Credit Rating Agency: its value to the market

Increasing participants in the industry has posed additional responsibility on the jobs of Credit Rating Agencies. Ratings issues by CRAs is considered to be public goods and has a greater influencing power. Despite the pervasive and influential power wielded by S&P, Moody’s and Fitch to shape markets and capital flows (granted by virtue of their exclusive oligopoly franchise which enables the three firms to control 94% of the industry) these firms have historically been able to escape regulation and oversight, including any degree of accountability for their ratings when such ratings are revealed as false. We have witnessed the lack of accountability and diligence of CRAs in case of Enron and WorldCom due to little regulations. Thus it is important to design a framework under which the system can work with better accountability and reliability. Regulation should not be considered as a hurdle as it will be just delegation of additional responsibilities of regulatory body to these CRAs. It will address the problem of due diligence, better mechanism and a more transparent system promoting larger number of market participants. However if I look on the other side then in some ways, governance of credit rating agencies or regulating them is a thornier problem than the governance of auditors. The only regulatory oversight of note for rating agencies is the NRSRO (nationally recognized statistical rating organization), status conferred by the SEC as a means to limit exposure to credit risk. Four credit rating agencies have NRSRO status - Moody's, Standard & Poor's, the Fitch Group and Dominion Bond Rating Service. If the issue is considered deeply, then the question arises that does designing standards that few can qualify will help the system in any means? Conferring the status to just four CRAs indicates that intentionally or unintentionally the event of regulation has been to create what is in effect a government-sponsored cartel. Even though S&P managers decline to accept that the regulatory body has helped their business in any ways as it creates barriers to entry and granting regulatory licenses. However, this issue can be taken care if the regulations promote entry of more CRAs and competition among them will force each of them for quality work and would address the issue of free riding.
The responsibility to choose among rating agencies and their services should be a decision of investors, financial advisors, issuers, creditors and other users of ratings—in short, to the market. A competitive market test, not a bureaucratic process, will then determine which rating agencies turn out to be widely accepted by the predominant users of ratings, and competition will provide its normal benefits. It will be a welcome decision as firms giving rating will have an opportunity to prove themselves with quality work rather than being subject to governmental shadow which will save them from any recourse. The alternative of having investors purchase the credit ratings arguably creates a superior incentive structure. Value of rating as well as of the firm will be dependent on the quality of work and its effect on market efficiency. This was the original historical model for the first 50 years of the rating agency business. If investors pay, it obviously removes the potential conflict of interest and any tendency toward a “race to the bottom” in ratings quality. I think this radical change will be a welcome change in the roles of agencies as it will not only address the issue of conflict of interest, current dual monopoly status of the top agencies but also redefine the system which will reflect more transparent methodology, better accountability and bigger participation in agency role.
Of course, a fully competitive rating agency market will not happen all at once and it will not be easy to grow business over a short span of time as there are significant natural (as well as the SEC’s artificial) barriers to entry in this sector, including the need to establish reputation, reliability, and integrity. Brand value of the rating agencies will be a determining factor when requesting for rating. Nevertheless, in time, innovation and better products can overcome such barriers, when not prevented by regulation and providing equal opportunities to all market participants. The desirable transition to a competitive rating agency sector would be evolutionary as I believe that the market will have a positive reaction to the fact that the agencies are no more ties to the regulatory regime and the opinion is issues not for the sake of marketing the bond but to give a picture of all the risks involved with it and its actual measure.
I recommend that a regulatory body be formed with a voluntary system to promote competition and fair play with all the advantages to customers that competition will bring, including better prices, more customer choice, more innovation, greater efficiency, and reduced potential conflicts of interest.