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An Analysis of Federal Financial Regulation Creating an Environment for Credit Rating Agency Oligopoly and its Subsequent Effect on the 2008 Financial Crisis

Authors:

Emily Ekins

Cato Institute

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Lessons from a Monopoly Model: Shifting Demand

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Historical Stock Prices 1998-2011: Moody's vs. Dow Jones and S&P 500 Indices

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Moody's Goodwill from Balance Sheet

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Comparison between Moody's, S&P, and Fitch Rating Scales Long-Term Rating Scales Comparison

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Executive Summary

During the financial crisis of 2008, the finan-

cial markets would have been better served if

the credit rating agency industry had been more

competitive. We present evidence that suggests

the Securities and Exchange Commission’s des-

ignation of Nationally Recognized Statistical

Rating Organizations (NRSROs) inadvertently

created a de facto oligopoly, which primar-

ily propped up three firms: Moody’s, S&P, and

Fitch. We also explain the rationale behind the

NRSRO designation given to credit rating agen-

cies (CRAs) and demonstrate that it was not in-

tended to be an oligopolistic mechanism or to

reduce investor due diligence, but rather was

intended to protect consumers. Although CRAs

were indirectly constrained by their reputation

among investors, the lack of competition al-

lowed for greater market complacency. Govern-

ment regulatory use of credit ratings inflated the

market demand for NRSRO ratings, despite the

decreasing informational value of credit ratings.

It is unlikely that this sort of regulatory frame-

work could result in anything except misaligned

incentives among economic actors and distort-

ed market information that provides inaccurate

signals to investors and other financial actors.

Given the importance of our capital infrastruc-

ture and the power of credit rating agencies in

our financial markets, and despite the good in-

tentions of the uses of the NRSRO designation,

it is not worth the cost and should be abolished.

Regulators should work to eliminate regulatory

reliance on credit ratings for financial safety

and soundness. These regulatory reforms will,

in turn, reduce CRA oligopolistic power and the

artificial demand for their ratings.

Regulation, Market Structure,

and Role of the Credit Rating Agencies

by Emily McClintock Ekins and Mark A. Calabria

No. 704 August 1, 2012

Mark A. Calabria is the director of financial regulation studies at the Cato Institute. Emily Ekins is a research fellow

at the Cato Institute, director of polling at Reason Foundation, and a PhD student at the University of California,

Los Angeles.

Miscalculations

by issuers,

investors, credit

rating agencies,

and regulators

contributed

to the crisis,

but such

miscalculations

should have

come as no

surprise given

the incentive

structure of

our financial

markets.

Introduction

Starting in late summer 2007, credit rat-

ing agencies (CRAs) began extensive down-

grading of mortgage-backed assets and con-

tinued to downgrade them through the fall

of 2008. On September 15, 2008, Moody’s,

Standard and Poor’s (S&P), and Fitch down-

graded American International Group (AIG),

the nation’s largest insurance company, af-

ter which AIG’s stock price fell 61 percent.

The same day, Lehman Brothers and Merrill

Lynch filed for bankruptcy, just months after

Bear Stearns declared its insolvency. Several

days afterward, U.S. Treasury Secretary Hen-

ry Paulson and Federal Reserve Chairman

Ben Bernanke asked Congress for the ability

to purchase $700 billion in bad mortgage-re-

lated debt. President George W. Bush warned

that without the bailout the “entire economy

was in danger.”

The credit rating agencies’ downgrading

of assets did not cause the financial crisis of

2008, but they did shock the world in how

they revealed what were apparently inflated

ratings for corporate debt. Miscalculations

by issuers, investors, credit rating agencies,

and regulators contributed to the crisis, but

such miscalculations should have come as

no surprise given the incentive structure of

our financial markets.

This policy analysis does not seek to ex-

plain all the causes of the financial crisis. In-

stead, we focus on the role that regulations,

implemented in 1936 by the U.S. Comptrol-

ler of the Currency and in 1973 by the Secu-

rities and Exchange Commission (SEC), had

in creating regulatory dependency on desig-

nated credit rating agencies’ ratings.1 These

regulations resulted in reduced competition

and inflated market demand in the CRA in-

dustry, which in turn likely led to sustained

complacency in ratings’ methodologies and

potentially allowed for massive risk to go ig-

nored in the marketplace.

The financial markets would have been

better served if the credit rating agency in-

dustry had been more competitive. We pres-

ent evidence that suggests the Securities and

Exchange Commission’s (SEC) designation

of Nationally Recognized Statistical Rat-

ing Organizations (NRSROs) inadvertently

created a de facto oligopoly, which primar-

ily propped up three firms: Moody’s, S&P,

and Fitch. The NRSRO designation given to

credit rating agencies was not intended to be

an oligopolistic mechanism or to reduce in-

vestor due diligence, but rather was intended

to protect consumers. Although CRAs were

indirectly constrained by their reputation

among investors, the lack of competition al-

lowed for greater market complacency. Gov-

ernment regulatory use of credit ratings in-

flated market demand for NRSRO ratings,

despite the decreasing informational value of

credit ratings.

Our analysis demonstrates how well-

intentioned regulation can have unantici-

pated effects, and, in some cases, these unin-

tended consequences become part of a perfect

storm of other problems contributing to a fi-

nancial crisis. We must consider not just the

intended effects of regulatory proposals, but

also the second- and third-order effects of the

regulations. Once those have been considered,

we should conduct a cost-benefit analysis. In

the case of the NRSRO designation and its

use in regulations, it is unlikely that this sort

of regulatory framework could result in any-

thing except misaligned incentives among

economic actors and distorted market infor-

mation that provides inaccurate signals to in-

vestors and other financial actors. Given the

importance of our capital infrastructure and

the power of credit rating agencies in our fi-

nancial markets, and despite the good inten-

tions of the uses of the NRSRO designation, it

is not worth the cost and should be abolished.

Regulators should work to eliminate regulato-

ry reliance on credit ratings for financial safety

and soundness. These regulatory reforms will,

in turn, reduce CRA oligopolistic power and

the artificial demand for their ratings.

We review the origins of the credit rating

agency industry, what credit ratings agencies

and their ratings do in the marketplace, and

how the industry became regulated. We then

examine the evidence to determine if the CRA

industry became a de facto oligopoly with

complacent rating methodologies, whether it

had captive and inflated demand, and what

impacts it had on the financial markets.

Credit Rating Agencies

What Credit Rating Agencies Do

Credit rating agencies offer predictions

as to the likelihood that a particular debt

instrument will be repaid, in part or whole.

Ratings can be offered on general corporate

debt, in which case it is the overall financial

health of the company that is being ana-

lyzed. Ratings can also be based on the credit

risk of assets within a pooled security, such

as a mortgage-backed security. Prior to the

Great Depression, rating agencies also of-

fered some limited analysis of corporate eq-

uity values. The major rating agencies have

generally asserted that they assess only credit

risk and do not offer judgments as to losses

that arise from an instrument’s liquidity or

lack thereof. Debate continues whether the

losses witnessed during the recent financial

panic were more the result of credit or liquid-

ity losses, but we will not attempt to settle

that debate here.

In the case of an asset-backed security the

security’s issuers purchase loans from banks,

such as mortgages or corporate debt, and re-

package the risk into a financial product that

is purchased by investors as an investment ve-

hicle. Investors pay issuers for the financial

instrument and in return they receive the

principal and interest paid on the debt (see

Figure 1). However, debt is not always repaid

The major rating

agencies have

generally asserted

that they assess

only credit risk

and do not offer

judgments as

to losses that

arise from an

instrument’s

liquidity or lack

thereof.

Figure 1

The Role of Credit Rating Agencies

Source: Figure constructed by authors.

Key: Solid lines represent asset transfer, dashed lines represent indirect payment transfer, and dotted line repre-

sents information transfer.

Generally, ratings

change only if

the prospects

of default

actually change

by a significant

amount, rather

than if there is a

change in

short-run

credit risk.

and thus investors have an interest in know-

ing the probability that they will be repaid.

Credit rating agencies provide a solution to

the information asymmetries between inves-

tors and financial firms that issue financial

products by providing risk assessments in

the form of creditworthiness gradations for

financial products, such as with an ordinal

scale, with the intent to make it easier for

investors to compare different potential in-

vestments (see Table 1). Essentially, investors

want to know the credit risk associated with

debt instruments, such as corporate debt or

mortgage-backed securities, in which they

are about to invest. As lenders innovate new

ways of repackaging risk in complicated se-

curitized financial products, investors are

even more interested in the amount of risk

associated with these new products. A com-

parison between ratings scales for Moody’s,

S&P, and Fitch can be found in Table 2.

Credit rating agencies do not frequently

incorporate new information that may im-

pact currently issued credit ratings, thus al-

lowing these ratings to remain fairly stable

over time. Generally, ratings change only if

the prospects of default actually change by a

significant amount, rather than if there is a

change in short-run credit risk. This is called

“rating through the cycle” rather than rating

at a “point in time.”2 For example, parties

who intend to hold assets over a long period

Table 1

Generic Moody’s Credit Ratings Scale

Rating Rating Definition

Aaa Obligations rated Aaa are judged to be of the highest quality, with minimal credit

risk

Aa Obligations rated Aa are judged to be of high quality and are subject to very low

credit risk

AObligations rated A are considered upper-medium grade and are subject to low

credit risk

Baa Obligations rated Baa are subject to moderate credit risk. They are considered

medium grade and, as such, may possess certain speculative characteristics

Ba Obligations rated Ba are judged to have speculative elements and are subject to

substantial credit risk

BObligations rated B are considered speculative and are subject to high credit risk

Caa Obligations rated Caa are judged to be of poor standing and are subject to very

high credit risk

Ca Obligations rated Ca are highly speculative and are likely in, or very near, default,

with some prospect of recovery of principal and interest

CObligations rated C are the lowest-rated class and are typically in default, with

little prospect for recovery of principal or interest

Source: Moody’s Investors Service, “Rating Symbols and Definitions: January 2011,” http://www.moodys.com/

researchdocumentcontent page.aspx?docid=PBC_79004.

Note: Moody’s appends numerical modifiers 1, 2, and 3 to each generic rating classification from Aa through

Caa. The modifier 1 indicates that the obligation ranks in the higher end of its generic rating category, the

modifier 2 indicates a mid-range ranking, and the modifier 3 indicates a ranking in the lower end of that generic

rating category.

Frequently

changing credit

ratings could

potentially

raise the cost

of financial

instruments.

may be less interested in small changes that

may be reversed with regular market move-

ments. This method imposes fewer direct

costs on issuers and investors since they

may devote fewer resources to ensuring they

are in compliance with regulatory capital

requirements. Moreover, contracts between

firms and investors often include “rating

triggers” that are impacted by the credit rat-

ings. A rating trigger is a contractual obliga-

tion to repay more quickly, provide more

collateral, or any other such requirement.

Frequently changing credit ratings could

potentially raise the cost of financial instru-

ments, as they could be subject to greater

volatility and thus trigger faster repayment

or additional collateral. For instance, when

the CRAs downgraded AIG, the company

was required to raise additional collateral,

which contributed to its liquidity crisis.

In general, the original point of these rat-

ings was to help investors make better deci-

sions about what financial products to invest

in. They also pressure issuers to respect their

obligations, as well as assist in the market

pricing of debt instruments. To prove that

they add value beyond that already reflected

in market prices, credit ratings need to dem-

onstrate accuracy over time. As the actual

performance of the rating will not be discov-

ered until long after its issuance, if even then,

reputation can serve as an important source

of market discipline, with changes to reputa-

tion having significant impact on credit rat-

ing agencies’ profitability and success.

The CRA business model generally works

in one of two ways. Credit rating agencies

can rate financial products and make those

ratings available though a subscription ser-

vice to investors. In this business model,

CRAs’ primary clients are investors, and the

CRAs have an incentive to keep ratings ac-

curate so that investors will continue to pay

their accurate ratings. The other CRA busi-

ness model is for CRAs to sell individual

ratings to financial-product issuers. The is-

suers then sell the financial products to in-

vestors, using the associated credit ratings

as a form of “certification.” In this model,

CRAs’ primary clients are issuers, and CRAs

have some incentive to rate higher, but with-

in what is credible, since their reputations

matter to investors who purchase the rated

financial products from the CRAs’ primary

clients. In a competitive market, market par-

ticipants would diminish the value of rat-

Table 2

Comparison between Moody’s, S&P, and Fitch Rating Scales

Long-Term Rating Scales Comparison

Standard & Poor’s AAA AA+ AA AA- A+ AA-

Moody’s Aaa Aa1 Aa2 Aa3 A1 A2 A3

Fitch IBCA AAA AA+ AA AA- A+ AA-

Standard & Poor’s BBB+ BBB BBB- BB+ BB BB- B+ BB-

Moody’s Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3

Fitch IBCA BBB+ BBB BBB- BB+ BB BB- B+ BB-

Standard & Poor’s CCC+ CCC CCC- CC C D

Moody’s Caa1 Caa2 Caa3 Ca C

Fitch IBCA CCC+ CCC CCC- CC C D

Source: Bank for International Settlements, “Long-term Rating Scales Comparison,” http://www.bis.org/bcbs/

qis/qisrating.htm.

There is some

evidence that

investors do

distinguish

among the

different rating

agencies on the

basis of quality.

ings inflation by discounting ratings that

were inflated simply to please issuers. There

is some evidence that investors do distin-

guish among the different rating agencies

on the basis of quality, as found in a recent

empirical study by Livingston, Wei, and

Zhou, which added to previous studies find-

ing similar results.3 The authors help to rec-

oncile previous findings that while issuers

view S&P as being more accurate, investors

favor Moody’s.4 Their findings suggest that

it is the view of investors that ultimately has

a greater impact on bond prices.

