Rating Agencies vs the Regulators – What It Means for You

One of the less predictable consequences of the recession has been the amount of ink and pixels devoted to rating agencies in the past two years. This week Warren Buffet was subpoenaed to appear before the Financial Crisis Inquiry Commission to discuss the causes of the crisis and the role played by ratings agencies. He defended them, saying, “They made a mistake that virtually everyone in the country made.”

On the other side of the argument, the European Union announced that it would consider setting-up its own European rating agency; a spokesman for Standard & Poor’s said, “We welcome any and all competition, but ultimately investors and the market will determine which ratings are credible and useful.”

Regulators’ Reaction around the Globe

What is certain is that new rating agency regulation is on its way:

• As an industry first, the Securities and Exchange Board of India, the Indian financial markets regulator devised a ruling that makes it mandatory for rating agencies to undergo an annual audit of, “all aspects of their operations”.

• The European Union will set up a new regulator for credit rating agencies that could be given even broader powers at a later date. Rating agencies will have to register with the Committee of European Securities Regulators and submit to greater oversight from national supervisors. The plan also proposes a rotating schedule for the senior officials that approve credit ratings, to promote greater independence and prevent the build-up of excessively ‘close’ relationships with the financial sector.

• The International Organization of Securities Commissions updated its code of conduct for rating agencies in May ’08 to improve investor protection.

• The United States Senate on 13^th May approved two amendments to the financial regulatory bill, including one proposal that would force federal officials to come up with alternative methods for judging securities and other investments as a way of limiting the reliance on rating agencies. The move is aimed at preventing the sellers of securities from ‘shopping around’ for the best rating.

Potential Changes Still to Come

Many commentators and legislators feel that ratings agencies face conflicts of interest, in particular because the agencies charge the company that floats the financial instrument being rated, and because they can charge the same clients for advisory services on how to achieve a better rating.

Other proposals we’ve seen discussed in our research on rating agency regulation are:

• Compulsory disclosure of the entire set of data used by agencies to devise a rating
• Overhaul of the entire rating business model, the issue of ‘who pays’ is an important part of this assessment.
• Enforcing the payment of an upfront fee by the issuer irrespective of the ratings issued and banning ‘credit shopping’.
• Making rating agencies a standalone business where they will be financed by a ‘transaction fee’ and not an ‘advice fee’.

What it All Means

Despite the hot air that politicians will expel doing their best ‘defense of the public’ routine, no sane regulator will seriously hobble one of the most important parts of the world’s capital markets.

So regulators will likely change how rating agencies can charge clients, and over some of the roles the agencies are seen to play in the markets. But it is unlikely that they will make fundamental changes to how rating agencies gather information and make decisions on rating a particular company.

Firms that have to deal with rating agencies should watch three things for now:

• Given the ‘front end’ changes that will be required of rating agencies (how they interact with clients, charge fees etc), expect the cost of acquiring a rating to rise. Regulators will make a show of making it harder for rating agencies to turn a profit.

• Whenever new rules are introduced people are initially more conservative than they would otherwise be. It will be the same for ratings analysts; expect it to be harder to acquire a favorable rating and easier for your firm to be downgraded.

• Keep an eye on new legislation and on CEB (we’ll be monitoring on your behalf) to see whether anything more fundamental is coming down the track.

And, most of all, hold on – it could be a bumpy ride.