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Jeffrey Manns is an Associate Professor at the George Washington University Law School.
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Break Up the Rating Agency Oligopoly

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Editor's note: A version of this post originally appeared at Structured Finance News.

The financial crisis starkly exposed the need for rating agency reform, yet the most important questions of how to enhance rating agency competition, accuracy, and accountability remain largely unanswered.

The Dodd-Frank Act promised to overhaul the industry through sweeping reforms. But the Securities and Exchange Commission has struggled to implement the act's competing, if not contradictory, objectives: marginalizing ratings; exposing rating agencies to greater sunlight and private liability exposure; and treating rating agencies as a regulated industry.

I advocate a new approach to reform: breaking up the rating agency oligopoly.

Antitrust law does not regulate oligopolies unless there is express collusion or review of a prospective merger. But regulators could encourage the leading rating agencies to divest by requiring independent, non-affiliated firms to rate each category of debt, such as government and corporate bonds, and barring raters from issuing evaluations for more than one asset category.

Raters would face the choice of vacating segments of the market or spinning off parts of their business into freestanding companies. For example, if raters of asset-backed securities had to be independent from rating agencies for other types of debt issues, then raters would have a single-minded focus on determining the risks of this asset class that played such a prominent role in triggering the financial crisis. This approach would remove the potential for rating agencies to give deferential ratings to asset-backed securities in exchange for kickbacks of retaining or securing other aspects of an issuer's business. Phasing in this reform over a number of years would give the leading rating agencies time to break up their business into multiple entities to maximize shareholder value and provide smaller rating agencies or new entrants with time to focus on a particular sector.

The SEC has made progress in increasing oversight and addressing the most egregious abuses that fueled the financial crisis, but its implementation of Dodd-Frank has failed to transform the industry in any meaningful way.

The biggest shortcoming of the Dodd-Frank Act is its failure to resolve the basic questions of how to create meaningful competition in an oligopolistic industry and how to encourage accurate and timely ratings. Congress sidestepped directly addressing these difficult questions, leaving the SEC with the unenviable task of providing some degree of coherence to Congress's spectrum of solutions.

The most important part of the Dodd-Frank Act remains the most unresolved: the SEC's mandate to design an alternative for the conflicts of interest created by debt issuers' selecting their rating agency gatekeepers. Commentators have long bemoaned the inherent conflict of having debt issuers select their rating agency gatekeepers as raters understandably do not want to bite the hands that feed them. The Government Accountability Office and the SEC have conducted a series of studies on alternatives for the issuer-pays system, yet have shied away from concrete action to overhaul the industry.

The proposal that appears to have garnered the most support during the SEC's comment period is the creation of an independent board or commission to select rating agencies for structured finance products. This approach would build on the Franken Amendment. But prospects for reform have foundered due to the intrinsic shortcomings of the potential methods to select and compensate rating agencies based on either random assignment, rotation of rating agencies, or performance-based metrics.

For example, a random assignment or rotation approach would eliminate the problem of issuers' selecting rating agencies. Yet neither approach would do anything to create incentives for rating agency accuracy. In the name of fostering the growth of smaller rating agencies, it could potentially create an entitlement system for private rating agencies that would receive assignments and funding solely due to their status as Nationally Recognized Statistical Rating Organizations.

The challenge of any performance-based selection and compensation is that no clear consensus exists on what performance-based standards to use to assess rating agencies. Proposals have suggested creating peer comparison models to examine whether rating agencies' percentage of predicted default of debt instruments deviated from that of their peers and whether annual yields of identically rated debt securities from different asset classes varied in a significant way. The dilemma of either of these performance-based metrics is that they may accentuate herding effects. Rating agencies would have greater incentives to engage in conscious parallelism to avoid liability, which could undercut the objectives of greater accuracy and accountability. Herding effects are already an issue in an oligopolistic industry, and the solution could worsen the problem. Additionally, whatever benchmark is used would swiftly become the centerpiece of rating agencies' methodologies, regardless of whether the standards incentivize accuracy and timeliness.

Breaking up the rating agency oligopoly would avoid the pitfalls that each of the other proposals face and effectively boost competition. Creating incentives for the leading rating agencies to break themselves up would foster the creation of smaller entities that would share in the reputational umbrella of their larger predecessors. In this way, policymakers could fast-track the creation of a competitive pool of smaller rating agencies that enjoy market credibility. This approach would also open up the possibility for smaller rating agencies to more plausibly compete, because a set of industry monoliths would not crowd out their competitors.

Jeffrey Manns is an Associate Professor at the George Washington University Law School and the author of a recent paper, Downgrading Rating Agency Reform.

