings and replace them with appropriate alternatives for evaluating creditworthiness.
Market Risk Capital NPR:
The Office of the Comptroller of the Currency (the “OCC”), the Board of Governors of the Federal Reserve System (the “Federal Reserve”) and the Federal Deposit Insurance Corporation (the “FDIC” and, together with the Federal Reserve and the OCC, the “agencies”) issued a joint notice of proposed rulemaking (the “Market Risk Capital NPR”) concerning their market risk capital rules applicable to certain U.S. banking organizations with significant trading operations by proposing standards of creditworthiness to be used in place of credit ratings when calculating the specific risk capital requirements for covered debt and securitization positions, including the following:
In our paper, Does It Matter Who Pays for Bond Ratings? Historical Evidence, forthcoming in the Journal of Financial Economics, we examine whether charging issuers for bond ratings is associated with higher credit ratings employing the historical setting wherein S&P switched from an investor-pay to an issuer-pay model in 1974, four years after Moody’s made the same switch.
Many commentators and policy makers claim that charging bond issuers for ratings introduces conflicts of interest into the rating process. For corporate bonds issued between 1971 and 1978, we find that, for the same bond, Moody’s rating is higher than S&P’s rating prior to 1974 when only Moody’s charges issuers. After S&P adopts the issuer-pay model in July 1974, the evidence indicates that S&P’s ratings increase to the extent that they no longer differ from Moody’s ratings. Because we use Moody’s ratings for the same bond as our benchmark, we can conclude that this increase in S&P’s ratings is not due to general changes affecting bond ratings.
In the paper, Capital Structure and Debt Structure, forthcoming in the Review of Financial Studies, we use a novel data set on the debt structure of a large sample of rated public firms and show that debt heterogeneity is a first order aspect of firm capital structure. The majority of firms in our sample simultaneously use bank and non-bank debt, and we show that a unique focus on leverage ratios misses important variation in security issuance decisions. Furthermore, cross-sectional correlations between traditional determinants of capital structure (such as profitability) and different debt types are heterogeneous. These findings suggest that an understanding of corporate capital structure necessitates an understanding of how and why firms use multiple types, sources, and priorities of corporate debt.
The Financial Panic of 2008
The first signs of an impending financial crisis appeared in the US in 2007, when US real estate prices began to collapse and early delinquencies in recently underwritten sub-prime mortgages began to spike. It culminated in a genuine financial panic during September and October of 2008. The most serious recession since the Great Depression of the 1930s followed. The Federal Reserve and other organs of the US Government responded by flooding the markets with money and other liquidity, reducing interest rates, providing extraordinary assistance to major financial institutions, increasing Government spending, and taking other steps to provide financial assistance to the markets.
We are proposing rules today that are mandated by, or that are intended to implement, provisions in the Dodd-Frank Act relating to issuer and third-party review of the assets underlying asset-backed securities.
I believe that, properly crafted, these rules will provide decision-useful information to investors by enhancing transparency into the asset review process undertaken by issuers and by making available to investors the results of asset reviews conducted by issuers and third parties.
Late last month the SEC issued a final rule amending Regulation FD to eliminate the exemption for disclosures made to credit rating agencies. (Exchange Act Release No. 63003) The amendment, which becomes effective upon publication in the Federal Register, was specifically required by the Dodd-Frank Act. We do not view this as a material development as some have suggested.
Companies routinely disclose material, nonpublic information to credit rating agencies for the purpose of developing a credit rating, including in advance of merger announcements or in connection with significant changes in capital structures. While some commentators have suggested the amendment will require issuers to make public disclosures of material nonpublic information that they disclose to credit rating agencies, the effect of the amendment is less than it seems. The public disclosure requirements triggered by Regulation FD are limited to disclosures by the issuer, or persons acting on its behalf, to certain enumerated persons, generally securities market professionals, investment advisers and holders of the company’s securities under circumstances where it is reasonably foreseeable that the person will purchase or sell the issuer’s securities on the basis of the information. In 2006, the Investment Advisers Act was amended to exclude from the definition of investment adviser any nationally recognized statistical rating organization unless it engages in issuing recommendations as to purchasing, selling or holding securities or in managing assets (including securities) on behalf of others.