Exploring the Oversight of Credit Rating Agencies

For a long time, credit rating agencies have been in the spotlight for the wrong reasons in both India and abroad. The issue first emerged during the Lehman crisis, but it was the downgrading of Amtek Auto and subsequently ILFS and DHFL that brought the Indian rating agencies under intense scrutiny. In response, the Securities and Exchange Board of India (SEBI) recently proposed new norms that could significantly alter the credit ratings business in the country. This article delves into the mechanisms that regulate credit rating agencies, with a focus on the United States' system and the ongoing debate over market self-regulation.

SEC and NRSROs: A Tale of Rigorous Oversight

In the United States, the Securities and Exchange Commission (SEC) plays a pivotal role in managing credit rating agencies. Specifically, the SEC determines which credit rating agencies should be designated as Nationally Recognized Statistical Rating Organizations (NRSROs). This designation is of utmost importance as it grants the agency a legal status that allows it to issue ratings that are considered 'securities' under U.S. law. If necessary, the SEC can revoke this designation, as demonstrated with the case of Egan-Jones.

The Egan-Jones Case: A Cautionary Tale

Egan-Jones exemplifies what can happen when a rating agency lacks credibility. In 2008, Egan-Jones gained NRSRO status by the SEC, setting it apart from the other major agencies such as SP, Moody's, and Fitch. However, in 2013, Egan-Jones was found to have lied to the SEC, resulting in the revocation of its NRSRO status. This case highlights the potential for bias and dishonesty within these agencies, particularly when they are paid by securities issuers. Unlike Egan-Jones, other major rating agencies were accused of being biased in favor of their clients, leading to a situation where only those who could afford to pay could obtain their ratings.

Market Regulation and Conflicts of Interest

While the SEC's role in designating NRSROs is crucial, it is not the only mechanism in place to regulate these agencies. The market itself plays a significant role in holding credit rating agencies accountable through self-regulation. If enough ratings are perceived as incorrect or biased, investors will cease to buy these ratings, and issuers will stop using them as well. This mechanism is effective, but it operates under the assumption that the market is efficient and that ratings decisions are made in the best interest of investors.

McGraw-Hill and Credit Conflicts

A notable exception to the general rule is SP Global, which is owned by the McGraw-Hill Company (MHC) and rated by Moody's, Fitch, and other NRSROs. This creates a conflict of interest, as SP Global's ratings can be seen as indicative of Standard Poor's ratings. Even though companies and countries are never rated as a whole, only their securities can be, this interconnectedness underscores the importance of maintaining strict standards.

The Curious Case of Quis Custodiet Ipsos Custodes?

The Latin phrase 'quis custodiet ipsos custodes' sums up the inherent challenges in regulating credit rating agencies. While the SEC confers and can revoke the legal status of NRSROs, the effectiveness of this mechanism is limited. The market takes years to assess the accuracy of ratings, which is not fast enough to prevent misinformed investments.

Exploring Alternative Measures

Another angle of inquiry involves considering whether credit default swap pricing can provide a more accurate measure of bond credit risk than the ratings issued by NRSROs. This question challenges the prevailing belief that credit ratings are the most reliable indicator of risk. Credit default swaps (CDS) reflect the collective opinion of the market on the creditworthiness of bonds, potentially offering a more transparent and dynamic assessment of risk.

In conclusion, while the SEC plays a vital role in regulating credit rating agencies through the designation of NRSROs, the effective oversight of these agencies remains a complex and multifaceted issue. The interplay between market regulation and the potential for conflicts of interest underscores the need for continuous scrutiny and innovation in regulatory frameworks.