Harvey Pitt has recently been designated by the Bush administration to be the next chairman of the Securities and Exchange Commission. After taking office, he will face a festering problem that is the antithesis of the SECs self-portrayal as the champion of fair, efficient, and competitive financial markets.
Im referring to the SECs entry barriers that protect the three large bond-rating firms Moodys Investors Service, Standard & Poors, and Fitch and prevent bond market participants from making their own decisions as to whether these rating firms provide worthwhile services.
As a former financial regulator, I have a solution for Mr. Pitt that would eliminate the barriers, enhance competition among bond raters, and clarify the role of the bond raters. Financial regulators must cease delegating safety decisions about bonds to the rating firms and instead develop and enforce their own safety criteria. The SEC could take the lead and then let the bond markets make their own decisions about the rating firms.
Since 1931 financial safety regulators have required banks and, subsequently, insurance companies and pension funds to heed ratings when investing in bonds. The SEC entered this arena in 1975, creating a new regulatory category: nationally recognized statistical rating organization.
The SEC had a legitimate concern: Whose ratings should be heeded? A bogus rating firm might bestow an AAA rating on the bonds of any company at all.
The SECs subsequent actions, however, were less benign. After grandfathering Moodys, S&P, and Fitch as nationally recognized, the SEC designated only two additional organizations in the early 1980s and then just two more a decade later. The agency has not approved any new entity since 1992, and all the newcomers have consolidated with Fitch.
Meanwhile other regulators have embraced the category and greatly expanded their safety regulations employing the recognized rating firms ratings. The proposal issued in January by the Basel Committee on Banking Supervision would further expand the regulatory demand for ratings.
Though a handful of small, niche rating firms exist, the absence of SEC recognition is a serious impediment to expansion or new entry. A bond issuers senior management has limited time to tell raters its financial story. Will General Motors executives talk to Upstart Rater Inc., whose rating cannot help GM sell its bonds to any regulated financial institution? Or will they talk only to Moodys, S&P, and Fitch?
Bond issuers governments as well as companies often complain about the arbitrary power of Moodys or S&P, especially after a downgrading. And the bond raters power may rest at least as much on their protected position as on their accuracy in predicting defaults.
Equivalently, because of the regulator-based demand for ratings and the SECs regulatory restriction on supply, there has not been an independent market test of the bond raters services since 1975.
In 1997 the SEC proposed formalizing the criteria that it had been using informally for its (infrequent) rating-firm recognitions. It specified five necessary characteristics:
Recognition as an issuer of credible and reliable ratings by the predominant users of securities ratings in the United States.
Adequate staffing, financial resources, and organizational structure.
Use of systematic rating procedures.
Contacts with managements of bond issuers.
Internal procedures to prevent misuse of nonpublic information.
Three-plus years later the SEC has not adopted its proposals. That is a blessing in disguise: The first characteristic would be instantly recognized by Yossarian, the protagonist of Catch-22, and the remaining four are indicators of inputs into the rating process rather than measures of results or the efficacy of a rating firm. Small or innovative rating firms would not qualify, and the SECs barriers to entry would be formally set in thicker regulatory concrete.
What should be done? As a stopgap, the SEC must cease erecting unnecessary entry barriers. It must scrap its three-year-old proposal and start over, focusing on the criterion that financial safety regulators care about most: a rating firms accuracy in predicting a bonds default and the extent of loss in the event of default.
Financial regulators must cease delegating safety decisions about bonds to the rating firms and instead develop and enforce their own safety criteria. The SEC could then abolish the nationally recognized category and the accompanying designations of companies. The bond raters fates, including those of entrants, would be decided in the financial markets.
Mr. White is a former chief economist at the Justice Department who now teaches economics in New York University's Stern School of Business.