This blog article summarizes a recent article published in Banking and Financial Services Policy Report.Reference: Norbert J. Gaillard, “Coping with Reliance on Credit Ratings”, Banking and Financial Services Policy Report, Vol.35, No.7, July 2016.
This article analyzes how and why dependence on CRAs increased and argues that the elimination of ratings-based rules is needed yet finding substitutes for credit ratings is an arduous task.
From Reliance to Overreliance
Historically, the success of CRAs was driven not only by the boom of corporate bonded indebtedness in the United States in the 1910s-20s but also by the extensive use of credit ratings among businessmen, investors, journalists, lawyers, and statisticians.
The increasing reliance on credit ratings by the financial community resulted in the enactment, by the OCC, of the first rule to incorporate ratings. This text, which was officially released in September 1931 indicated that banks were to value their portfolios as follows. US government and municipal bonds as well as other domestic and foreign securities given the four highest ratings (Aaa/AAA, Aa/AA, A/A, and Baa/BBB) could be reported at face value. Domestic and foreign securities rated in the speculative-grade category (i.e., Ba/BB and below) would be reported at market value. This rule aimed to prevent high-grade bonds from being unfairly depreciated. In 1936, a second regulatory rule incorporating credit ratings was enacted by the OCC. This ruling, which did not concern US government and municipal bonds, was more stringent in that it prohibited the holding by banks of speculative-grade or defaulting bonds. These ratings-based regulations created regulatory licenses for major CRAs (Gaillard 2008).
Few regulations that referenced credit ratings were enacted until 1975, when the SEC’s amendment of Rule 15c3-1 introduced the concept of a nationally recognized statistical rating organization (NRSRO) for the purpose of categorizing debt as investment grade (or not) when calculating broker-dealer capital. This codification was a milestone in the history of the credit rating business. It constituted a barrier to new entrants that helped the initial NRSROs – Fitch, Moody’s and S&P – preserve their oligopoly and paved the way for extensive use of NRSRO ratings by US legislators and regulators.
Professor Frank Partnoy found that the number of SEC no-action letters and releases relying on NRSROs exceeded 100 in 1982 and reached 750 in 2000. At the turn of the 21st century, there were also 60 references to NRSRO ratings in the Code of Federal Regulations and eight in the United States Code (Partnoy 2002).
Credit ratings are generally used for five main regulatory purposes: calculating capital requirements; identifying or classifying assets, usually in the context of eligible investments or permissible asset concentrations; providing a credible evaluation of the credit risk associated with assets purchased as part of a securitization offering or a covered bond offering; determining disclosure requirements; and determining eligibility of a prospectus for public offering.
Eliminating Overreliance on Credit Ratings
Discussions about overreliance on credit ratings did not arise until the 2007-2008 turmoil in the subprime mortgage-related securities markets. In July 2008, the SEC reviewed the role of Fitch, Moody’s, and S&P in the crisis. The Commission identified flaws in their models and practices that had yielded inaccurate structured finance ratings (SEC 2008). Afterward, the SEC and the Permanent Subcommittee on Investigations (PSI) of the US Senate released reports that showed how CRAs had failed in their role as gatekeepers of the debt market (SEC 2009; US Senate 2010).
The conclusions of these investigations were instrumental in fashioning Title IX, Subtitle C (“Improvements to the Regulation of Credit Rating Agencies”) of the Dodd-Frank Act of July 2010. Section 939 of the Dodd-Frank Act removes statutory references to credit ratings and NRSROs from the Federal Deposit Insurance Act, the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, the Investment Company Act of 1940, the Securities Exchange Act of 1934, and section 5136A of title LXII of the Revised Statutes of the United States (12 U.S.C. 24a).
Section 939A mandates that each federal agency review “any regulation issued by such agency that requires the use of an assessment of the credit-worthiness of a security or money market instrument” and “any references to or requirements in such regulations regarding credit ratings.” Each such agency was required to modify any such regulations identified to “remove any reference to or requirement of reliance on credit ratings and to substitute in such regulations such standard of credit-worthiness as each respective agency determine[s] as appropriate for such regulations.”
