Unintended consequence – an unregulated U.S. credit rating industry? – The Scott McCleskey Report

November 11, 2010

By Scott McCleskey, Complinet

Suppose a law were passed that made driver licenses optional. If you want one, you’d still need to pass exams and pay fees every few years, and you’d be subject to fines for speeding and parking violations. Or you could just say ‘no thanks’, turn in your license, and get back on the road. Of course, no lawmaker would contemplate such a thing. But flawed provisions in the Dodd–Frank Act would do exactly that for the credit ratings agencies, making regulation an optional multimillion dollar expense.

The license in question is designation as a Nationally Recognized Statistical Rating Organization (NRSRO). Having this status used to mean something. NRSRO ratings have been written into the financial regulations for a good thirty years, so that the designation was a license to print money. Yet until Congress passed a law regulating them in 2006 (only implemented in late 2007), there were virtually no regulatory requirements imposed on NRSROs and their activities. We all know how that turned out.


The 2006 law imposed requirements, costs and penalties for non-compliance on the NRSROs, but it was still worth the bother to be one because the designation was required in order to do business. But the financial crisis exposed both the flaws in the way the NRSROs conducted their ratings and the widespread damage that their mistakes could cause, and the politicians were out for blood.

Putting a large portion of the blame on the rating agencies was not unfair. (Disclosure: I was responsible for compliance at one of the NRSROs, but have testified in Congress against the firm and we are no longer on speaking terms). Yet the policymakers’ obsession with killing off the NRSROs led them to take the foolhardy approach of requiring the removal of references to NRSRO ratings from all federal regulations. In so doing, they will remove the primary reason to be an NRSRO, taking away the benefit and leaving only the cost.

And the cost is not small: In the quarterly report most recently issued by Moody’s, the firm estimated the cost of complying with new regulations to increase by approximately $15m in 2010 and $15m to $25m in 2011. That’s on top of whatever they’re spending now, and it’s a safe bet that S&P and Fitch are also writing some pretty big checks. Only a fraction of that figure will actually go to compliance departments, as the figure no doubt includes defending themselves in court and the cost of lobbying Congress. Nonetheless, that’s all money they could keep if they didn’t have to comply with NRSRO regulations.

So why bother? At some point in the next few years, maybe sooner, the big NRSROs could say ‘no thanks’ to NRSRO status and de-register.


Would they really do it? You bet. The Big Three fired their warning shots right after Dodd–Frank passed, when all three refused (independently, mind you) to allow their ratings to go into offering documents because the new law removed their existing protection against liability. This collective labor strike effectively shut down new issuance of asset-backed securities, among other things. The SEC blinked, and for the time being has waived requirements that offerings include the rating. The rating agencies had made their point.

But regardless of whether they actually de-register, it is clear that the ultimate sanction under the 2006 law – losing the NRSRO license – is now an empty threat. By removing the risk of punishment for cutting corners or bad behavior by NRSROs, Congress has inadvertently created a whole new kind of moral hazard.


There are still remedies available. The most straightforward would be to change the scope of the 2006 law and the relevant Dodd-Frank provisions to apply to all credit rating agencies, rather than just NRSROs. Registration would no longer trigger oversight, but providing ratings would. Extending the reach of regulation this way would not be an easy task in a Congress where the GOP has just found its ‘mojo’, but even free marketeers should support the move rather than watch the rating agencies run and hide.

A swifter remedy would be to designate the major rating agencies as systemically important non-bank financial institutions. Doing so would require a few regulatory contortions but would bring the rating agencies under the purview of systemic risk regulations. This is better than nothing, but is not ideal since those regulations are aimed primarily at the financial soundness of targeted institutions. Also, they are not supervised by the SEC, where responsibility for NRSRO regulation currently lies.


The regulators’ ultimate weapon in the long run is to make rating agencies irrelevant by enabling financial institutions to do the job themselves. The SEC has already taken a big step in this direction by proposing rules for asset–backed securities which would require that the creator of the pools underlying the securities publish the relevant data on each loan in that pool, as well as relevant information such as payment priorities and credit enhancements. That is hugely significant. As long as the industry can’t assess creditworthiness efficiently by itself, firms will go to the rating agencies regardless of whether regulations require them to do so or not. But when it becomes cheaper for firms to do their own due diligence, raters will find themselves staring all day at a phone that doesn’t ring.

Whatever else happens, Congress would do well in the future to remember the warning of former SEC Chairman Christopher Cox: “Voluntary regulation doesn’t work.”

Scott McCleskey is managing editor, North America, at Complinet and is the author of When Free Markets Fail: Saving the Market When It Can’t Save Itself (John Wiley and Sons). The views he expresses in this column are his own and do not necessarily reflect those of Complinet or its parent, Thomson Reuters Inc.

Complinet, part of Thomson Reuters, is a leading provider of connected risk and compliance information and on-line solutions to the global financial services community. Established in 1997, Complinet serves over 100,000 industry professionals in 80+ countries. Our connected approach provides one single place to get all the relevant regulatory news, analysis, rules and developments from the region to support firms in highly regulated industries.

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