Bernie Sanders offered a big financial reform idea during the 2016 campaign: convert credit rating agencies into not-for-profit entities. Like former Senator Al Franken, Sanders recognized that the rating agency business model is fundamentally broken: bond issuers pay for credit ratings and pit the agencies against one another in the pursuit of lower credit standards. This analytical race to the bottom resulted in all three agencies assigning AAA ratings to toxic mortgage-backed securities in the run-up to the 2008 financial crisis. Although the solutions offered by Franken and Sanders are outside the realm of possibility under a Republican Congress, incremental progress may be feasible.
In 2010, Franken offered an amendment to the Dodd-Frank Act that would have placed a firewall between bond issuers and rating agencies. Instead of selecting agencies directly, issuers would have had to go to an independent selection body that would hire a rating agency on their behalf. This way, rating agencies could retain their “issuer pays” business model without having to dumb down their credit standards to remain in business. Franken’s amendment was stripped just before Dodd Frank passed. Instead, the new law instructed the Securities and Exchange Commission to study Franken’s idea, and in 2013, the SEC opted not to do anything.
Sanders’ approach would have also ended the practice of ratings shopping by doing away with rating agencies’ profit motive. But even if Sanders had won the general election, he would have faced tough challenges in implementing his idea. Moody’s and S&P are publicly traded companies with tens of billions in market capitalization, mostly attributable to their ratings franchises. A forced conversion of these ratings businesses into non-profits would have destroyed massive amounts of shareholder wealth. Stockholders might have challenged the reform as an unconstitutional “taking”, triggering years of litigation.
Neither Franken nor Sanders’ ideas are going to find their way into the current Congress’ financial legislation. The full House and the Senate Banking Committee have approved bills that scale back some Dodd Frank reforms. The current Senate bill does not change credit rating agency regulation, while the House bill, known as the Financial CHOICE Act, eliminates some Dodd Frank provisions related to credit rating agencies.
But the House bill leaves in place an onerous SEC registration process for rating agencies that keeps out new competitors. To become a Nationally Recognized Statistical Rating Organization (an NRSRO), an agency must submit ten letters from Qualified Institutional Buyers (QIB) stating that they have happily used the agency’s services for three years. This is a high barrier, first because financial institutions are reluctant to place themselves on the SEC’s radar, by, for example, signing a QIB letter. Second, it may be hard for start-ups to operate profitably for three years without a government license against the big three rating agencies who are publishing and monitoring hundreds of thousands of credit ratings at no charge to investors. For more discussion of SEC rating agency regulation, please see my new Reason Foundation study.
On some level, the SEC’s registration process is understandable: we don’t want unscrupulous rating agency startups publishing poorly researched or inflated ratings. But, on the other hand, the SEC has erected barriers to entry that reduce competition against established credit rating agencies, allowing them to do shoddy work while making large profits.
One way forward would be for Congress to order the SEC to register not-for-profit credit rating agencies under a streamlined process. Many universities and some think tanks have the analytical skills needed to produce credit ratings and may be interested in joining the fray. The National University of Singapore’s business school has a Credit Risk Initiative that produces model-based corporate credit assessments. Several top US universities could match the NUS initiative domestically.
One not-for-profit that has demonstrated an ability to provide objective, high quality rating services over several decades is Consumers Union. While bonds are admittedly different from consumer products, the analysis provided in CU’s magazine (Consumer Reports) often approaches the intellectual complexity required to meaningfully assess debt securities. Although many ratings in CR are the result of simple consumer surveys, others involve the creation and implementation of complex testing procedures by industry experts.
A Democratic takeover of Congress may shift the debate in 2019, but successful legislation this year will most likely require a deregulatory narrative. Relaxing SEC regulations to allow non-profits to compete against established rating agencies should not offend Republican sensibilities. Perhaps it is an idea that could be attached to the Senate’s financial bill when it reaches the floor.
Marc Joffe is a Senior Policy Analyst at the Reason Foundation and a guest contributor to the Oxford Business Law Blog.