Typically, issuers purchase two credit rat-

ings for each financial product, and some-

times three if the first two are split.5 Inves-

tors, however, typically rely on only one

rating. When the investor is a commercial

bank and when multiple ratings exist for a

security, capital rules generally require the

lower rating to be utilized for calculating

risk-weighted capital. Financial regulations

usually require only a single rating when de-

termining whether a particular asset can be

“held,” and, in the case of multiple ratings,

allow the higher rating to be used to deter-

mine whether an asset is eligible to be held.6

The History of Rating Agencies

The present-day credit rating industry

has a long history, beginning in the 19th

century with financial publishing. The Mer-

cantile Agency, one of the first credit report-

ing agencies, was formed in 1841 and used

a network of agents to gather information

on operating statistics, business standing,

and creditworthiness on businesses. (In fact,

Lewis Tappan established the Mercantile

Agency to ameliorate information asymme-

tries that likely led to the financial crisis of

1837.) It then disseminated this information

to subscribers. Eventually what became to-

day’s credit rating agencies first emerged at

the turn of the 20th century, as publishers

from the financial press, such as John Moody

and Henry Poor, began collecting finan-

cial and operating statistics on the railroad

bond market and selling the information to

subscribers. This information collection in-

cluded examining the quality of a business’s

portfolio of opportunities and the manage-

ment’s success in pursuing these opportu-

nities, its ability to respect debt obligations,

and its tendency to honor debts.7 Eventu-

ally this information was used to create an

estimate of risk associated with corporate

debt. What we would now recognize as credit

ratings were first issued by Moody’s Analy-

ses Publishing Company in 1909, H. V. and

H. W. Poor Company in 1916, Standard Sta-

tistics Company in 1922, and Fitch Publish-

ing Company in 1924.8 Langohr and Lan-

gohr argue that the expansion of the credit

rating industry formed an information in-

frastructure necessary for bond markets to

expand throughout the 20th century.9

During the Great Depression, John

Moody’s and Henry Poor’s credit rating firms

performed well, with their highly rated bonds

being significantly less likely to default dur-

ing a period of high bond default rates. This

bolstered these companies’ reputations for

accuracy and dependability. Between World

War II and the 1970s, the financial markets

experienced relative stability, but innovation

stagnated. For this reason, CRAs were only

modestly profitable.

Major structural shifts took place during

the later part of the 1960s and the 1970s,

as market-based corporate funding became

more common and the demand for ratings

increased rapidly. The conduct of credit

analysis is a function of banks and credit

rating agencies. These entities compete in

the marketplace for the provision of credit

analysis. Commercial bank credit analysis

usually takes place in the context of a loan,

often held on its balance sheet, whereas rat-

ing agency analysis is performed in concert

with the issuance of a marketable debt in-

strument. As inflation began to accelerate in

the late 1960s and 1970s, commercial banks

and thrifts found it increasingly difficult to

raise deposits because of the legal limit, un-

der Regulation Q, on what they could pay

depositors. The extension of Regulation Q

to savings and loans in 1966 further restrict-

ed the ability of traditional lenders to pro-

The

inflation-induced

disintermediation

of bank business

lending led to

the growth of

the nonfinancial

commercial paper

market, which

tripled in size

between 1975

and 1980.

vide credit. Others, such as mutual funds,

found that banks’ funding problems pre-

sented a business opportunity in the provi-

sion of credit. As these other market partici-

pants generally lacked an infrastructure to

conduct extensive bank-like credit analysis,

they turned to the major rating agencies.

The first segment to undergo this tran-

sition was business lending. While railroad

bonds had served as the catalyst for the

growth of the U.S. corporate bond market,

until the 1960s other nonfinancial indus-

tries still relied almost exclusively on either

bank loans or internal funding for their fi-

nancing needs. The inflation-induced disin-

termediation of bank business lending led to

the growth of the nonfinancial commercial

paper market, which tripled in size between

1975 and 1980.10 The longer-maturity cor-

porate bond market grew by 80 percent dur-

ing these same years. With this growth in

the structured finance market also came an

increasing demand for credit ratings.11 Then

the boom of the U.S. residential mortgage-

backed securities and home-equity loan

markets rapidly increased the structured fi-

nance market. Starting in the 1980s, another

contributing factor to increased demand

was globalization, which enticed credit rat-

ings agencies to expand beyond the United

States. Agencies opened offices in the United

Kingdom, Japan, France, Australia, Canada,

India, Sweden, Russia, Mexico, and Austra-

lia. Thus, globalization and the introduction

of new financial products to be rated drove

greater demand for CRA products and ac-

counted for a large share of CRAs’ profitabil-

ity.12

In response to changes in the market-

place, in 1974 Standard and Poor’s shifted

its business model and began charging is-

suers for ratings rather than charging a

subscription service to investors. Lawrence

White points out that this business model

transition also coincided with the spread of

low-cost photocopying that led to free rid-

ing among investors, who would share rat-

ings.13 The 1970 Penn Central default on

$82 million in commercial paper, followed

by liquidity crises, also refocused attention

on the importance of credit risk. As issuers

wanted to assure investors of quality rat-

ings, they began actively seeking out rat-

ings. As market demand for ratings shifted,

CRAs began charging issuers rather than in-

vestors.14 This business model change also

coincided with the SEC introducing the

NRSRO designation and incorporating it

into regulations.

The History of Credit Rating Agency

Regulation

While the financial markets were chang-

ing and structured finance grew, govern-

ment regulators also played a key role in

the credit rating agency industry.15 Regula-

tors did not seek to regulate CRAs directly,

but rather used credit ratings as a means

to oversee the financial markets. Securities

and Exchange Commission regulators wrote

many rules that specifically identified CRAs,

thereby indirectly creating a regulatory

framework reliant on CRAs.

The first set of regulations involving cred-

it rating agencies went into effect after the

onset of the banking crisis in March 1931.

Banks were in need of greater liquidity fol-

lowing the onset of the Great Depression,

and so they dumped their lower grade bonds

on the market, which contributed to the

overall decline in bond prices. This lower val-

uation of bonds reduced the market value of

bank’s bond portfolios overall and contrib-

uted to bank failures, demonstrating that

bond values, rather than simply defaults,

also mattered to bank survival.16 Conse-

quently, the Office of the Comptroller of the

Currency (OCC) set out to regulate banks’

capital reserves with the hopes of preventing

future bank failures. To do this, the OCC set

minimum capital reserve requirements to

ensure banks did not become overleveraged.

To ensure compliance with the new reg-

ulations, the OCC looked for an outside

group with expertise in evaluating bonds to

determine how much risk, and thereby, how

much value, was associated with banks’ as-

sets. Credit ratings helped the OCC conduct

Obtaining a

designation was

not necessary

for credit

rating agencies

to operate,

but doing so

put them at

a significant

advantage.

a valuation of national bank bond portfo-

lios, and the OCC provided incentives for

investments highly rated by a CRA, increas-

ing demand for ratings. The comptroller

stipulated that national banks would not be

required to charge off depreciation to mar-

ket value on bonds receiving one of the four

highest ratings.17 This meant that publically

traded bonds rated BBB or higher by at least

one CRA could be valued at book value.18

This increased the demand for credit rat-

ings because otherwise defaults would have

counted 25 percent against bank capital. In

1936, the OCC and the Federal Reserve di-

rected that banks not hold bonds rated be-

low BBB by at least two credit rating agen-

cies. These rules introduced CRAs into the

financial regulatory framework. Banks were

now required to obtain credit ratings for

their assets to ensure they met federal capital

reserve requirements, and they also were pro-

vided additional incentives for having bonds

rated highly by CRAs.

In the late 1960s, a considerable increase

in volume on the New York Stock Exchange

overwhelmed the mechanisms that brokers

used to transfer securities. This, combined

with a subsequent trading volume decline,

drove nearly 100 brokerage firms out of busi-

ness.19 The SEC later concluded that inade-

quate access to liquid capital exacerbated the

crisis, and thus sought to enforce more strin-

gent capital requirements. Consequently, the

SEC adopted another wave of banking regu-

lation, beginning in 1973, with a uniform

net capital rule.20 Part of this wave included

the Net Capital Rule for broker-dealers (Rule

15c3-1), which was intended to ensure “that

registered broker-dealers have adequate liq-

uid assets to meet their obligations to their

investors and creditors.”21 To ensure com-

pliance, regulators turned to select credit

rating agencies to measure leverage. This es-

tablished a new designation for select credit

rating agencies called the Nationally Recog-

nized Statistical Rating Organization.

The broker-dealer net capital rule required

broker-dealers to deduct percentages of mar-

ket value from their proprietary securities’

position from their net worth, depending

on the ratings of these securities.22 This was

intended to safeguard broker-dealer propri-

etary securities from price fluctuation risks.

Obtaining investment-grade ratings from at

least two NRSROs reduced the requirement

of deducting particular percentages of mar-

ket value from the net worth of instruments.

This incentivized broker-dealers to invest in

higher NRSRO rated instruments because it

translated into higher net capital.

The SEC instituted the NRSRO designa-

tion to ensure that bank issuers would not

simply find credit rating agencies whose only

purpose was to deliver high ratings on finan-

cial instruments. Not all credit rating agen-

cies were bestowed the NRSRO designation;

instead, the SEC grandfathered in Moody’s,

S&P, and Fitch rating agencies. These com-

panies were selected because of their previ-

ous record of accurate ratings. The NRSRO

designations did not ensure future accurate

ratings, but instead were an endorsement

of Moody’s, S&P’s, and Fitch’s past achieve-

ments. Obtaining a designation was not

necessary for CRAs to operate, but doing so

put them at a significant advantage, as par-

ticular investors (including both public and

private pension funds, as well as insurance

companies) were legally mandated to pur-

chase investments highly rated by NRSROs.

Moreover, other investors were also incentiv-

ized to purchase investments highly rated

by NRSRO CRAs to obtain regulatory ben-

efits. This boosted demand specifically for

NRSRO CRA ratings.

The SEC did not grant many NRSRO des-

ignations, and those companies for which

they did often merged, keeping the total

number of NRSRO CRAs to about three to

four. In 1982, the SEC designated Duff &

Phelps, and in 1983, McCarthy, Cristanti

and Maffei (MCM). In 1991, Duff & Phelps

purchased MCM and spun off its credit rat-

ing business. That same year, the SEC des-

ignated IBCA, and in 1992, it designated

Thomson Bankwatch for banks and finan-

cial institutions specifically. However, IBCA’s

frustration with the SEC’s preventing them

Over time,

regulators

became

increasingly

dependent on

Nationally

Recognized

Statistical Rating

Organization

credit rating

agencies.

from expanding their designation beyond

bank ratings drove them to purchase Fitch in

1992. Fitch later bought both Duff & Phelps

and Thomson BankWatch in 2000. Mergers

quickly brought the number of CRAs down

to three by the turn of the millennium.

Over time, regulators became increasingly

dependent on NRSRO credit rating agencies,

and as Langohr and Langohr argue, “the use

of ratings in regulations is most widespread

in . . . the U.S.”23 In fact, by June of 2005, there

were at least 8 federal statues, 47 federal rules,

and 100 state laws referencing credit ratings

issued by NRSRO CRAs.24 Table 3 high-

lights several examples of regulatory uses of

NRSRO CRA credit ratings.25

CRAs came under fire in the early 21st

century with the implosion of Enron,

WorldCom, and Parmalat. The dominant

CRAs with NRSRO designations gave most

of these companies’ bonds investment-

grade ratings within a few days or months

of them declaring bankruptcy. Beyond these

evident errors, critics blamed CRAs for insti-

gating crises in particular industries. France

Telecom SA’s CEO Michel Bon blamed a

Moody’s downgrade for initiating a debt

crisis. Interest groups with a stake in credit

ratings, regulators, and legislators joined

in greater scrutiny of credit rating agencies

and regulatory dependency on the ratings.

The U.S. Senate began conducting investi-

Table 3

Sample List of Rules Referring to Nationally Recognized Statistical Rating

Organization (NRSRO) Credit Rating Agencies (CRAs)

Investment Company Act of 1940

Rule 2a-7 enacted in 1991

Less than 5 percent of money market mutual fund assets may

be invested in commercial paper that NRSROs assign lower

than the first or second highest tier. (NRSRO mentioned 29

times in Rule 2a-7.)

Securities Exchange Act of 1934

“Exchange Act” Rule 15c3-1

Required broker-dealers to deduct percentages of their pro-

prietary securities’ market value when computing net capital.

However, reduced deductions are required for particular

securities rated investment grade by at least two NRSROs.a

Secondary Mortgage Market

Enhancement Act of 1984

Congress used the term NRSRO in the definition of “mort-

gage related security,” requiring it to be rated in one of the

two highest rating categories by at least one NRSRO.

Simplification of Registration

Procedures for Primary Securities

Offerings, Securities Act 1992

The SEC uses NRSRO ratings to help distinguish between

different types of securities that may be issued using simpli-

fied registration procedures.b

Investment Company Act of 1940

Rule 2a-7

This rule requires money market funds to limit investments

to “eligible securities” that are rated in either of the top two

short-term debt rating categories by the requisite number of

NRSROs.c

Investment Company Act of 1940

Rule 3a-7

Issuers of fixed-income securities rated in one of the top four

rating categories by at least one NRSRO are exempted from

registering and complying with the Investment Company Act.d

Securities Exchange Act of 1934

“Exchange Act” Rule 10b-6

Exempts particular transactions in nonconvertible debt and

nonconvertible preferred securities from Exchange Act provi-

sions if the securities are rated investment grade by at least

one NRSRO.e

Continued next page.