The policy implemented by the SEC to reduce its reliance on ratings merits more detailed discussion. In July 2011, the Commission adopted new rules to remove credit ratings as eligibility criteria for companies filing Forms S-3 and F-3 – the short forms that eligible issuers can use to register securities offerings under the Securities Act of 1933. The previous investment-grade rating criterion was replaced with five alternative criteria. An offering of nonconvertible securities (other than common equity) is now eligible for registration if the issuer:
- has issued at least $1 billion in nonconvertible securities over the prior three years; or
- has outstanding at least $750 million of nonconvertible securities, other than common equity, issued in primary offerings for cash, not exchange, registered under the Securities Act; or
- is a wholly-owned subsidiary of a well-known seasoned issuer (WKSI) as defined in Rule 405 under the Securities Act; or
- is a majority-owned operating partnership of a real estate investment trust that qualifies as a WKSI; or
- discloses in the registration statement that it has a reasonable belief that it would have been eligible to register the securities offerings proposed to be registered under such registration statement pursuant to General Instruction I.B.2 of Form S-3 or Form F-3 in existence prior to the new rules and discloses the basis for such belief.
In December 2013, the SEC deleted references to credit ratings in Rule 15c3-1 (among other rules). New paragraphs of Rule 15c3-1 require that a broker-dealer establish, document, maintain, and enforce policies and procedures – to assess and monitor the creditworthiness of each security or money market instrument – that are reasonably designed for the purpose of determining whether the position has only a minimal amount of credit risk and thus permits the application of lower “haircuts” associated with commercial paper, nonconvertible debt, and preferred stock. When assessing whether a security or money market instrument has only a minimal amount of credit risk, a broker-dealer should consider (pursuant to the policies and procedures it establishes, documents, maintains, and enforces) the following factors: credit spreads, securities-related research, internal or external credit risk assessments, default statistics, the quality of the assets underlying structured finance products, and so forth.
In September 2015, the SEC adopted additional amendments to remove credit rating references in Rule 2a-7, which governs money market funds. As amended, Rule 2a-7 establishes that, in making its minimal credit risk determinations, a money market fund is required to consider these four factors when assessing the capacity of each security’s issuer or guarantor to meet its financial obligations:
- its financial condition (e.g., cash flow, revenue, expenses, profitability, short-term and total debt service coverage, and leverage);
- its sources of liquidity (e.g., bank lines of credit and alternative sources of liquidity);
- its ability to react to future marketwide and issuer- or guarantor-specific events (e.g., adverse evolution of yields or spreads); and
- its competitive position in its industry (e.g., the diversification of its sources of revenue).
Beyond Eliminating Overreliance on Credit Ratings
In order to help prevent future economic meltdowns due to misinformation about securities risk, it is necessary but not sufficient to drastically reduce regulatory reliance on the ratings published by CRAs. US federal agencies should bear in mind that the development of ratings-based regulatory rules was driven by investors’ extensive use of credit ratings. That phenomenon is still in evidence today. Regulators should therefore continue to supervise CRAs.
A de-emphasis on credit ratings is complicated by the difficulty of finding robust substitutes. The five alternative criteria proposed by the SEC to replace investment-grade rating criteria on Forms S-3 and F-3 have a signal weakness: they fail to reflect the issuer’s solvency. The amendments to remove references to credit ratings in Rule 15c3-1 are certainly a step in the right direction because they encourage broker-dealers to develop their own capacity for credit risk assessment and due diligence.
The only credible alternative to external ratings is for banks, insurance companies, and major registered investment companies and private funds (e.g., those with more than $50 billion in assets under management) to develop internal ratings and to use them for regulatory purposes. Regulators would be responsible for monitoring, testing, and “back testing” these internal ratings on a regular basis.
- Gaillard N. (2008), Les méthodologies de notation souveraine, PhD Dissertation, Sciences Po Paris.
- Partnoy F. (2002), “The Paradox of Credit Ratings” in R. Levich, G. Majnoni, and C. Reinhart (Eds.), Ratings, Rating Agencies and the Global Financial System, Kluwer Academic Publishers.
- SEC (July 8, 2008), Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies.
- SEC (August 27, 2009), The SEC’s Role Regarding and Oversight of Nationally Recognized Statistical Rating Organizations (NRSROs), Report No.458.
- SEC (various years), various releases.
- US Senate (April 23, 2010), PSI, Exhibits – Hearing on Wall Street and the Financial Crisis: The Role of Credit Rating Agencies.