We have regularly written about the need to encourage rating agencies to be accurate and objective.
Last week, the Reason Foundation submitted a comment letter to the SEC that suggests an interesting angle to promoting healthy ratings competition.
First things first though. We think it’s unhealthy to simply promote ratings competition. That tends to lead to a decrease in standards as ever more raters fight for the same pie of new deals. But if they can be encouraged to compete on accuracy, the reputational model appropriately dismissed by JP Hunt comes back into play.
We think the Reason Foundation would agree with us on that. They argue that a random (or arbitrary) assigning of credit rating business, by a government-driven public or private utility or self-regulatory organization to NRSROs could “remove incentives to compete in this manner, and could thus result in worse rating methodologies. If a firm obtains no competitive benefit from publishing a more analytically robust methodology, it may stop making the investment in research to improve its methodologies.” (Our aside – business could or should better be allocated, proportionally, in line with historical performance.)
Here’s their coup de grâce. They put forth as one alternative a 3rd party “challenge” process, that challenges what are thought to be incorrectly assigned ratings. (Us again – we might encourage this for stale ratings too, perhaps defined as having been inaccurate for a period longer than 6 months.)
“Under such a system, an independent credit assessment firm could submit a statement to the Federal Reserve challenging the rating assigned by an NRSRO. If the Federal Reserve determined that the challenge had merit, it could ask the NRSRO to respond and potentially hold a public hearing to determine the validity of the challenge. If the Federal Reserve determined that the rating was flawed, the affected securities would attract a maximum capital charge until the rating agency issued a rating supported by the challenger or another rating agency selected by the issuer published a rating.”
If the challenging party had a tennis-like restricition on the number of challenges it may make, the challenge process (or the threat of being challenged) would encourage raters to be better focused on maintaining up-to-date, consistent, reliable and defensible ratings.
Perhaps if they were required to turn over ill-deserved or ill-gotten revenues for inaccurate ratings for the entire time they were inaccurate, we would see a desirable positive feedback loop: they would have a real financial incentive to remain accurate.
Posted on September 23, 2011
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