Credit ratings

are intended

to reduce

information

asymmetries

between firms

and investors.

gations, holding hearings, and making pro-

posals for reforms. This eventually led to the

Credit Rating Agency Reform Act of 2006.

CRAs’ Dual Role

The regulatory use of credit ratings reveals

their dual role in the marketplace. As Beaver,

Shakespeare, and Soliman explain, credit rat-

ings have valuation and contractual uses.26

First, credit ratings are intended to reduce

information asymmetries between firms

and investors and improve the functioning

of financial markets. They are an opinion

about the measure of investment quality

and default probability. These, in turn, help

marketplace investors form valuations of

investments’ value and risks. Second, credit

ratings are used for contractual purposes,

primarily for regulatory compliance and

private contracts. In a sense, NRSRO credit

ratings are a regulatory license indicating a

debt instrument is eligible by law for par-

ticular kinds of investments and regulatory

perks. This license also helps insulate fidu-

ciaries’ liability when making investments.27

Under a regulatory licensing regime, favor-

able NRSRO ratings can reduce the costs of

regulation to market participants. As Coffee

explains, “such sales of regulatory licenses

need not be based on trust or reliance on the

rating agencies … but only on the short-term

cost savings realizable”; or, in other words,

the regulatory benefits realized.28 NRSROs

received their designations because of past

good performance, not necessarily because

of future good performance; as such, a regu-

latory license is not necessarily indicative of

the quality or risk of the financial instru-

ment receiving it.

Hypotheses

Oligopoly

A cursory overview of regulatory reliance

on NRSRO-designated CRA ratings suggests

Federal Deposit Insurance Act

Section 1831e

Congress defines “investment grade” corporate debt for sav-

ings associations as only securities rated in one of the four

highest categories by at least one NRSRO.f

Employee Retirement Income

Security Act of 1974

Required both public and private pension funds to base part

of their investment criteria on bond ratings provided by

NRSRO designated CRAs.

Retirement Income Security Act

of 1974

Mandated that both public and private pension funds base

part of their investment criteria on bond ratings provided by

NRSRO designated CRAs.

Source: Jonathan G. Katz, SEC Concept Release: Nationally Recognized Rating Organizations, Release Nos: 33-7085,

34-34616, IC-20508, International Series Release No. 706 (Washington: SEC, 1994)( File No. S7-23-94), p. 12.

a Please see 17 CFR 240,15c3-1, Adoption of Amendments to Rule 15c3-1 and Adoption of Alternative Net

Capital Requirement for Certain Brokers and Dealers, Exchange Act Release No. 11497 (June 26, 1975); and 40

FR 29795 (July 16, 1975). Please also see Securities and Exchange Commission, Securities Exchange Act Rel. No.

34-10,525 (Washington: SEC News Digest, 1973).

b Please see Adoption of Integrated Disclosure System, Securities Act Release No. 6383 (March 16, 1982) and

Adoption of Simplification of Registration Procedures for Primary Securities Offerings, Securities Act Release

No 6964 (October 22, 1992).

c See 17 CFR 270.2a-7.

d See Exclusion from the Definition of Investment Company for Structured Financing, Investment Company

Act Release No 19105 (November 19, 1992), 52 SEC Dkt. 4014.

e See 17 CFR 240 10b-6(a)(4)(xiii).

f See footnote five of 12 U.S.C. 1831e(d)(4)(A), enacted in 1989, at http://www.sec.gov/rules/concept/34-34616.pdf.

Table 3 Continued

In a competitive

market new firms

would enter

the industry to

capture a share

of economic

profits, but in an

oligopoly they

are prevented

from doing so by

barriers to entry.

these firms likely operated in an oligopolis-

tic market. Before examining the evidence

we must first define what an oligopoly is,

how it is created, and how it works.

An oligopoly is an industry dominated

by few firms that is protected from addi-

tional competing firms by either artificial

or natural barriers to entry, making it diffi-

cult for new firms to enter the market and

credibly compete with the dominant firms.

Reduced marketplace competition provides

oligopolistic firms greater market power

than competitive firms because they can set

price profitability above competitive levels

and reduce output. This allows oligopolistic

firms to enjoy higher profits than competi-

tive firms because fewer firms fulfill market

demand. In a competitive market new firms

would enter the industry to capture a share

of economic profits, but in an oligopoly

they are prevented from doing so by barriers

to entry (see Figure 2).

Figure 2

Lessons from a Monopoly Model

Source: Chart constructed by authors.

Note: The figure demonstrates higher prices and lower quantity (or lower quality) of credit risk information

with oligopolistic conditions compared with a competitive market. The shaded box represents economic profits

gained via oligopolistic market power. MC is the marginal cost curve and AC is the average cost curve of conduct-

ing research and analysis to determine the quality of financial instruments. D is the demand curve, represent-

ing the demand for credit-risk information for financial instruments, and MR is the marginal revenue for each

additional rated financial instrument. These, in turn, determine the price for credit ratings and the quantity (or

quality) of credit risk information supplied. One can also view quantity of information supplied as informa-

tional quality because more information improves the quality of credit risk estimation.

Reputational

factors create

natural barriers

to entry in the

credit rating

agency market,

but most barriers

result from

the regulatory

designation

of Nationally

Recognized

Statistical Rating

Organization

credit rating

agencies.

Generally, oligopolies result from either

natural barriers to entry or government-

created barriers to entry. Both tend to have

higher prices, higher profits, and reduced

quantity supplied than would otherwise be

the case in a competitive market. Oligopo-

lies sustained by natural barriers to entry

remain susceptible to new technology and

new entrants overtaking their oligopoly, cre-

ating a more competitive market. Oligopo-

lies sustained by government regulation are

also subject to competitive markets, but in

some instances, their oligopolies may be

sustained by government mandates.29

Although reputational factors create

some natural barriers to entry in the CRA

market, most of the barriers to entry result

from the regulatory designation of NRSRO

CRAs. Thus, we would expect the CRA mar-

ket to be generally resistant to competitive

pressure, be dominated by few firms, have

high profits, and have restricted output sup-

plied. Restricted output supplied can be in

terms of informational output (quality as

a dimension of quantity), rather than the

sheer number of ratings produced. Without

the threat of competition, oligopolistic CRAs

are likely to become more complacent in

their methodologies. Also, with fewer firms

and reduced competition, markets may find

it less likely to discover new tools to better

measure credit risk.

Reduced Investor Due Diligence

Regulations incentivize investors to

purchase financial instruments with high

NRSRO credit ratings, rather than credit rat-

ings with high informational value. Since it

is hard to determine the accuracy of credit

ratings, it is understandable why regulators

use high NRSRO credit ratings as a proxy.

Nevertheless, if investors were primarily

concerned with accurate credit ratings, they

would be more likely to make investment

decisions in line with their own risk-return

preferences and they would reward CRAs

that are better at innovating methodologies

to derive accurate ratings. However, if inves-

tors were primarily concerned with obtain-

ing regulatory benefits, they would be more

likely to make investment decisions based on

investments receiving high NRSRO credit

ratings, and they would reward CRAs that

were better at innovating methodologies to

derive high ratings. Although the NRSRO

firms charged with identifying investment

vehicles eligible for purchase and or regula-

tory perks may also be the firms most likely

to deliver accurate ratings, this is not neces-

sarily the case. The NRSRO designation was

given to firms for past good performance,

but that does not guarantee those firms will

continue to offer the most accurate ratings.

Given investors’ competing incentives to ob-

tain accurate credit ratings (for information)

and high NRSRO credit ratings (for regula-

tory benefit), it is not clear whether investors

would necessarily punish NRSRO credit rat-

ing agencies that offered low-quality ratings.

Inflated Demand

Regulatory reliance on credit ratings,

specifically NRSRO CRA ratings, suggests

regulation may have artificially boosted de-

mand for these ratings. Table 3 shows a se-

lection of regulations mentioning NRSRO

CRAs. Regulations would likely increase the

demand for high NRSRO credit ratings (rat-

ings’ contractual role), rather than increase

the demand for credit ratings with high in-

formational value (ratings’ valuation role),

because preferential regulatory treatment

was bestowed on high NRSRO credit ratings

rather than ratings with high informational

value (see Figure 3). We would expect pric-

es to rise above competitive levels, and the

quantity of information supplied to remain

below the competitive level.

Regulatory Impact:

Evidence

Regulations referencing NRSRO CRAs

created a de facto oligopoly in the ratings

market and regulation requiring or incen-

tivizing investors to purchase highly rated

products inflated and captured demand for

One of the

great strengths

of markets is

to convey a

tremendous

amount of

information in a

relatively simple

and efficient

manner via the

price mechanism.

high NRSRO ratings (even if those ratings

did not provide substantial informational

value). They also failed to incentivize inves-

tors to seek out ratings on the basis of high

informational value so they would invest in

high quality products. Instead, the regula-

tions incentivized investors to seek out high

NRSRO ratings in efforts to obtain regula-

tory privilege. This, in turn, reduced compe-

tition, increased prices, resulted in method-

ological complacency in credit risk modeling

innovation, and reduced investor due dili-

gence. The following section details evidence

of barriers to entry, high profits, restricted

output, inflated market demand, and inves-

tor due diligence.

Overview

One of the great strengths of markets is

to convey a tremendous amount of infor-

mation in a relatively simple and efficient

manner via the price mechanism. In markets

with relatively uniform goods and common-

ly shared knowledge, the price mechanism

is indeed quite powerful. In markets with

more heterogeneous goods and imperfect or

Figure 3

Lessons from a Monopoly Model: Shifting Demand

Source: Figure constructed by authors.

Note: The figure demonstrates higher prices and lower quantity (or lower quality) of credit risk information

with oligopolistic conditions compared with a competitive market. A shift in demand increases the difference

between competitive and oligopolistic results. The shaded boxes represent economic profits gained via oligopo-

listic market power. The lighter shaded box represents economic profits before demand shifts; the darker shaded

box represents additional economic profits after demand shifts.

Some investors

are legally

required,

and others

incentivized,

to invest in

the Nationally

Recognized

Statistical Rating

Organization’s

credit rating

agency products.

asymmetric information, nonprice mecha-

nisms often evolve in order to avoid Aker-

lof’s familiar “lemons problem,” or adverse

selection, in which some markets risk being

dominated by the sellers of shoddy goods.30

In markets where quality is revealed post-

purchase, producers may be able to commit

to providing high-quality goods by estab-

lishing a reputation for doing so. In essence,

reputation posts a “bond” that will be forfeit

if producers disappoint or cheat. That bond

can take the form of a brand name or cor-

porate goodwill, and the value of many cor-

porations depends heavily upon intangibles

such as these.

Goodwill, while reducing the information

asymmetries, can also end up as a barrier to

entry. Without a track record, how does one

compete with incumbent firms? One possi-

bility is for those with a strong reputation in

one line of business to expand into another.

Given that the quality of credit analysis

by a rating agency will likely not be discov-

ered for months or years after the initial

analysis, this would appear a market likely

to be dominated by a handful of firms with

significant reputations. And indeed, even

before the advent of extensive federal finan-

cial regulation, the market for credit ratings

was so dominated.

Regulation is often offered as a method

for ensuring the provision of a minimum

quality. While making no claims as to the

actual quality provided, the SEC’s involve-

ment in the market for credit ratings has

been an attempt to institute minimum qual-

ity standards. However, minimum quality

standards can also restrict competition, in-

crease concentration, and reduce consumer

welfare, and do not necessarily guarantee

the sought-after minimum quality. Whether

they do so, or whether they improve compe-

tition and consumer welfare, is ultimately

an empirical question, although theory can

guide the interpretation of relevant data.

When imposing minimum quality stan-

dards on an industry already characterized

by high concentration and strong repu-

tations, the standards’ net impact can be

evaluated by two metrics. First, minimum

quality standards should reduce the value

of incumbent firms’ reputational capital

(goodwill). If all new entrants need to do is

meet the new standard, then they should

not have to build reputational capital in

order to be competitive. For this reason, ob-

served market concentration should also fall

with the decrease in incumbent goodwill. If

concentration and incumbent reputational

capital increase with the imposition of qual-

ity standards, then such standards are likely

welfare-decreasing. We will come back to

measures of concentration and goodwill as

we examine the market for credit ratings.

Inflated Market Demand for NRSRO

CRA Ratings

Regulatory wording alone demonstrates

how regulations arguably drove additional

business to the NRSRO CRAs than would

have otherwise been the case (see Table 3).

Some investors are legally required, and oth-

ers incentivized, to invest in NRSRO CRA-

rated products. If demand were not inflated,

we would expect reduced relative informa-

tional value of ratings to be associated with

lower demand. Yet if the greater value from

NRSRO CRA ratings came from gaining

access to the regulatory license or to prefer-

ential regulatory treatment, then we would

expect the relative informational value to

matter less.

