Forging a Hybrid Model for Credit Rating Agency Reform
August 20, 2013
Regulators tasked with reforming the credit rating industry have been hesitant to rock the boat, taking great pains to explore every option. Furthermore, the fact that structured products such as securitized mortgages and loans are the main target of scrutiny, yet have been the most profitable line of business for these firms, presents a considerable headwind against reforms. As a result, talks have slipped beneath the waters, floundering along in slow motion. Recently we discussed a prominent aEURoerating clearinghouseaEUR? proposal that has raised industry objections. The table below provides a brief review of the options before regulators up to this point. The debates and negotiations of the last few years have put a spotlight on the weaknesses of a range of proposals. With that education under its belt, the SEC must construct a model that effectively erases the conflict-of-interest problem, yet avoids regulatory overreach. It must furthermore be operationally feasible and affordable to implement. Whatever the eventual formula, it should take heed of those constraints. First, it needs to prevent conflicts of interest and aEURoerating shopping,aEUR? in which issuers seek out the agency that offers the highest appraisal. To do that, it must actually be utilized, unlike the inert Rule 17g-5 program, an early effort that failed to motivate agencies and investors to participate. Also, solving one conflict of interest could create new ones if incentives are not managed carefully. The investor-owned models run this risk, as investors have an interest in seeing advantageous rating results just as issuers do. One important distinction to make, when designing a solution, is whether the conflict stems more from the payment mechanism (i.e., who pays the agency), or from the selection mechanism (i.e., who selects the agency). In the process, it should take care to avoid regulatory overreach. Legislation and regulation can be too ambitious or aggressive; policies can have unintended consequences. In this case, investorsaEUR(TM) free access to ratings must be preserved, competition within the industry should not be undermined, and issuers should not be overly burdened. Third, it should be operationally feasible. The complexity of rating deals under the new regime should not overwhelm regulatorsaEUR(TM) capacity or an assigned agencyaEUR(TM)s expertise. Without the requisite experience, a central clearing party or assigned agency could cause delays, and the quality of service could decline. Therefore, whatever system is put in place must speedily and efficiently handle the deal type and flow and adequately compensate the rating agencies. Preferably, it wouldnaEUR(TM)t require legislation to enumerate new powers for it to work. Questions of cost and feasibility have tended to plague the Section 15E(w) program, as well as the stand-alone and designation models. Lastly, it should be affordable to implement. A serious loss of market efficiency would be unacceptable, and the cost of forming a new oversight body would be prohibitive. Even increasing the size of a regulatory agency may be a nonstarter when government is trying to do the opposite. One approach that could combine these lessons is a hybrid model, in which issuers and investors are stakeholders of a fund that is responsible only for collecting fees from new issuances (from issuers) and secondary transactions (from investors) as well as disbursing payments to selected agencies. Unlike the clearinghouse model, the fund would have no active role in selecting agencies to rate securities. Rather, agencies would initially be placed in a random queue to receive assignments, unless they were unable to rate a particular issue. Along with randomization, the qualification of agencies capable of rating complex structured transactions would be built into the process, rather than decided later by a centralized body. In the future, assignments would be determined by performance. This solution would cover most of the constraints discussed above and takes a step toward satisfying the question of feasibility. It breaks many of the links between issuer, agency, payment, and selection that often generate conflicts of interest. By bringing issuers and investors together as stakeholders, it balances the various conflicts between raters, issuers, and investors. Although it might sacrifice deal speed and volume because it would be blind to individual NRSRO competencies, it requires no new government oversight board or clearinghouse responsible for determining assignments. Queuing up agencies that are prequalified to rate structured deals would still achieve the random assignment effect. Though imperfect, such a hybrid model would be a step forward in a dormant effort, with strengths that reformers can build upon.