The detrimental role of credit rating agencies Moody’s, S&P, and Fitch in the credit boom and bust has been widely documented. 

The U.S. Financial Crisis Inquiry Commission’s report said “the three credit rating agencies were key enablers of the financial meltdown." A European Parliament report highlighted three key problems in the industry: lack of competition, over-reliance on external ratings in the regulatory framework, and no liability for ratings by the agencies. Further, ratings changes are lagging indicators: downgrades or upgrades mostly reflect information already analyzed and digested by financial markets.

In response, regulators and legislators on both sides of the Atlantic drafted new rules to reduce the intrusion of rating agencies in the regulatory framework. 

Unfortunately, recent regulatory developments in the U.S. and the U.K. attempt to reverse these efforts to dethrone rating agencies. Likewise, the sovereign debt crisis in Europe and the debt-ceiling debate in the U.S. have also given rating agencies a perfect opportunity to reinsert themselves back into the headlines and resurrect their own relevance by making tired pronouncements about sovereign ratings.

Section 939A of the Dodd-Frank Wall Street Reform Act, passed in July 2010, calls for U.S. regulatory agencies to review and remove all references to credit ratings from the regulatory framework.  Last month, the Federal Reserve Board issued a report to Congress reviewing the use of credit ratings in its regulations and identified 46 references to credit ratings, the majority of which, not surprisingly, appear in capital adequacy measures for banks, such as risk-weighting.  The Fed concluded by saying it will propose amendments to remove references to credit ratings from its capital requirements and rely on substitute standards of creditworthiness for capital calculations that currently rely on external ratings. 

This initiative to develop alternative methods to calculate bank capital will continue through December 2011.  An important consequence, though, is that the implementation in the United States of Basel II (long overdue) and Basel 2.5 (the Basel rule specifically focused on market risk) will most likely be further delayed given the vast use of external ratings in those regimes.

Basel II, in various forms, has been in place for European banks for some years. The European Commission, the executive body of the EU, also just released the draft for CRD IV (Capital Requirements Directive, the mechanism by which the EU translates Basel guidelines into regulation) to implement Basel III; an important element of the CRD is an effort to reduce the use of external ratings. This directive does not go as far as Dodd-Frank to remove all references to ratings, but when banks have material exposures to certain assets, European regulators prefer that banks develop their own internal credit opinions. 

CRD IV also incorporates ideas from two earlier documents.  The Financial Stability Board, established in 2009 and hosted by the Bank for International Settlements, released a report in October 2010 entitled Principles for Reducing Reliance on CRA Ratings – clear enough!

In a March 2011 report, the European Parliament again called for the reduction in the use of external ratings. Crucially, this report goes further and calls for rating agencies to be exposed to civil liability for their ratings in the event of gross negligence or misconduct.

This is an important point in the context of bank capital.  The role of rating agencies in the 21st century has evolved from just being intermediaries of information. External ratings are now embedded in banks’ regulatory requirements and serve to officially endorse or certify different capital measures, such as the assignment of risk weights to securitization exposures and the determination of eligibility of certain guarantors and collateral for purposes of credit risk mitigation.  The European Parliament report concludes: “if external credit ratings fulfill a regulatory purpose they should not be classified as mere opinions, and … rating agencies should be held accountable for the consistent application of the underlying methodology of their credit ratings.”

In the U.S., it is important to note, Dodd-Frank tried to do just that by rescinding Rule 436(g) of the Securities Act of 1933, which exempted rating agencies from expert liability – the same expert liability faced by accounting firms, for example.  Subsequently, the consumer asset-backed securities market came to a halt as rating agencies refused to allow their ratings to appear in prospectuses and registration statements.  The SEC came to the rescue with two “no action” letters allowing issuers to omit ratings indefinitely.

But even more troublesome, the House Financial Services Committee last month passed the Asset-Backed Market Stabilization Act of 2011 reinstating Rule 436(g) and protecting rating agencies from liability.  Proponents say that this is necessary to avert the shutdown of the ABS market, but is cutting back the liability of rating agencies the way to go?  The lesson of the financial crisis is to make rating agencies more accountable for their actions, not less. This bill takes a giant step backward in this regard.

The same reversal of fortune for the rating agencies is also taking place in the United Kingdom, whose Financial Services Authority in May released a consultation paper strongly criticizing the use of bank internal models to calculate capital for securitization exposures, a method known as the supervisory formula method. Rather, the FSA indicated its preference for the use of external ratings rather than banks’ own credit assessments in determining risk-weightings; the FSA will “expect firms to obtain a public rating on retained tranches to apply the Ratings Based Approach (RBA) instead of using the Supervisory Formula Method (SFM).” 

It is still unclear how significant this one document will be or how it will mesh with directives coming from the EU and other standard-setters such as the Fed, but the idea that a leading bank regulator is advocating for the use of external credit ratings is concerning enough and goes against the grain of recent regulatory initiatives.

Lastly, the continuing crises surrounding sovereign debts and national deficits from Greece to Portugal to the United States are affording rating agencies another opportunity to boost their own importance. By threatening the imminent downgrade of the ratings for these countries, the rating agencies keep their names in the news and constantly rattle the chains of issuers, regulators, and investors.  

Yet their pronouncements never really give any new information.  But that is the rating agencies’ secret to success: it is not the information contained in a downgrade or upgrade which is newsworthy, it is the rating change itself which is supposedly newsworthy. 

In a new global regulatory framework, the role of rating agencies must be trimmed back and banks must be encouraged to develop standardized methods of calculating risk and capital as a substitute for external ratings. Conversely, to the extent that rating agencies fulfill a regulatory role, they must be held accountable.

Michael Shemi is a director at Christofferson, Robb & Co., a money management firm with offices in New York and London.