In fact, many people do question the in-

formational value of these ratings.31 Some

have argued that credit spreads could sub-

stitute for credit ratings, suggesting that

NRSRO CRA ratings may not provide sub-

stantial additional information.32 Moreover,

advances in information technology and the

increasing interconnectedness of society may

indeed have reduced the relative informa-

tional value of ratings compared with their

value in the past.33

Some believe credit ratings are “lagging

indicators of credit quality.”34 As James Van

Horne concludes, “[w]hile the assignment of

a rating for a new issue is current, changes

in ratings of existing bond issues tend to lag

While a few

misses are to be

expected, the

rating agencies

uniformly failed

to forecast a

major decline

in the housing

market,

illustrating that

the system is

subject to more

than just a few

random errors.

behind the events that prompt the change.”35

Packer and Cantor also find evidence to sug-

gest that agencies lag behind the market when

agencies initiate a ratings change.36 More-

over, credit ratings have proved themselves

to be quite inaccurate at times, such as with

WorldCom, Enron, Parmalat, and the 2008

financial crisis.37 While a few misses are to

be expected under any market structure, the

fact that the rating agencies uniformly failed

to forecast a major decline in the housing

market illustrates that the system is subject

to more than just a few random errors. Bruce

Lehmann at Columbia Business School ar-

gued that he has “never known a portfolio

manager who goes by the ratings.”38 A 2002

survey by the Association of Financial Profes-

sionals found only 29 percent of profession-

als believe rating changes to be accurate.39

In sum, it is not clear how ratings contin-

ue to offer significant additional informa-

tion if they lag behind alternative indicators,

and are, in some cases, underestimating the

ultimate risk of default. One would expect

their value in the marketplace to decline

following the bankruptcies of WorldCom

and Enron. One would also expect the de-

mand for credit ratings to decline or at least

remain fairly constant, at least among the

prominent NRSRO CRAs (as well as the

NRSRO CRAs’ values).

Nevertheless, NRSRO CRAs’ fees and prof-

itability have soared, especially from 2002 to

2008.40 It is estimated that the average rate of

return for credit rating agencies was slightly

over 42 percent from 1995 to 2000, with oper-

ating margins as high as 54 percent in 2006.41

Figure 4 demonstrates Moody’s skyrocketing

Figure 4

Historical Stock Prices 1998–2011: Moody’s vs. Dow Jones and S&P 500 Indices

Source: Compiled by the authors from Google Finance, Historical Data, http://www.google.com/finance/

historical?q=NYSE:MCO; and Yahoo Finance, Historical Data, http://finance.yahoo.com/q/hp?s=MCO+Hist

orical+Prices.

Figure 5

Moody’s and S&P Rated Residential Mortgage-Backed Securities (RMBS) and

Collateralized Debt Obligations (CDOs) in 2002 and 2006

Source: Carl Levin and Tom Coburn, Wall Street and the Financial Crisis: Anatomy of a Financial Collapse, Permanent

Subcommittee on Investigations (Washington: United States Senate, 2011), http://www.ft.com/cms/fc7d55c8-

661a-11e0-9d40-00144feab49a.pdf.

Rated CDOs per year

Rated RMBS per year

Regulations that

were intended

to incentivize

investors to

make better

decisions instead

incentivized them

to prioritize high

credit ratings

over quality

investments.

stock price in contrast to the Dow Jones and

S&P 500 indices. Figure 5 shows the jump in

the number of rated Residential Mortgage-

Backed Securities and Collateralized Debt

Obligations (CDOs) between 2002 and 2006

for both Moody’s and S&P. Figure 6 demon-

strates several jumps in Moody’s goodwill

between 1999 and 2010. Together, Figures

4–6 demonstrate that at least several NRSRO

CRAs continued to be highly valued as com-

panies and they continued to rate more prod-

ucts. This is surprising, because if a product

is becoming less valuable in the marketplace,

investors would most likely turn to other

sources of risk assessment.

Even those who argue that credit ratings

continue to have significant additional in-

formational value should expect that reputa-

tional values would have at least been tainted

throughout the crises of WorldCom, Enron,

and the 2008 financial crisis. Yet if only in-

formational value and reputational factors

matter, we cannot explain the evidence in

Figures 4–6.

Instead, a more likely explanation is one

described by Langohr and Langohr, who ar-

gue that “the regulatory uses of ratings . . .

created a captive demand for credit ratings

per se by market participants.”42 If investors

demanded credit ratings in efforts to meet

regulatory requirements and to obtain pref-

erential regulatory treatment, rather than

to obtain informational value, then it is not

surprising that demand for NRSRO CRAs’

ratings remained high during this time pe-

riod, as preferential treatment for NRSRO–

rated investments continued.

Investor Due Diligence

Regulations that were intended to in-

centivize investors to make better decisions

instead incentivized them to prioritize high

credit ratings over quality investments. Since

regulators used credit ratings as a proxy

for credit quality, it is understandable that

rules were implemented to incentivize high

ratings. Nevertheless, regulators could not

ensure that high credit ratings did indeed

Figure 6

Moody’s Goodwill from Balance Sheet

in millions ($)

Source: Moody’s Annual Reports.

Note: Goodwill is found on the company’s balance sheet by stating the difference between its purchase price and

the sum of the fair value of net identifiable assets, and could possibly be driven by reputation.

Credit ratings

often lag behind

market indicators

by as much as six

months.

represent high investment quality. The rules

incentivized firms to hold riskier assets with-

in a single credit rating. Instead of due dili-

gence, or seeking out accurate information

on investment quality, investors were incen-

tivized (or required) to focus on purchasing

instruments with high NRSRO ratings. In-

vestors faced a choice: they could prioritize

pursuing regulatory privilege by purchasing

investments with high NRSRO credit rat-

ings, or they could seek high informational

quality. They chose the former.

This explains why demand for NRSRO

CRAs did not seem to decline after high, yet

inaccurate, ratings were issued for World-

Com and Enron months, if not days, before

their announced bankruptcies. Figures 4,

5, and 6 show how NRSRO CRAs seemed

to continue to be rewarded with increas-

ing stock prices, more business, and higher

goodwill.

Conflict of Interest

It is possible that the 1973 regulatory

changes, instituting the NRSRO designa-

tions, may have played a role in incentiviz-

ing NRSRO CRAs to switch their business

models from investor-pays to issuer-pays.

It is easy to understand how an issuer-pays

business model is prone to conflicts of in-

terest.43 This model raises concerns about

incentives for CRAs to issue inflated ratings

to promote their business with clients.44 In

theory, CRAs could gain short-term profit by

overstating issuer or investment quality, but

this would come at the expense of long-term

reputational loss to their respective firms.45

Although reputational concerns may con-

strain NRSRO CRAs from engaging in overt

catering to issuers, their increased market

power may have allowed them to at least

marginally construct higher ratings. Also,

NRSRO ratings still offer regulatory benefits

regardless of whether investors or issuers

purchase them.

CRAs have assured regulators they man-

age conflict-of-interest problems, for in-

stance, by separating compensation from

revenue. Also, the SEC has written regula-

tions to try and manage conflict-of-interest

problems by prohibiting coercive actions and

anti-competitive behavior.46 Nevertheless,

evidence continues to mount demonstrat-

ing that non-NRSROs tend to respond more

quickly to information changes in the mar-

ket, and that NRSRO CRAs do tend to lag

in reporting downgrades.47 Moreover, other

empirical research finds that credit rating ad-

justments tend to adjust in favor of slightly

higher ratings, and that ratings often lag

behind market indicators by as much as six

months.48 Han Xia finds evidence to suggest

that the issuer-pays rating model contributes

to CRAs’ incentives to issue inflated ratings.49

Alternative explanations do exist for the

business model change. Rather than captive

demand, photocopying may have reduced

the profitability of rating subscription ser-

vices, as investors would share informa-

tion.50 Langohr and Langohr argue that the

increase in market-based financing in the

1970s made it difficult for CRAs to meet

demand with subscription-based services.51

Another explanation is that the early 1970s

liquidity crisis, subsequent to the 1970 Penn

Central default in commercial paper, moti-

vated issuers to assure investors of quality

ratings.

Although these explanations may very

well be partially correct, it still remains un-

clear why the market would continue to tol-

erate a conflict of interest between NRSRO

CRAs and issuers, especially after Moody’s,

S&P, and Fitch had rated Enron investment

grade four days before the company declared

bankruptcy.52 It also remains unclear why

investors would continue to trust the sub-

jective opinions of CRAs, who contend they

manage conflict of interest (which can result

in lower quality ratings) or that they believe

the SEC’s regulations are capable of prevent-

ing conflict of interest. CRAs’ management

of conflict of interest was also challenged in

2011, when the Permanent Subcommittee

on Investigations found that Moody’s and

UBS executives met to discuss when to start

downgrading and the problems it would

cause.53

Regulations

stipulating

that regulatory

preference only

be afforded to

those credit

rating agencies

designated by

the Nationally

Recognized

Statistical Rating

Organizations

created barriers

to entry.

The evidence demonstrates continued

NRSRO CRA profitability, despite their fail-

ure to detect problems in WorldCom, Par-

malat, Enron, and mortgage-backed securi-

ties, as well as potential conflict-of-interest

problems. Thus, if reputation is not the

most important factor driving profitability,

it suggests that regulations creating captive

demand for NRSRO ratings may fill that

role instead. The incentives to obtain regula-

tory privilege may explain the shift in market

power from investors to the NRSRO CRAs.

Oligopoly

Barriers to entry: few firms. We have ar-

gued that regulations bolstered market de-

mand for NRSRO CRAs and potentially per-

petuated an investor-pays business model.

These problems may have been mitigated

had there been greater competitive threat

from additional firms or new entrants. New

firms may have acted as whistleblowers,

which may have resulted in greater meth-

odological innovation in the marketplace.

However, regulations stipulating that regu-

latory preference only be afforded to those

using NRSRO-designated CRA ratings creat-

ed barriers to entry for non-NRSROs CRAs,

because NRSRO CRAs’ ability to essentially

sell “regulatory licenses” gave them a signifi-

cant market advantage over potential new

entrants.

Interestingly, the SEC did not prevent

non-NRSRO CRAs from issuing ratings, but

instead excluded them from offering regula-

tory privilege. The NRSRO-designated CRAs’

ability to offer regulatory privilege was a bar-

rier to entry to a very important and profit-

able area of the marketplace. Thus, Table 3

provides several examples for how barriers to

entry were constructed in the CRA market-

place.

Besides a cursory overview of regulatory

uses of NRSRO CRAs, additional evidence

points to barriers to entry: namely, sustained

high profits and high market concentra-

tion with few firms. As explained earlier, the

NRSRO CRA market has experienced in-

creased profitability. Economic theory sug-

gests that new firms would enter the market

to capture some of the increased profits.

However, the SEC did not often grant new

NRSRO designations, so increasing profit-

ability for only a few firms continued.

The Herfindahl-Hirschman Index (HHI)

is a quantitative measure of industry concen-

tration that accounts for both the number of

firms in the industry and each firm’s market

share. Specifically, the measure takes into ac-

count NRSRO revenues, the number of enti-

ties issuing NRSRO-rated debt securities, and

the dollar amount of new U.S.–issued asset-

backed securities. An HHI index lower than

1,000 is considered a competitive market.

Most of the HHI indices in Table 4, 5, and 6

are instead over 3,000, demonstrating high

market concentration. By the middle of the

decade, 80 percent of rated issues were rated

by only Moody’s and S&P, and 14 percent

rated by Fitch.54 Although sustained profits

should have attracted more firms to the mar-

ket, it did not, and high market concentration

remained. This suggests there are either regu-

latory or natural barriers to entry.

It is possible that the CRA industry tends

toward natural concentration because of net-

work and reputation effects. Lawrence White

explains how a few CRAs benefit from a “net-

work effect” because many users desire con-

sistency across ratings categories and tend

to use the same rating agency to achieve this

goal.55 Reputation effects may result from

the time it takes for a CRA to develop investor

trust. This would suggest early CRA entrants

have an advantage that continues even as new

incumbents enter the market. For this reason,

Langohr and Langohr argue that “a small

number of CRAs with the highest reputa-

tion for quality and independence will always

dominate” independent of regulations.56

Nevertheless, the dominant NRSRO CRAs

did not prove their quality ratings during

the WorldCom and Enron collapses or the

2008 financial crisis. Nor do their conflicts

of interest instill confidence in their indepen-

dence and role as objective evaluator of credit

risk. Moreover, if early entrant CRAs fail to

produce consistently accurate ratings, it does

The process

to obtain the

Nationally

Recognized

Statistical Rating

Organization

designation

was opaque,

without clear and

consistent rules.

not follow that the few dominant CRAs will

be the same firms over time.

Since reputation alone need not explain

CRAs’ small number and continued success,

it suggests that the small number of exist-

ing firms is not solely the product of natural

barriers to entry, but instead also regulatory

barriers to entry: namely the NRSRO desig-

nation.

Non-NRSRO. Considering the perspec-

tive of non-NRSRO CRAs provides addi-

tional evidence that the small number of

firms in the industry is not the result of nat-

ural barriers to entry. Non-NRSRO CRAs

believed the SEC restricted their entry and

prevented them from capturing increasing

economic profits.57 Typically, these firms

waited 2–7 years to receive a status deter-

mination.58 The process to obtain NRSRO

designation was opaque, without clear and

consistent rules. Figure 7 shows NRSRO

CRAs as of 2010, the number of years they

produced credit ratings, and when they re-

ceived recognition as NRSROs.

Table 4

Herfindahl-Hirschman Index Based on Dollar Value of Newly Issued U.S.

Asset-based Securities, January 2004–June 2010

Asset Class 2004 2005 2006 2007 2008 2009 2010a

All U.S. asset-backed securities 3444 3375 3469 3398 3396 2973 2809

U.S. Commercial Mortgage-

Backed Securities 3224 3222 3359 3212 3751 2916 2804

U.S. Traditional Asset-Backed

Securities 3374 3338 3314 3280 3305 3262 3046

U.S. Prime Residential-

Mortgage Backed Securities 3677 3672 3542 3376 3148 3222 4145

U.S. Nonprime Residential-

Mortgage Backed Securities 3390 3177 3344 3515 3531 10000b6009

U.S. Collateralized Debt

Obligations 3772 3944 4173 4253 4846 3795 5561

Source: Securities and Exchange Commission, Action Needed to Improve Rating Agencies Registration Program and

Performance-Related Disclosures (Washington: United States Government Accountability Office, 2010).

a The HHIs for 2010 are based on data through June 30, 2010.

b Only one deal was issued in 2009, and it was rated by a single NRSRO.

