CRAs – Essential Industry with a Checkered Past and Problematic Future

In this article, we explore the history of credit rating agencies (CRAs), where agency conflicts arise, and possible conflict mitigation. Note, CRA flaws raised within do not even address the essential underlying problem that the rating industry is an oligopoly with all the related downsides.

History of Credit Rating Agencies

Rating agencies in the United States developed primarily around the turn of the 20^th century with the boom in railroad bond issues. Such corporate and later, sovereign, ratings proved invaluable to investors and the industry grew. However, the CRAs’ business model was subscription based, i.e., ratings paid by rating buyers. This limited CRA revenues because it did not provide returns sufficient to justify the demand for faster and more comprehensive service.¹ In 1975, a new issuer-pay model was adopted by the big three nationally recognized statistical rating organizations (NRSRO)—Moody’s, S&P and Fitch—and most other raters.

The new issuer-pay model solved two problems: (1) limits to revenue growth and (2) “free riders” who use ratings after they are made public. The issuer-pay model benefits the investment market because all market participants can access the rating information at the same time. For this reason, issuers would still be willing to pay for ratings because they can maximize their product prices when investors are better informed. Issuers would pass expenses to securities buyers.

Also, the investor-pay model eliminated CRAs’ information advantage compared to the issuer-pay model, under which the CRAs had special information access.

Credit Rating Agency Conflict

The credit rating industry has since been plagued by conspicuous conflicts of interest, which has led to sometimes egregious rating inflation. The catastrophic failure of CRAs’ role as financial information intermediaries during the Financial Crisis, c.2008, is a well-known example of this.

• First, conflicts of interest derive mainly from the fact that CRAs are paid by issuers under the issuer-pay model. Issuers can exert pressure on CRAs for higher ratings by shopping CRAs which leads to rating inflation because CRAs are under pressure to produce more lax ratings to retain issuers’ business.² However, investors are the principles of rating services for which the CRAs’ work is done, even though issuers contract and pay for CRAs, thus creating a conflict of interest. United States v. Arthur Young & Co. held that a public gatekeeper (an auditor) should always maintain total independence from the client and require complete fidelity to the public trust.³ CRAs should also remain independent from the corporations or entities who pay for services and be accountable to the public.
• Second, the reputational cost was insufficient to motivate CRAs to eliminate conflicts of interest.⁴ Between the 1970s and the 2000s, most believed the major CRAs navigated a good balance between avoiding conflicts of interest and preserving the CRA’s reputation by separating internal operating procedures from analysts’ compensation policies. This arrangement worked until the profits from the booming market for new financial products no longer provided sufficient incentives to mitigate conflicts of interest. The quality of ratings progressively declined when the market peaked between the start of 2005 and mid-2007.⁵ CRAs are more likely to inflate the quality of investment when investors are more trusting and/or when the CRAs’ expected reputational costs are lower, particularly during economic boom times.⁶
• Third, established policies and practices failed to staunch conflicts of interest. CRAs insisted they had effective policies under self-regulation, such as requiring rating decisions to be made by a rating committee, imposing investment restrictions, adhering to fixed fee schedules, and separating the ratings services from the influence of other businesses.⁷ In practice, conflicts of interest were not well managed.

US Regulation Options

To enhance the oversight and integrity of NRSROs and to address the conflicts of interest issue and the financial damage they can and did cause, there were two primary pieces of legislation:

The Credit Rating Agency Reform Act of 2006 (the Reform Act) – The goal of the Reform Act was to improve ratings quality for the protection of investors. In the 12 months that ended in June 2011, the SEC found the big three and their flawed methodology still issued 97% of all credit ratings, down from 98% in 2007.⁸

The Dodd–Frank Wall Street Reform and Consumer Protection Act 2010 (Dodd–Frank Act) – Regarding Dodd-Frank, Congress’s initiative has not been acted upon nor has the SEC implemented any of the recommendations.

According to the US Government Accountability Office (US GAO), a third piece of legislation, the Franken Amendment/Random Selection Model is the most favored model, although there is no agreement on its adoption.

Finally, the EU model for managing and regulating CRAs has some support in the US. It imposes shareholding limitation rules and the mandatory analyst-rotation rule to eliminate influence on credit ratings and the process. It also imposes mandatory rating rotation and the double-rating rule, which should reduce untoward relationships between CRAs and issuers, and eliminate the potential for rating shopping.

Conclusion: A Balanced Solution

The EU law appears more effective in reducing the conflicts of interest and focuses on dealing with the “disease” and a balanced cure. In the US, legal reforms are modestly successful, although gaps still exist because the SEC did not fully carry out Congress’s intentions, such as failing to improve the issuer-pay model.

So where do we go from here? The SEC should continue to enhance the compliance of NRSROs. The most important provision under the US law should be to adopt an alternative remuneration model and to replace the issuer-pay model. Although this was proposed by US Congress, the SEC failed to put the initiatives into effect.

The solution for this problem can be two-fold: to adopt the modified Franken Amendment/Random Selection Model or to adopt the EU-like multifaceted approach without overhauling the existing remuneration system.

An approach incorporating the EU model might be a workable compromise, whereby the US regulators would consider adopting the shareholding limitation, the mandatory contract rotation and the double rating rules. The reality is that the problem of conflicts of interest and rating inflation continues to impose a formidable challenge to the rating industry.

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¹ Richard Cantor and Frank Packer, ‘The Credit Rating Industry’ (1994) FRBNY Quarterly Review/Summer–Fall 4.
² John Coffee, ‘The Ratings Agencies’, Gatekeepers: The Professions and Corporate Governance (OUP 2006) 295.
³ United States v Arthur Young & Co (1984) 465 US 805, 818–19.
⁴ Gianluca Mattarocci, ‘Rating Agencies and the Rating Service’, The Independence of Credit Rating Agen (Elsevier 2014), ch. 1.2; Sinclair (n 1) 424.
⁵ Boom Adam Ashcraft, Paul Goldsmith-Pinkham and James Vickery, ‘MBS Ratings and the Mortgage Credit’ (2010) Federal Reserve Bank of New York Staff Reports, No 449, 1.33
⁶ Patrick Bolton, Xaiver Freixas and Joel Shapiro, ‘The Credit Ratings Game’ (2012) 67 Journal of Finance 88, 96.
⁷ Amadou NR Sy, ‘The Systemic Regulation of Credit Rating Agencies and Rated Markets’ (2009) International Monetary Fund, WP/09/129, 9.
⁸ Gordon, Greg (August 7, 2013). "Industry wrote provision that undercuts credit-rating overhaul", McClatchy Newspapers. https://www.mcclatchydc.com/news/nation-world/national/economy/article24751870.html