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Comments (6)
I think that the author has correctly identified the problem: too few in the ratings business, meaning not enough competition and therefore too little market discipline. I also believe that he has identified the cure, namely, more competitors. I don't think that his means gets us there, though. Just "breaking up" the existing firms could actually be counterproductive as it increases government involvement in the rating business, reinforcing incentives for firms to succeed by political pull rather than by market success. It is that heavy-handed government involvement that has given us the highly constrained competitive environment. I would suggest giving a closer look to barriers to entry for newcomers in the ratings business and doing as much as possible to remove barriers to entry that act as shields against competition.
Posted by WayneAbernathy | Wednesday, September 04 2013 at 11:25AM ET
Wayne, thank you for your always thoughtful comments. To play devil's advocate: Is more competition necessarily desirable under an issuer-pays model? Mightn't lowering barriers for entry increase the risk of issuers shopping for the most lenient treatment, e.g. picking the agency (or agencies) that require the weakest credit enhancement levels to grant a AAA rating in a securitization structure? During the housing boom we saw a race to the bottom among mortgage originators to win loans by lowering ("expanding") underwriting standards. In the short term this could be said to have benefited the consumers, who got to buy bigger/fancier houses and/or owe lower (initial) monthly payments. But we know how it turned out for all involved...On the other hand, you could argue that over the long run, those rating agencies whose ratings hold up best should find the strongest demand among investors, and therefore issuers. But the learning process, a.k.a. market adjustments, can be painful (see housing again)....Related question: if we agree that lowering barriers to entry is a desirable means, does that mean dropping the government's NRSO "seal of approval"? I welcome Wayne's and other readers' thoughts.
Posted by Marc Hochstein, Executive Editor, American Banker | Wednesday, September 04 2013 at 12:01PM ET
Raters had been around for almost a century prior to the sub-prime lending debacle. The problem is that risk-based capital rules allowed bankers to use regulatory arbitrage based on ratings that left little or no issuer capital in securitization. It is banking regulation that needs to change!
Posted by kvillani | Wednesday, September 04 2013 at 12:21PM ET
The proposal in this article is ridiculous. Any proposal that begins with "regulators should force this particular restructuring of the [insert here] industry and micromanage its operation" is prima facie wrongheaded. In the real world, what benefit would there be to having a bunch of narrow oligopolies each operating in an asset class under the supervision of bureaucrats who aren't smart enough to succeed in the private sector?

There is nothing inherently wrong with the issuer-pays model. Regulators caused the problems in the rating industry when they defined an oligopoly of agencies as acceptable for institutional investor decisions and financial institution capital requirements. Before regulators meddled, the major agencies competed on the basis of their credibility with investors; that competition for reputation was the market discipline enforcing quality work by the agencies. Once the regulators insulated the major agencies from competition by giving, de jure, blanket endorsement of their reputations as NRSOs, that market discipline dissolved and issuers and sell-side bankers began to call the tune.

Mr. Abernathy is correct: remove the barriers to entry and allow the free market to determine which rating agencies are most credible. Absolutely we should eliminate the NRSO regime and allow the market to evolve naturally. Issuers will then select agencies based on whose rating will be most effective in getting their bonds sold by being most credible with investors; this appraisal is made not by issuers, but by investors.

Limiting rating franchises to narrow asset classes would do nothing to address the real problem. Reforming the industry to re-establish reputation and credibility as the bases of competition is the answer. This will be accomplished by returning to the free market and getting the regulators out of the way.
Posted by Bob Newton | Wednesday, September 04 2013 at 4:32PM ET
Marc, fair questions. My answers would be similar to the points raised by Bob Newton. Issuers may want to shop for the most favorable rating, but the rating matters most to investors, who will want to rely upon the most credible rating program. In the end, issuers will want to be rated by the firm whom their investors most rely upon.

The collapse in quality for mortgage originators that helped feed the housing bubble came about specifically because of inadequate market discipline, diluted by the various government and GSE guaranties. Without those government guaranties masking underwriting standards, investors would have demanded some sort of proof of adequate underwriting before they ponied up their money.

Do we need an NRSO to act as some sort of standard setter for the rating agencies? I would tend to think not. My fear is that if you have such a federal standard it can become a tool for the existing rating agencies to block new entrants and new competition. Without an NRSO standard a firm would have to stand on quality, rather than a government seal of approval, to attract business.

Painful learning curve? Maybe, but I think that starting from where we are now, the current rating agencies would have an "early entrants'" advantage because they are already known and have customers who rely on them. Their challenge would be to take their performance up a notch (or two) to retain customers, while new entrants would have to offer powerfully convincing evidence to attract their first customers, which that may not be a bad thing.
Posted by WayneAbernathy | Wednesday, September 04 2013 at 4:52PM ET
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