Table 5

Herfindahl-Hirschman Index for Nationally Recognized Statistical Rating

Organizations Based on Total Revenues, 2006–2009

2006 2007 2008 2009

All asset classes 3617 3511 3333 3324

Annual Percentage Change (%) -2.93 -5.08 -0.27

Source: Securities and Exchange Commission, Action Needed to Improve Rating Agencies Registration Program and

Performance-Related Disclosures (Washington: United States Government Accountability Office, 2010).

The only

stable Nash

equilibrium

in a Bertrand

duopoly is zero

profits for all

firms.

Sean Egan, CEO of Egan-Jones,testifying

before the Senate Committee on Banking,

Housing, and Urban Affairs, stated that the

“ratings industry is suffering from a state

that is hard to characterize as anything oth-

er than dysfunctional.”59 He contended that

the industry suffered from a lack of competi-

tion under the old NRSRO system—a “part-

ner monopoly” as he called it. Egan-Jones

had been quicker to downgrade ratings for

WorldCom, Enron, and the Ford Motor

Company than the dominant NRSRO com-

panies, yet Egan-Jones had been excluded

from the NRSRO designations while exist-

ing NRSRO CRAs retained their designa-

tions.60 Egan-Jones had applied for NRSRO

status in 1998; however, it only received the

designation in 2007—nine years later. Egan-

Jones argued the application process was

exclusive and categorically unfair. It believed

it had proven to have more accurate rat-

ings, superior risk assessment models, and

reduced conflict-of-interest problems since

the company used a subscriber-based busi-

ness model.

Dominion Bond Rating Service was

founded in 1976, but did not receive the

NRSRO designation until February 2003,

despite its application three years earlier. Do-

minion also argued that recognition from

the SEC would help it expand in the U.S.

credit rating market and put it on a level

playing field with its competitors.61 Larry

Mayewski, Chief Rating Officer at AM Best,

a CRA specializing in the insurance industry,

pointed out “there are still companies that

would like to see us with the NRSRO desig-

nation before they’ll do business with us.”62

These accounts from non-NRSRO CRAs

demonstrate the importance of the NRSRO

designation for CRAs’ ability to compete in

the marketplace. Since the NRSRO desig-

nation is a regulatory product, it could be

argued that regulatory, rather than natural

barriers to entry, structure the CRA market.

Competition and market power. Popular

accounts of the market for credit ratings

generally overlook two important interre-

lated considerations in the study of mar-

ket power. The first is that in concentrated

markets (particularly those where products

are homogeneous), fewer firms can actu-

ally reduce prices and, hence, profits. Mar-

ket dynamics characterized by two firms

with nearly identical products could, under

plausible assumptions, result in a Bertrand

outcome, where profits converge to zero be-

cause any firm could capture the entire mar-

ket by simply lowering its price below that

of its rival(s). The only stable Nash equilib-

rium63 in a Bertrand64 duopoly is zero prof-

its for all firms. The power of the Bertrand

model is not in disproving the existence of

duopoly rents, but in proving that the exis-

Table 6

Herfindahl-Hirschman Index for Nationally Recognized Statistical Rating

Organizations Based on Number of Issuers Rated, 2006–2009

Asset Class 2006 2007 2008 2009

Corporate Issuers 3069 2625 2596 2483

Financial Institutions 2773 2555 2550 2452

Insurance Companies 3353 3066 2826 2749

Issuers of Government Securities 3822 3820 3846 3889

Issuers of Asset-backed Securities 3602 3561 3553 3493

Source: Securities and Exchange Commission, Action Needed to Improve Rating Agencies Registration Program and

Performance-Related Disclosures (Washington: United States Government Accountability Office, 2010).

tence of such rents is dependent upon more

than just the number of sellers.65

The second issue is a basic confusion

about market power. In the standard con-

flict-of-interest narrative, rating agencies are

“corrupted” by the fact that they are paid

for the ratings by the debt issuer. Obviously

any issuer would prefer a higher rating, so

competition forces the raters to lower their

standards and sell inflated ratings. For this

outcome to hold, market power would have

to be on the side of the issuer, not the rat-

ing agency. In addition, this narrative never

explains why raters would only compete on

quality and not price. Once the raters only

sell the highest rating, then the agency sell-

ing the highest at the cheaper price should

capture the market, hence there are very

strong incentives for price competition in

the conflict-of-interest model, yet in the real

world we witness substantial profits on the

part of the largest agencies, indicating that

we are not in a Bertrand equilibrium or any-

thing like it. It is more likely that the rat-

ing agencies possess market power because

of various regulatory requirements, rather

than the market power being possessed by

the issuers.

Restricted output: quality information and

complacency in methodology. Regulatory bar-

riers to entry reduce competition in the CRA

marketplace. Without competitive threat,

the CRAs may have had reduced incentives

to innovate more sophisticated rating meth-

odologies to keep up with the changes in

structured finance. If this were the case, we

would expect NRSRO CRAs to have restrict-

ed, or the organizational structure in the

marketplace to have limited, the quantity or

quality of information in the marketplace

about credit risk relative to an open market

industry. Or, as John Coffee explains, the

“lack of competition is important [because]

. . . it permits these nominal competitors to

shirk, engaging in less effort and research

than if there were true active competition.”66

Figure 7

Credit Rating History of Current Nationally Recognized Statistical Rating Organizations

Source: Securities and Exchange Commission, Action Needed to Improve Rating Agencies Registration Program and Performance-Related Disclosures

(Washington: United States Government Accountability Office, 2010).

Opening up

the Nationally

Recognized

Statistical Rating

Organization

market without

addressing

inflated

demand may

not sufficiently

incentivize those

credit rating

agencies to

innovate better

methodologies

to measure credit

risk.

Also, had there been more NRSRO CRAs,

it may have increased the likelihood that

at least one of them would have innovated

methodologies better able to measure and

detect credit risk.

To be clear, NRSRO CRAs did not restrict

the output of the number of credit ratings;

on the contrary, they had strong incentives

to rate as many as possible. According to

the oligopoly model shown in Figure 5, with

lower competitive threat, NRSRO CRAs re-

stricted the quantity of information produc-

tion supplied to the market—in contrast to

what would have been supplied under a mar-

ket regime. In addition, conflicts of interest

between NRSRO CRAs and issuers, likely

maintained by inflated/captive demand,

also disincentivized NRSRO CRAs from

information production. The CRAs often

worked with issuers to structure financial

products that would obtain higher ratings

rather than focusing on instrument quality.

This incentivized NRSRO CRA methodolo-

gies that would formulate more highly rated

instruments rather than detecting increased

credit risks in more sophisticated and com-

plicated financial products.

This perception of NRSRO CRAs’ meth-

odological complacency was found in a

2002 survey by the Association for Financial

Professionals. According to the survey, 40

percent of individuals working for compa-

nies with rated debt thought rating changes

were timely, 29 percent found them to be ac-

curate, and 22 percent believed the ratings

favored the interest of investors.67

Another important issue with rating meth-

odologies is that two bonds could have the

same rating but vastly different returns. This

overlooks the risk-return tradeoff and sug-

gests that an Aa investment with a 12 percent

return is just as safe as an Aa investment with

a 6 percent return. Rating firms argue that

their ratings are “relative measures of risk”

and that’s why “the assignment of ratings in

the same categories to entities and obligations

may not fully reflect small differences in the

degree of risk.”68 However, there seemed to be

a significant difference in risk when Moody’s

Baa-rated CDOs had a default probability of

20 percent while their Baa-rated corporate

bonds had a default probability of only 2 per-

cent.69 In other words, CDOs’ debts with the

same rating were ten times as risky as similarly

rated corporate debts.70

Bo Becker and Todd Milbourn argue that

increased competition within this regulatory

framework actually reduces methodologi-

cal efficacy. In a regulatory regime in which

the existing firms enjoy captive and inflated

demand—which in turn helps bolster a lu-

crative issuer-pays business model—adding

an additional NRSRO actually may not im-

prove the quality of ratings.71 As NRSRO

CRAs seek to meet the needs of their cli-

ents, which are primarily issuers, Becker and

Milbourn find that the ratings agencies do

marginally inflate their ratings and allow rat-

ings’ quality to decline.72 This demonstrates

the importance of not merely opening up the

NRSRO market to more competition, but

also addressing the issues of captive/inflat-

ed demand, which spur conflict-of-interest

problems. Opening up the NRSRO market

without addressing inflated demand may

not sufficiently incentivize NRSRO CRAs to

innovate better methodologies to measure

credit risk.

Regulatory Regime Models

So far, we have analyzed the problems

resulting from SEC regulations creating a

de facto oligopoly of NRSRO-designated

credit rating agencies and a captive market

demand for NRSRO CRAs’ ratings. Our

findings also suggest that markets may have

been better served with a different regulato-

ry framework. We will now examine alterna-

tive regulatory scenarios including an open

access regime, a licensing regime, and a licensing

regime with captive demand.

Open Access

Not all industry-specific regulatory frame-

works are created by government. To the con-

trary, there are copious examples of industry

Without

preferential

regulatory

treatment for

particular

investments,

investors would

seek out credit

risk analysis and

expertise based

on reputational

factors.

self-regulation, in which companies and in-

dustries learn and standardize best practices

for their industry based on the incentives

faced. An open access regime is an industry-

specific regulatory framework not stipulated

by the state. According to Langohr and Lan-

gohr: “[N]o government or regulatory body

distorts the market outcomes of natural sup-

ply and demand conditions. These condi-

tions would not be distorted through the use

of selected agencies’ ratings in regulations

nor through licensing mechanisms.”73

Under these conditions, there would not

be NRSRO designations, and regulations

would neither require nor incentivize inves-

tors to hold certain kinds of investments.

In this scenario, investors would still face

information asymmetries between their risk

preferences and financial instruments’ risk

offerings. Since investors care about the

probability of default, as well as the value of

investment return, they would conduct their

own due diligence about investments’ risk.

To do this, they would likely seek outside

opinion about financial products and their

associated credit risks. This advice might

take the form of risk categories calculated

by credit rating firms, or it might include a

conglomerate of market-based measures for

credit risk, possibly including credit spreads.

Since investors would be the primary de-

mander of credit risk information, finan-

cial innovation would likely search for new

methodologies and technologies to meet in-

vestor demand. Without preferential regula-

tory treatment for particular investments,

investors would seek out credit risk analysis

and expertise based on reputational factors,

rather than exogenous designations like the

NRSRO. Most likely, investors would trust

the credit risk analysis of those with incen-

tives independent of those selling the invest-

ments (investor-pays, not issuer-pays). This

would devolve the responsibility for due dili-

gence to individual and group investors.

If those providing credit risk analysis de-

cided they could increase profits by selling

ratings directly to issuers, they would need

to somehow prove to investors that con-

flicts of interest would not dominate their

ratings. If credit risk analysts cheated by

giving in to conflicts of interest, if investors

became uncomfortable with the clear con-

flict-of-interest problems, or if investors lost

confidence in the analyses’ informational

value, investor demand for issuer-paid credit

risk analysis would decrease. Consequently,

issuers would have less reason to purchase

analysis from credit risk analysts.

As issuer demand declined, credit risk

analysts would either have to change their

business model to issuer-pays or lose market

share to competitors. Moreover, competitor

analysts would have incentive to offer a busi-

ness model not entrenched with conflicted

interests to capture investor demand. But

competitor analysts might also have an in-

centive to develop new methodologies to de-

termine credit risk. Investors would have an

incentive to shop around for more valuable

sources of credit risk information.

It might be that reputational and network

effects create an environment such that only

a few credit analysts emerge. Or it might be

that investor-pays/subscriber-based models

are not extraordinarily profitable, and thus

only a few credit analysts are attracted to the

market. If this were the case, the competitive

threat would still remain to provide an incen-

tive for credit analysts to maintain quality

risk assessment models and innovate new

methodologies to keep up with financial in-

novations. Credit risk firms might even offer

greater transparency to persuade investors to

purchase their risk analysis.

The overall effect of an open regime on

the market would be little to no cheating in

analysis, few conflicts of interests, and in-

centives for analysts to innovate to increase

the informational value of their credit analy-

sis. The result would be more accurate credit

risk analyses. With increased accuracy in

credit risk analysis, issuers would have an

increased incentive to offer higher quality

investments. Investors’ primary incentive

would be to create a portfolio representative

of their risk preferences, rather than to ob-

tain preferential regulatory treatment.

It might be that

reputational

and network

effects create an

environment in

which only a few

credit analysts

emerge.

Licensing Regime

Under a licensing regime, the state would

stipulate that credit risk analysis be used to

either require or incentivize investors to pur-

chase high quality financial instruments.

This assumes that the state knows how to

define high quality credit risk analysis, and

also assumes that credit risk analysts pro-

duce accurate analyses. In order to comply

with the state or obtain benefits from the

state, investors would seek to purchase high-

ly rated investments.

Suppose, at first, that credit risk analysts

sell their analysis to investors. In contrast

to the open market regime, where investors

care most about risk analysis quality, inves-

tors under a licensing regime would care

about two things: risk analysis quality and

obtaining a high rating. Investors would

benefit from obtaining accurate ratings be-

cause they would be more likely to achieve a

portfolio they desire, and by obtaining high

ratings they would be eligible for state-be-

stowed benefits.

Now suppose credit risk analysts deter-

mined they could increase profits by sell-

ing ratings directly to issuers. They would

need to prove to investors that conflicts of

interest would not dominate their ratings.

