Opinion Riled over ratings

What are the problems with the rating agency market,and how has the market changed since the pre-crisis years?

First,the firms that sold the financial products usually are the ones who pay for the ratings. Despite the agencies’ protestations,“issuer pays” poses a serious conflict of interest,as rating agencies naturally want to please their customers,who are the people selling the products,not those buying them. In debating the Dodd-Frank act,the US Congress considered attacking this problem by randomly assigning the agency or agencies that would rate certain securities,but adopted an ambiguous provision whose only clear mandate was that the Securities and Exchange Commission study the issue. In the meantime,even smaller competitors that sought to market themselves as alternatives to the issuer-pays model have found themselves paid more and more by issuers rather than subscribers.

Second,the market has long been dominated by a few large US-based players and in the mid-2000s,Congress and the SEC tried to encourage competition by making it easier for new entrants to get into the market. Yet,despite the high-profile launch of new competitors such as Kroll and Morningstar,the SEC reports that the three largest incumbents,including S&P,still have 96 per cent of the market. A more fundamental problem is that when issuers pay,competition may be bad rather than good,as the agencies may compete to attract business by issuing lax ratings.

Third,US and international regulators have written credit ratings into financial rules such as capital regulations and rules for the instruments that money-market funds can invest in. This creates demand for ratings that exists more or less independent of their quality. Although US regulators,spurred by the Dodd-Frank act,have made progress in removing credit ratings from US regulations,credit ratings continue to be used in international regulation (and at the state level within the US). The more fundamental problem here is that private parties seem to want standard measures of credit quality,so poor-quality ratings are damaging even if they are removed from government rules.

Finally,there has been no clear way to hold rating agencies liable for poor performance unless it rises to the level of fraud. With some notable exceptions such as a 1500-page,AUD 30 million judgment in Australia against S&P last November that S&P has vowed to appeal,the agencies generally have escaped liability for their role in the financial crisis. One of the agencies’ major defences has been their claim that their ratings are merely journalistic opinions,protected by the US Constitution’s guarantees of freedom of speech and of the press. Of course,the agencies’ defences to liability face their most serious threat yet now that the US department of justice is deploying a novel theory of liability against S&P.

Unless there is some way of breaking free of the issuer-pays business model or displacing ratings from their central position in the financial system — both of which seem unlikely at the moment — accountability is a critical part of any strategy to avoid a repeat of the agencies’ behaviour leading up to 2007 and to deter agencies from rating deals “structured by cows”.

The writer is acting professor of law at the University of California,Davis,US