In the wake of the financial crisis, countries across the globe have put in place or are considering new regulatory regimes designed to produce greater accountability, transparency and oversight for credit rating agencies. But as new regulations are developed, questions have surfaced. What are the goals of such regulation? How does one create a framework that avoids regulatory arbitrage? What can be done to reduce undue reliance on ratings?
Credit ratings are intended to address one aspect of an investment decision—credit quality—although they are sometimes incorrectly used by investors for other purposes.
It is important to recognize that they have a limited function and should not be unduly relied upon. Their role as opinions of the relative creditworthiness of an issuer or issue is an important one, which is why regulation of them needs to be carefully considered and well-conceived.
Standard & Poor’s believes any new regulatory architecture should focus on the following goals:
Safety and soundness of financial markets
Business conduct based on transparency and fair dealing
Efficient and cost-effective regulation with alignment of responsibilities among different marketplace participants
Consistent regulation across similar businesses
Internationally consistent standards and coordinated enforcement
Adaptable to accommodate future innovations and changes in market structure
Analytically sound, independent, and unbiased credit ratings, including independence in establishing analytical criteria and methodologies and
Fair and healthy competition among rating agencies encouraging different views on creditworthiness to benefit investors.
We believe that well-crafted regulation of credit rating agencies can serve to meet the goals described above. It can also enhance the ratings process and restore investor confidence through consistent application of practical and flexible standards coupled with appropriate regulatory supervision. While regulation should never dictate how a rating agency performs its analysis, a well-functioning ratings process can benefit the economy as a whole by contributing to greater investor confidence. In order to address areas where investors and policymakers have identified gaps and key issues in the current regulatory regime for credit rating agencies, we have highlighted below the significant investor concerns and expectations we have heard and how we believe regulation might enhance the process.
1. Independently-derived, credible, and unconflicted credit ratings
Appropriate regulation that addresses the effective management of potential conflicts of interest can only benefit the marketplace. This is an area where regulation can be particularly helpful by requiring credit rating agencies to promote ratings quality and market confidence, provided that regulators protect analytical independence by avoiding rules and examination processes that interfere with the substance of ratings opinions and an agency’s analytics.
2. The meaning and use of ratings should be clear
Rating agencies should be transparent about the meaning and limitations of their ratings—for example, clarifying that credit ratings do not address the suitability of a security for any individual investor. Regulation that encourages transparency regarding the nature of rating agency opinions and pertinent information used in the ratings process could help enhance investor knowledge.
3. Consistency and comparability of ratings across asset classes and geographies—accountability for ratings quality
Regulation that requires rating agencies to publicly disclose their ratings performance statistics across asset classes and geographies would aid market participants in assessing ratings quality.
4. Transparency and soundness of analysis
Regulation that requires robust disclosure of the ratings process, including criteria and methodologies for assigning and updating ratings, would give investors additional information to make informed decisions, to compare ratings, and to form their own opinions on the soundness of an agency’s analytics. Regulation could also require identification of the models and underlying assumptions used in a rating agency’s analysis. In addition, regulation that requires agencies to publicize their ratings performance statistics enhances the market’s ability to draw comparisons across geographies, certain asset classes and with competitors and informs independent investor analysis. Rating agencies could add to this informational process by making personnel available to explain their methodologies to users.
5. Ratings on different securities should be differentiated
The financial crisis highlighted the need for markets to better understand the meaning of ratings, including ratings on structured finance securities, and how they differ from other ratings. Regulation could play a role in enhancing transparency about those differences.
6. Availability of information
Rating agencies that operate under an issuer-pay business model receive confidential information from issuers and others throughout the ratings and surveillance process. Regulation that requires agencies to follow policies and procedures to avoid the disclosure and misuse of confidential information would be consistent with current securities regulation. Where markets and regulators believe the confidential information should be made available to a rating agency’s competitors or to others, regulation should require issuers and others responsible for the quality of that data to make this information available to such parties.
7. Regulatory oversight
Regulation that provides for regulatory authorities to check agencies’ compliance with their processes and policies can be beneficial to promoting ratings quality and market confidence, provided that regulators protect analytical independence by avoiding rules and examination processes that interfere with the substance of ratings opinions and an agency’s analytics.
8. Competitive market for ratings with more and varying views on credit quality from qualified providers
Ratings based on a high degree of integrity and intellectual rigor benefit the marketplace. A registration regime for rating agencies that follows globally consistent standards can be beneficial, but regulators should be transparent about the criteria they use in accepting applications, including the need for sufficient analytical and financial resources. Regulation that requires disclosure about staffing, number of ratings issued, and training requirements would allow regulators to make more informed decisions regarding the adequacy of an agency’s resources. Regulators could also increase their ability to evaluate agencies by analyzing financial information from agencies provided to regulators on a confidential basis. However, regulators must protect analytical independence and not attempt to supplant their own judgments about ratings analysis for that of independent rating agencies. Evaluations as to the quality of ratings and ratings processes should be left ultimately to the market.
Regulation of credit rating agencies remains important. While many steps have been taken, more work remains to be done. In particular, the harmonization of existing regulation and proposed regulation will be critical.
Because the financial markets are global, a regulatory framework that provides consistent standards across jurisdictions can promote greater investor confidence and, ultimately, improved capital flows and economic growth, maintain policies and procedures that address potential conflicts of interest at the institutional and staff levels. These include a code of ethics that requires disclosure of potential conflicts and how they are managed, with oversight of the code’s effective application for all rating agency business models. Regulations could also prohibit activities that are clearly anticompetitive.