If credit risk analysts cheated by giving in

to conflicts of interest, if investors became

uncomfortable with the clear conflict-of-

interest problems, or if investors lost confi-

dence in the analyses’ informational value,

demand for issuer-paid credit risk analysis

would not necessarily decrease, since inves-

tors value both high ratings and risk analy-

sis quality. If credit risk analysts cheated by

inflating ratings sold to issuers, it would

decrease their reputational value among in-

vestors, but the inflated ratings would still

make their investments eligible for state-

bestowed benefits. Thus, the net impact of

cheating on demand would depend on the

negative impact of cheating compared with

the value of state-bestowed benefits. If inves-

tors became uncomfortable with the clear

conflict-of-interest problems, the net im-

pact on demand would also depend on neg-

ative impact of concerns compared with the

value of state-bestowed benefits. If investors

lost confidence in the analyses’ informa-

tional value, then the net impact on demand

would also depend on the cost of unhelpful

ratings or the extent to which the ratings are

uninformative compared with the value of

state-bestowed benefits.

As long as credit risk analysts could keep

the costs of cheating, conflicts of interest,

and low informational value below the ben-

efit of investors obtaining state-bestowed

benefits, then this business model would

likely continue.

However, if the costs of cheating, con-

flicts of interest, or low informational value

exceeded the value of state-bestowed bene-

fits, then investors would not value analysts’

credit risk analyses. In turn, issuers would

have less incentive to purchase analysis on

behalf of investors. Then credit risk firms

would either have to reduce cheating and

conflicts of interests, improve their analyses’

informational value, or begin selling analy-

ses directly to investors. If not, they could

lose market share to a competitor.

It might be that reputational and network

effects create an environment in which only

a few credit analysts emerge. Or it might be

that investor-pays/subscriber-based models

are not extraordinarily profitable, and thus

only few credit analysts are attracted to the

market. If this were the case, then some com-

petitive threat would still exist and could

still provide an incentive to maintain qual-

ity risk assessment models, but it would also

depend on the relative costs and benefits of

obtaining a high quality rating to obtain

state-bestowed benefits.

Some competition for investor business

would remain. Since, in some cases, inves-

tors would demand higher quality products

and products would be rated more accurate-

ly, issuers would have some increased incen-

tive to offer higher quality products.

The overall effect on the marketplace

would be some cheating in ratings, with

conflicts of interests and less informational

value associated with credit analysis com-

Investors would

benefit from

obtaining

accurate ratings

because they

would be more

likely to achieve

a portfolio they

desire.

pared with an open market regime. However,

competitive threat would reduce incentives

to cheat and increase incentives to improve

informational value. Credit risk analysis

would not likely be as accurate as that under

an open market regime, but it would tend

towards accuracy. Issuers would have less

incentive to offer high quality ratings than

they would under an open market regime,

but they would tend towards offering a high-

er quality analysis.

Designated Licensing Regime

Under a designated licensing regime, the

state would stipulate that credit risk analy-

sis be used to either require or incentivize

investors to purchase high quality financial

instruments from issuers. In addition, the

state would also stipulate, or “designate,”

whose credit risk analyses would be eligible

to be used to meet requirements or incentives

when purchasing financial instruments. This

assumes that the state knows how to define

high quality risk analysis and also assumes

that credit risk analysts produce accurate

analyses. It further assumes that the state

knows whose credit risk analysis is the best

and thus should be eligible to meet state re-

quirements or incentives. In addition, it also

assumes that the firms’ whose credit analysis

is best today will continue to be the best in

the future.

In order to comply with the state or ob-

tain benefits from the state, investors would

seek to purchase highly rated investments

from designated firms. Under this regula-

tory framework, investors want both credit

rating analyses to be accurate so that they

obtain the portfolios they desire, but they

also want to obtain high ratings from desig-

nated credit analysts.

Suppose, at first, credit risk analysts sell

their analyses to investors. In contrast to

the open market regime where investors

care most about risk analysis quality, and in

contrast to a licensing regime where inves-

tors care most about risk analysis quality

and obtaining high ratings, investors under

a designated licensing regime care about

three things: risk analysis quality, obtaining

high ratings, and obtaining high ratings

only from designated firms. Investors would

benefit from obtaining accurate ratings be-

cause they would be more likely to achieve

a portfolio they desire, and by obtaining

high ratings only from designated credit risk

analysts, they would be eligible for state-be-

stowed benefits.

Now suppose credit risk analysts deter-

mined they could increase profits by selling

ratings directly to issuers. They would need

to prove to investors that conflicts of inter-

ests with issuers, especially among analysts

with reduced competition, would not impact

their ratings. If credit risk analysts cheated

by giving into conflicts of interest, if inves-

tors became uncomfortable with the clear

conflict-of-interest problems, or if investors

lost confidence in the analyses’ information-

al value, demand for issuer-paid credit risk

analysis would not necessarily decrease, since

investors value both high ratings from desig-

nated firms and risk analysis quality. Under

this regime, credit risk analysts have fewer

competitors because the state only designat-

ed a few of the analysts. If credit risk analysts

cheated by inflating ratings sold to issuers,

it would decrease their reputational value

among investors, but the designated inflated

ratings would still make their investments

eligible for state-bestowed benefits. Analysts

would also be able to get away with more

cheating because of less threat of competi-

tion in the marketplace. Thus, the net impact

of cheating on demand would depend on the

negative impact of cheating compared with

the value of state-bestowed benefits. If inves-

tors became uncomfortable with the clear

conflict-of-interest problems, the net impact

on demand would also depend on the nega-

tive impact of concerns compared with the

value of state-bestowed benefits. If investors

lost confidence in the analyses’ informa-

tional value, then the net impact on demand

would also depend on the cost of unhelpful

ratings or the extent to which the ratings are

uninformative compared with the value of

state-bestowed benefits.

Holding credit

rating agencies

liable for ratings

does not address

the problems of

inflated demand

or reduced

competition.

As long as credit risk analysts could keep

the costs of cheating, conflicts of interest,

and low informational value below the ben-

efits of investors’ obtaining state-bestowed

benefits, then this business model would

likely continue.

However, if the costs of cheating, con-

flicts of interest, or low informational val-

ue in any combination exceeded the value

of state-bestowed benefits, then investors

would not value credit risk analysts’ analy-

ses. In turn, issuers would have less incentive

to purchase analyses on behalf of investors.

Then credit risk firms would either have to

reduce cheating and conflicts of interest, im-

prove their analyses’ informational value, or

begin selling analyses directly to investors.

If not, they could lose their market share

to a competitor. However, since the market

is much less competitive, they retain some

market power over how much cheating and

conflicts of interest will be tolerated, as well

as over informational value of ratings. Credit

risk analysts would still have some incentive

to increase the quality of ratings through re-

duced cheating and reduced conflicts of in-

terest, or to improve their methodologies to

provide value-added to investors. However,

this incentive would be mitigated because

there would be less threat of competition in

the marketplace.

If the analysts still could not bolster de-

mand, then they might have to change their

business model to an investor-pays model

or lose their market share to competitors.

However, with reduced competition in the

marketplace, they may be able to continue

the issuer-pays business model.

Although reputational and network ef-

fects may contribute to a smaller number of

credit risk analysts, the special designations

given to particular credit risk analysts also

significantly contribute to the concentrat-

ed market and reduced competition. Some

competitive threat would remain in the mar-

ketplace and provide incentive for credit risk

analysts to maintain quality risk assessment

models, but it would also depend on the

degree of market power the designated ana-

lysts maintained, as well as the relative costs

and benefits of purchasing high ratings to

obtain state-bestowed benefits from desig-

nated firms.

Since credit risk analysts have greater mar-

ket power than in the previous models, issu-

ers will recognize that there is less competi-

tive threat, with less incentive for the credit

risk analysts to rate financial instruments as

accurately as possible. As such, there may be

less reason to only offer the highest quality

products.

The overall effect of designated credit

analysts on the marketplace would be more

cheating in ratings, greater conflicts of in-

terest, limited competition, and less incen-

tive to improve informational value than in

a licensing or open regime. Credit risk analy-

sis would not be as accurate as it would be

under a licensed or open market regime. In

turn, issuers would have less incentive to of-

fer high quality products.

Reforms Not To Pursue

Some have argued that problems relat-

ed to credit rating agencies result from the

SEC passing off its responsibility to private

companies. But requiring the SEC to con-

duct valuations of credit risk would not deal

with the problem of inflated and captive de-

mand. Moreover, it is unlikely that the SEC

is equipped or could ever become equipped,

without major market stifling, to handle

credit risk valuation on its own. For exam-

ple, a 2002 Senate study found that SEC of-

ficials had managed to review only 16 per-

cent of the 15,000 annual company reports

submitted in the previous fiscal year, and

they had not reviewed Enron in a decade.74

Some contend that holding CRAs liable

for their ratings would force them not to

cheat and to innovate better ratings method-

ologies. First, holding CRAs liable for ratings

does not address the problems of inflated

demand or reduced competition. Second,

CRAs argue they are a “part of the media”

since they are financial publishers.75 For this

Another risk

from subjecting

rating agencies to

liability is that, in

order to protect

themselves, the

agencies would

utilize “consensus

forecasts” of

key economic

variables. Yet the

consensus could

be dangerously

off.

reason, they argue that the First Amendment

applies to them and protects their speech.

Third, it remains true that they do not have

a federal mandate, as NRSRO CRA analysts

contended at a Senate panel in the wake of

Enron’s collapse: “S&P operates with no gov-

ernmental mandate, subpoena power, or any

other official authority. It simply has a right,

as part of the media, to express its opinion

in the form of letters and symbols.”76 More-

over, since actual credit risk is nearly impos-

sible to know and CRAs are limited by issu-

ers’ financial disclosure, it would be difficult

to prove in court that CRAs purposefully in-

flated credit ratings.

Another risk from subjecting rating agen-

cies to liability for either their statements or

processes is that, in order to protect them-

selves, the agencies would adopt a “reason-

able man” approach. For instance, if the

agencies used government forecasts of house

prices in their mortgage default models,

then it is likely that any court would deem

such assumptions “reasonable”; after all,

these are the assumptions that regulators

rely upon. If such assumptions are, however,

grossly in error, as were the housing price

forecasts used by various federal agencies,

then the value of information created by the

rating agencies would also be reduced, if not

compromised. A reasonable-man approach

would also encourage rating agencies to uti-

lize “consensus forecasts” of key economic

variables. Yet the consensus could be danger-

ously off. The economic forecasting profes-

sion does not exactly have a great record at

predicting turning points, and it also missed

the decline in house prices. A system of liabil-

ity would likely destroy whatever additional

information the rating agencies bring to the

market, as the agencies would face tremen-

dous pressure to simply mimic widely held

beliefs, which themselves would already be

priced into the market.

Others have advocated restricting the

practice of “notching.” CRAs engage in puni-

tive notching if they compel issuers to pur-

chase more products by threatening to notch

down other rated financial instruments.

When or if notching does occur, it is anti-

competitive; however, prohibiting notching

also ignores the problem of inflated demand

and reduced competition. Moreover, CRAs

would have less ability to compel issuers to

buy their products if they had less oligopo-

listic market power.77

Another proposal has been to ban finan-

cial instruments that are determined to be

too complex for adequate risk assessment.

This also neglects the core problems of in-

flated demand and the de facto NRSRO

CRA oligopoly. It further assumes that fi-

nancial regulators and lawmakers have the

knowledge necessary to determine which

instruments are “too complex.”78 Finally, it

overlooks the significant opportunity costs

associated with preventing innovation in fi-

nancial markets.

Recent Development in CRA Regulatory

Reform

In the wake of Enron, the 2002 Sarbanes-

Oxley Act required the SEC to reexamine the

“role and function of rating agencies in the

operation of the securities market” and to

specifically address potential barriers to en-

try.79 In 2003, the SEC sought comments on

whether NRSRO credit ratings should con-

tinue to be used for regulatory purposes. Ac-

cording to the SEC, most of the 46 comments

responding to the 2003 Concept Release sup-

ported continuing the NRSRO designation

and expressed concern that “eliminating the

NRSRO concept would be disruptive to capi-

tal markets.”80 However, it is worth noting

the SEC’s primary citation for those in favor

of keeping the NRSRO designation was a

“Letter from Leo C. O’Neill, President, Stan-

dard & Poor’s, to Jonathan G. Katz, Secretary,

Commission (July 28, 2003).”81 The SEC

mentioned that only four commenters sup-

ported elimination of the concept, and cited

professors Frank Partnoy of the University

of San Diego School of Law and Lawrence J.

White of NYU’s Stern School of Business.82

From these comments, the SEC attempted

to clarify the process of identifying NRSROs

with a proposed definition:83

Barriers to

entry alone

were not solely

responsible for

problems in

market structure.

i. issues publicly available credit ratings

that are current assessments of the

creditworthiness of obligors with re-

spect to specific securities or money

market instruments;

ii. is generally accepted in the financial

markets as an issuer of credible and

reliable ratings, including ratings for a

particular industry or geographic seg-

ment, by the predominant users of se-

curities ratings; and

iii. uses systematic procedures designed

to ensure credible and reliable ratings,

manage potential conflicts of interest,

and prevent the misuse of nonpublic

information, and has sufficient finan-

cial resources to ensure compliance

with those procedures.

The non-NRSRO CRA community ex-

pressed concern that these proposed reforms

would, in fact, strengthen incumbent power

in the market rather than reduce barriers

to entry. First, the proposed rules would re-

quire CRAs to provide public credit ratings,

although this would be essentially offering

their products free of charge for subscrib-

er-based CRAs. The rule clearly catered to

the firms that used an issuer-pays business

model rather than a subscriber-pays model.

Second, the requirement for CRAs to be

“generally accepted” created something like

a chicken-and-egg problem for new firms.

As Banking, Housing, and Urban Affairs

Committee Chairman Sen. Richard Shelby

put it, “to receive the license a firm must be

nationally recognized, but it cannot become

nationally recognized without first having

the license.”84 As Lawrence White argues, in

order to be “generally accepted” it would re-

quire ratings be linked “to the views of the

predominant users of securities ratings.”85

Ultimately, the SEC did not move forward

with these proposals.

In 2005, the House considered legislation

to reduce barriers to entry in the CRA mar-

ket, and on September 29, 2006, President

Bush signed the Credit Rating Agency Act

of 2006. A primary result of the legislation

was to reduce arbitrary SEC power to desig-

nate NRSROs and instead set timelines for

SEC response. Under the 2006 law, any credit

rating firm issuing ratings for at least three

years could apply to the SEC to receive the

NRSRO designation. The SEC would need

to render a decision or set a timeline for eval-

uation within 90 days, and make a final deci-

sion within 120 days. The rules also aimed to

avoid bolstering a particular business model,

whether subscriber-pays or issuer-pays. The

law ensured that neither the SEC nor the

state could regulate credit ratings’ content,

procedures, or methodologies, and prohib-

ited NRSROs from allowing conflicts of in-

terest to impact rating integrity or “condi-

tioning ratings . . . on an issuer’s purchasing

other services from the NRSRO.”86

Despite these attempts to reduce barriers

to entry in the CRA marketplace, Langohr

and Langohr argue that this merely “re-

placed one form of controlled access to [the

CRA market] with another” by replacing the

opaque NRSRO subjective recognition sys-

tem with an objective recognition system.87

They argue that these “objective” measures

still used criteria that systematically favor

incumbent firms while continuing to disad-

vantage competitors. Still, there is evidence

that some ratings markets did experience

reduced concentration, as demonstrated in

Table 4.

Barriers to entry alone were not solely re-

sponsible for problems in market structure.

Instead, regulatory dependence on NRSRO

ratings also led to distorted incentives and

outcomes. As a result, policymakers have

considered reducing the role of NRSRO rat-

ings in regulation.

The Dodd-Frank Act

While each financial crisis seems to have

a cycle of complaints about failures among

the rating agencies, previous legislative re-

sponses, such as the Sarbanes-Oxley Act,

have relied mostly on further study rather

than wholesale reform of the ratings pro-

cess. The Dodd-Frank Act attempts to ad-

dress the quality of ratings via a variety of

The primary

focus of Dodd-

Frank’s changes

to the regulation

of rating agencies

is in attempting

to “insulate” the

agencies from

various perceived

conflicts of

interest.

mechanisms. The most extensive of these

are found in Section 932.

The primary focus of Dodd-Frank’s

changes to the regulation of rating agencies

is in attempting to “insulate” the agencies

from various perceived conflicts of interest.

For instance, Dodd-Frank requires improved

“internal controls” for the ratings process,

separating the sales and marketing functions

of the agencies from the ratings process, in-

creasing the number of independent direc-

tors on the agencies’ boards of directors, and

increasing the responsibilities of the ratings

agencies’ boards. Many of these features

mirror the expanded corporate governance

requirements for auditors imposed by the

Sarbanes-Oxley Act. This should not be too

surprising, as it was the same congressional

staffers who drafted the similar sections in

both acts. What is surprising is the expecta-

tion that such provisions would work any

better in improving credit ratings than they

did, or failed to do, in improving the quality

of financial audits.

The quest for board independence is a

repeated theme in corporate governance re-

forms. As mentioned, the Sarbanes-Oxley

Act increased the number of independent

board members for auditors, with similar

provisions covering rating agencies in the

Dodd-Frank Act. These repeated attempts at

independence, however, find little support in

the academic literature. In the case of banks

during the financial crisis, some research-

ers find that greater board independence is

actually associated with worse outcomes.88

Dodd-Frank further muddies the waters by

allowing some of the “independent” board

members to be users of ratings. This ignores

the fact that investors in rated securities have

their own incentives to avoid downgrades.

Instead of reducing conflicts of interests,

Dodd-Frank may very well simply be substi-

tuting one conflict of interest for another.

One of the Dodd-Frank rating agency re-

forms has already had tremendous negative

impact on our capital markets—so much so

that the SEC has effectively voided the pro-

vision. This Section, 939G, repeals SEC rule

436(g), which had exempted NRSROs from

being deemed part of a security’s registra-

tion statement for the purposes of securities

fraud. Rule 436(g) had protected NRSROs

from liability under Section 11 of the 1933

Securities Act. This protection actually in-

creased the flow and quality of information

received by investors by encouraging the

use of ratings in offering statements. Dodd-

Frank’s repeal of Rule 436(g) effectively shut

down the new offerings market for asset-

backed securities and corporate debt. It was

only the issuance of a “no-action” letter from

the SEC to Ford Motor Credit Company that

allowed this market to function. However,

this no-action letter is temporarily in effect,

leaving considerable uncertainty as to how

our debt markets will function in the ab-

sence of Rule 436(g), at least until such time

the markets evolve beyond the regular use of

credit ratings.

The Dodd-Frank Act, like the Sarbanes-

Oxley Act before it, attempts to remedy

regulatory failures with the increased use of

private litigation. Section 933 expands the

potential legal liability of rating agencies in

three ways. First, it established a private right

of action under Section 18 of the 1934 Se-

curities Act for any material misstatements

contained in reports to the SEC. Second, it

established liability for errors in factual as-

sumptions used in a ratings methodology.

An example would be the range of forecast-

ed house prices over the life of a mortgage-

backed security. Third, and last, there is es-

tablished legal liability under Section 21E

of the 1934 Securities Act for misstatements

in any forward-looking statements made by

the rating agencies. Of course, one defense to

these charges would be to adopt a reasonable-

man approach to ratings methodology and

predictions. Basing ratings on consensus, or

even government forecasts of key economic

variables, would likely provide some shield

to liability. Providing a consensus viewpoint

could, however, greatly reduce the informa-

tional value provided by ratings. Increased

liability could easily make rating agencies

risk-averse and less likely to offer unconven-

Overall, the

Dodd-Frank Act

is a mixed bag

when it comes to

the credit rating

agencies.

tional points of view. Agencies could also be

subject to suit by investors “harmed” by the

downgrade of assets which they hold. Un-

til these provisions are tested in the courts,

their ultimate impact on ratings’ quality will

remain unknown. It is likely, however, that

the increased incentives for risk aversion will

greatly reduce the value of ratings to our

capital markets, with potential harm to both

price discovery and liquidity.

Other provisions of Dodd-Frank are also

likely to reduce the utility of rating agencies,

with detrimental impacts on our capital

markets. For instance, Section 939B elimi-

nates the rating agencies exemption from

Regulation FD, which covers the “fair dis-

closure” of information. Regulation FD pro-

hibits senior executives of public companies

who regularly communicate with the public

from making selective disclosure of non-

public informational material to select per-

sons. Prior to Dodd-Frank, the rating agen-

cies were exempted, with the understanding

that the ratings process would be better in-

formed if the rating agencies had occasional

access to nonpublic information. Section

939B has the potential to reduce the flow of

information between public companies and

the rating agencies, with the result that rat-

ings become less informed.

Not all of the credit rating provisions

of Dodd-Frank are harmful or misguided.

In fact, the law takes a serious step toward

reducing the regulatory reliance on the rat-

ing agencies. Section 939A of Dodd-Frank

requires all federal agencies to review their

existing regulations and to provide alter-

native standards of credit risk. Although

the federal bank regulators have, as of the

publication of this paper, requested public

comments as to possible alternatives, these

same regulators have moved slowly on Sec-

tion 939A and have shown a general resis-

tance to abandoning their reliance on the

rating agencies. While Section 939A has

the potential to address some of the central

flaws discussed in this paper, it also leaves

considerable discretion to the very same

regulators who instituted those flaws. For

Section 939A to have real impact, however,

it may well take the continued involvement

of Congress.

Overall, the Dodd-Frank Act is a mixed

bag when it comes to the credit rating agen-

cies. Some provisions have a real potential for

reform, but their success is also contingent

on the same regulatory process that created

the problems. Unfortunately other more

concrete provisions of Dodd-Frank have al-

ready had a significant negative impact on

our capital markets. A repeal of these latter

provisions, particularly Sections 932, 933,

939B, and 939G, would protect the positive

capital market functions of the rating agen-

cies. Section 939A, which attempts to reduce

regulatory reliance on the rating agencies,

should be retained, but may be in need of

strengthening.

Proposal for Reform

The open-market regime provides results

closest to the regulatory ideal and best serves

the public good. It calibrates incentives in

such a way that issuers, investors, and credit

rating agencies have an incentive to promote

the public good while seeking their own self-

interest. The benefits likely achieved in the

open-market regime include higher quality

investment instruments, higher quality rat-

ings, increased methodological innovation,

and investor focus on informational value

rather than regulatory privilege.

To achieve open-market regime benefits

would require ending regulatory reliance on

credit rating agencies. It would also require

repealing the Nationally Recognized Sta-

tistical Rating Organization (NRSRO) des-

ignation and allowing competition in the

marketplace of credit rating firms. Market

participants may still use credit ratings to

evaluate credit risk, but they should also be

free to innovate their credit-risk evaluations.

Ultimately, these reforms will help reduce

CRA oligopolistic power and reduce artifi-

cial demand for credit ratings.

To the extent that this is not politically

feasible, or that policymakers worry that cap-

ital controls are required to prevent system-

One contributor

to the financial

crisis was a

significant

reduction in due

diligence on the

part of investors,

regulators,

financial

institutions,

borrowers, and

politicians.

atic bank runs, regulators should strongly

consider eliminating references to NRSRO

credit ratings as often as possible. Moreover,

when ratings are required, they could be

used to calculate net capital at the time of

purchase, rather than over time. Also, regula-

tors may consider innovations in credit risk

analysis, or market-based measures such as

credit spreads or market implied ratings, in

evaluating credit risk. In addition, many of

these measures of credit risk can be used by

investors themselves, promoting investor

due diligence in investment decisions.

Conclusion

A variety of factors contributed to the

worldwide financial crisis of 2008. One of

those was the mistaken belief that risky as-

sets, such as mortgage-backed securities and

sovereign debt, were actually risk-free. This

perception facilitated both the massive lev-

els of leverage and excessive degrees of asset

concentration witnessed within our finan-

cial system. In all likelihood, such leverage

and asset concentration would not have oc-

curred had the assets in question not been

blessed by the CRAs, or had financial regu-

lators not embedded the use of ratings into

the fabric of prudential regulation.

A lack of competition, in part the result

of regulatory barriers, along with mandated

usage by many financial market participants

has resulted in a dysfunctional credit ratings

industry. Entrenched market power has led

to the predictable result that ratings agen-

cies would reduce the quality of their servic-

es. Unfortunately, their services were signifi-

cant components in our financial regulatory

system. This reduction in ratings quality

also resulted in a reduction in the efficacy of

financial regulation.

Increased competition alone, however,

will be insufficient to address the failings in

the ratings market. In order to move toward

a functioning, competitive ratings market,

the users of ratings, particularly investors,

must be free to reject the use of ratings. In

fact, increased competition, coupled with a

continued “gate-keeping” role for CRAs, is

just as likely to increase financial fragility as

reduce it. To the extent that rating agencies

are performing police power functions of

the state, those functions should be trans-

ferred back to the state.

One contributor to the financial crisis

was a significant reduction in due diligence

on the part of investors, regulators, financial

institutions, borrowers, and politicians. To

some extent this reduction was facilitated

by a belief that rating agencies could pro-

vide such due diligence on behalf of other

market participants. Reducing the central

role of rating agencies in financial regula-

tion would undoubtedly increase the due

diligence cost of other market participants.

It would, however, greatly increase the qual-

ity and quantity of monitoring of financial

risk by market participants.

Ultimately, both taxpayers and financial

market participants would be better served by

rating agencies that were subject to competi-

tive market pressures. Such pressures would

most effectively be brought to bear by a re-

duction in regulatory barriers to entry and

the removal of artificial demand due to vari-

ous compliance requirements placed upon

other market participants, such as banks, in-

surance companies, and mutual funds.

Notes

1. For background information, please see

Securities and Exchange Commission, “Com-

ments on Proposed Rule: Rating Agencies and

the Use of Credit Ratings under the Federal Secu-

rities Laws,” http://www.sec.gov/rules/concept/

s71203.shtml.

2. Carol Ann Frost, “Credit Rating Agencies in

Capital Markets: A Review of Research Evidence

on Selected Criticisms of the Agencies,” Journal of

Accounting, Auditing, and Finance 22, no. 2 (2007):

25.

3. Miles Livingston, Diana Wei, and Lei Zhou,

“Moody’s and S&P Ratings: Are They Equivalent?

Conservative Ratings and Split Bond Yields,”

Journal of Money, Credit and Banking 42 (2010):

1267–94.

4. Kent Baker and Sattar Mansi, “Assessing

Credit Rating Agencies by Bond Issuers and In-

stitutional Investors,” Journal of Business Finance &

Accounting 29 (2002): 1367–98.

5. Herwig Langohr and Patricia Langohr, The

Rating Agencies and their Credit Ratings: What They

Are, How They Work, And Why They Are Relevant

(West Sussex, UK: John Wiley and Sons, Ltd.,

2008).

6. Richard Cantor and Frank Packer, “Multiple

Ratings and Credit Standards: Differences of

Opinion in the Credit Rating Industry,” Federal

Reserve Bank of New York Staff Report (New York:

Federal Reserve Bank,1996); Patrick Van Roy,

“Credit Ratings and the Standardized Approach

to Credit Risk in Basel II,” European Central Bank

Working Paper no. 517 (July 25, 2005): 1–55.

7. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

8. Lawrence J. White, “The Credit Rating In-

dustry: An Industrial Organization Analysis,” in

Rating Agencies in the Global Financial System (New

York: NYU Stern School of Business, 2001).

9. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

10. Federal Reserve, Federal Reserve Board Flow of

Funds (Washington: Federal Reserve Statistical Re-

lease, 2011).

11. Ibid.

12. P. E. Apgar, D. Arthur, and L. Monaco,

Moody’s, Equity Research Report (New York: Mor-

gan Stanley, 2005), pp. 1–16; B. Crockett, J. Jowe,

and F. Searby, Moody’s: Attractive Business, but

Growth Hiatus in 2004 (New York: North Ameri-

can Equity Rearch: JPMorgan, 2003), pp. 1–44.

13. Lawrence J. White, “The Credit Rating In-

dustry: An Industrial Organization Analysis” and

“Good Intentions Gone Awry: A Policy Analysis

of the SEC’s Regulation of the Bond Rating In-

dustry,” in Public Law & Legal Theory Research Pa-

per Series (New York: New York University School

of Law, 2005): 13–16.

14. White, “The Credit Rating Industry: An In-

dustrial Organization Analysis.”

15. For a concise discussion, see Lawrence J.

White, “A New Law for the Bond Rating Indus-

try,” Regulation 30, no. 1 (2007): 48–52.

16. Milton Friedman and Anna J. Schwartz, A

Monetary History of the United States 1867–1960

(Princeton, NJ: Princeton University Press, 1963).

17. Ibid.

18. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

19. Wyatt Wells, “Certificates and Computers:

The Remaking of Wall Street, 1967 to 1971,” Busi-

ness History Review 74, no. 2 (2000): 193–235.

20. Securities and Exchange Commission, Secu-

rities Exchange Act Rel. No. 34-10,525 (Washington:

SEC News Digest, 1973).

21. Michael P. Jamroz, “The Net Capital Rule,”

Business Lawyer 47 (1991–1992): 863–912.

22. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

23. Ibid.

24. Ibid.

25. For more information, see George Stigler,

“The Theory of Economic Regulation,” Bell Jour-

nal of Economics and Management Science (1971):

3–21. Stigler argues that one of the four primary

reasons industries lobby the state is to control en-

try into the market so they can reduce the compe-

tition and increase their profits.

26. William H. Beaver, Catherine Shakespeare,

and Mark T. Soliman, “Differential Properties in

the Ratings of Certified vs. Non-Certified Bond

Rating Agencies,” Working Paper (2006), http://

ssrn.com/abstract=59662.

27. Frank Partnoy, “The Siskel and Ebert of

Financial Markets? Two Thumbs Down for the

Credit Rating Agencies,” Washington University Law

Quarterly 77 (1999): 681–90; and John C. Coffee

Jr., Gatekeepers: The Professions and Corporate Gover-

nance (London: Oxford University Press, 2006).

28. Coffee, Gatekeepers.

29. George Stigler, “The Theory of Economic

Regulation.”

30. George Akerlof, “The Market for “Lemons”:

Quality Uncertainty and the Market Mecha-

nism,” Quarterly Journal of Economics 84 (1970):

488–500.

31. Partnoy, “The Siskel and Ebert of Financial

Markets?”; Claire A. Hill, “Why Did Anyone Lis-

ten to the Rating Agencies after Enron?” Journal of

Business and Technology Law 4 (2009): 283–94.

32. Frank Partnoy, “How and Why Credit Rat-

ing Agencies Are Not Like Other Gatekeepers,”

Legal Studies Research Paper Series (2006): 89–94.

33. Frank Partnoy, “The Siskel and Ebert of Fi-

nancial Markets?”

34. David Zigas, “Why the Ratings Agencies Get

Low Marks on the Street,” Business Week, March

12, 1990, p. 104.

35. James Van Horne, Financial Market Rates

and Flows (Upper Saddle River, NJ: Prentice Hall,

2000).

36. Richard Cantor and Frank Packer, “Determi-

nants and Impacts of Sovereign Credit Ratings,”

Economic Policy Review 2, no. 2 (1996): 45–46.

37. Hill, “Why Did Anyone Listen to the Rating

Agencies after Enron?”

38. Zigas, “Why the Ratings Agencies Get Low

Marks on the Street.”

39. Association for Financial Professionals, Rat-

ings Agencies Survey: Accuracy, Timeliness, and Regu-

lation (Bethesda, MD: Assocation for Financial

Professionals, 2002).

40. P. Jenkins, “DBRS to Challenge Big Agen-

cies,” Financial Times (London), January 10, 2006.

41. Lawrence J. White, “The Credit Rating Indus-

try: An Industrial Organization Analysis”; Coffee,

Gatekeepers.

42. Some argue that reputational factors mat-

ter more than conflicts of interest. See Daniel M.

Covitz and Paul Harrison, “Testing Conflicts of

Interest at Bond Ratings Agencies with Market

Anticipation: Evidence That Reputation Incen-

tives Dominate,” FEDS Working Papers (Washing-

ton: Board of Governors of the Federal Reserve

System, 2003): 1–23. However, we find this argu-

ment, operationalization, and empirical assess-

ment less than compelling.

43. Ibid.

44. Han Xia, “The Issuer-Pay Rating Model and

Rating Inflation: Evidence from Corporate Cred-

it Ratings,” Working Paper (2010): 56.

45. Covitz and Harrison, “Testing Conflicts of

Interest at Bond Ratings Agencies with Market

Anticipation.”

46. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

47. Beaver et al., “Differential Properities in the

Ratings of Certified vs. Non-Certified Bond Rat-

ing Agencies.”

48. John M. Griffin and Dragon Yongjun Tang,

“Did Subjectivity Play a Role in CDO Credit Rat-

ings?” McCombs Research Paper Series (2010): 13–

15; Gailen Hite and Arthur Warga, “The Effect

of Bond-Rating Changes on Bond Price Perfor-

mance,” Financial Analysts Journal 53 (1997): 35–

51; Frank Partnoy, “The Paradox of Credit Rat-

ings,” in Law and Economics (2001): 1–23, http://

www.riskcenter.com.tr/kredirisk/kredifiles/YM/

the_paradox_of_credit_ratings.pdf.

49. Han Xia, “The Issuer-Pay Rating Model and

Rating Inflation: Evidence from Corporate Cred-

it Ratings,” Working Paper (2010): 56.

50. White, “The Credit Rating Industry: An In-

dustrial Organization Analysis” and “Good In-

tentions Gone Awry.”

51. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

52. Hill, “Why Did Anyone Listen to the Rating

Agencies after Enron?”

53. Permanent Subcommittee on Investiga-

tions, “Wall Street and the Financial Crisis: Anat-

omy of a Financial Collapse,” eds. Carl Levin and

Tom Coburn (Washington: United States Sen-

ate, 2011).

54. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

55. White, “The Credit Rating Industry: An In-

dustrial Organization Analysis.” White contends

that the CRA industry is also concentrated as a

result of regulatory restrictions by the SEC deter-

mining who can be an NRSRO.

56. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

57. Sean J. Egan, “Statement of Egan Jones on

Credit Ratings Agencies,” letter submitted to the

SEC (2002).

58. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

59. Sean Egan, Managing Director, Egan-Jones

Rating Company, “The Role of Credit Rating

Agencies in the Capital Markets,” Testimony be-

fore the Senate Committee on Banking, Housing

and Urban Affairs (Washington: 2005), 1–12.

60. Egan, “Statement of Egan Jones on Credit

Ratings Agencies.”

61. Langohr and Langohr, The Rating Agencies and

their Credit Ratings.

62. J. Wiggins, “A Chance to Step into the

Light,” Financial Times (London), December 9,

2002.

63. A “Nash equilibrium” is a position in a game

or interaction involving two or more actors, in

which no actor has anything to gain by changing

only his own strategy unilaterally. Since there is

no unilateral action by either actor that would

improve their respective positions, the implica-

tion is that such an outcome will produce a stable

equilibrium.

64. A Bertrand duopoly is one in which a duo-

poly is sufficient to drive prices down to marginal

cost and produces a result consistent with that

found under perfect competition. While the Ber-

trand model is conditioned upon a number of

simplifying assumptions, it does decribe a situa-

tion where even a few competitors (a highly con-

centrated market) can mirror outcomes found

under perfect competition.

65. First articulated in Joseph Bertrand, review

of “Theorie Mathematique de la Richesse Sociale

and of Recherches sur les Principles Mathema-

tiques de la Theorie des Richesses” by Léon Wal-

ras, Journal des savants 67 (1883): 499–508.

66. Coffee, Gatekeepers.

67. Association for Financial Professionals, “Rat-

ings Agencies Survey.”

68. Fitch Ratings, “Definitions of Ratings and

Other Forms of Opinion” (2012).

69. Charles W. Calomiris, The Debasement of Rat-

ings: What’s Wrong and How We Can Fix It (New

York: Columbia Business School, National Bu-

reau of Economic Research, 2009), pp. 1–14.

70. Ibid.

71. Bo Becker and Todd Milbourn, “How Did

Increased Competition Affect Credit Ratings?”

NBER Working Paper Series (2010): 1–31; Bo

Becker and Todd Milbourn, “Reputation and

Competition: Evidence from the Credit Rating

Industry” Harvard Business School Working Pa-

pers (2009): 1–41.

72. Ibid.

73. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

74. Kevin Dowd and Martin Hutchinson, Alche-

mists of Loss: How Modern Finance and Government

Intervention Crashed the Financial System (West Sus-

sex, UK: John Wiley and Sons, Ltd., 2010).

75. Partnoy, “The Siskel and Ebert of Financial

Markets?”

76. James Van Horne, Financial Market Rates

and Flows (Upper Saddle River, NJ: Prentice Hall,

2000); U.S. Securities and Exchange Commis-

sion, Report on the Role and Function of Credit Rat-

ings Agencies in the Operation of the Securities Markets

(Washington: U.S. Securities and Exchange Com-

mission, 2003).

77. See further discussion in Fabian Dittrich,

The Credit Rating Industry: Competition and Regula-

tion (Cologne, Germany: University of Cologne,

2007), pp. 110–14, 153–55.

78. For more discussion about how insufficient,

and often unobtainable, knowledge makes cen-

tralized planning suboptimal, see F. A. Hayek,

“The Use of Knowledge in Society,” American Eco-

nomic Review 35 (1945): 519–30.

79. U.S. Securities and Exchange Commission,

Report on the Role and Function of Credit Ratings Agen-

cies in the Operation of the Securities Markets.

80. U.S. Securities and Exchange Commission,

“Proposed Rule: Definition of Nationally Rec-

ognized Statistical Rating Organization,” Federal

81. Ibid. See also, Securities and Exchange Com-

mission, “Comments on Proposed Rule: Rating

Agencies and the Use of Credit Ratings under

the Federal Securities Laws,” http://www.sec.gov/

rules/concept/s71203.shtml; and Leo C. O’Neill,

letter to Jonathan G. Katz, July 28, 2003, http://

www.sec.gov/rules/concept/s71203/standard

072803.htm.

82. White, “The Credit Rating Industry: An In-

dustrial Organization Analysis” and “Good Inten-

tions Gone Awry.”

83. U.S. Securities and Exchange Commission,

“Proposed Rule: Definition of Nationally Recog-

nized Statistical Rating Organization.”

84. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

85. White, “A New Law for the Bond Rating In-

dustry.”

86. Ibid.

87. Langohr and Langohr, The Rating Agencies

and their Credit Ratings.

88. Sanjai Bhagat and Bernard Black, “The Un-

certain Relationship between Board Composition

and Firm Performance,” Business Lawyer (ABA) 54

(1999): 1–3, 38–39; and Andrea Beltratti and René

M. Stulz, “Why Did Some Banks Perform Better

During the Credit Crisis? A Cross-Country Study

of the Impact of Governance and Regulation,”

NBER Working Paper Series (2009): 1–33.

ResearchGate has not been able to resolve any citations for this publication.

Testing Conflicts of Interest at Bond Rating Agencies with Market Anticipation : Evidence that Reputation Incentives Dominate

Article

Dec 2003

This paper presents the first comprehensive test of whether well-known conflicts of interest at bond rating agencies importantly influence their actions. This hypothesis is tested against the alternative that rating agency actions are primarily influenced by a countervailing incentive to protect their reputations as delegated monitors. These two hypotheses generate a number of testable predictions regarding the anticipation of credit-rating downgrades by the bond market, which we investigate using a new data set of about 2,000 credit rating migrations from Moody's and Standard & Poor's, and matching issuer-level bond prices. The findings strongly indicate that rating changes do not appear to be importantly influenced by rating agency conflicts of interest but, rather, suggest that rating agencies are motivated primarily by reputation-related incentives.

Differential Properties in the Ratings of Certified vs. Non-Certified Bond Rating Agencies

Article

Jan 2006

We examine whether the properties of bond ratings from certified agencies (designated by the SEC) differ from those of non-certified bond rating agencies. Bond ratings from non-certified agencies are used solely for investment advice. Certified ratings are used by a variety of constituents, many of whom write contracts incorporating these ratings. We find that the properties of the ratings from the two agency types differ in predictable ways. Our results show that the non-certified agency's ratings are consistent with their role of providing information to investors. The certified agency is generally more conservative, consistent with their significant role in contracting.

How Did Increased Competition Affect Credit Ratings?

Article

Jan 2010

The Theory of Economic Regulation

Article

Jan 1971

George J. Stigler

The Debasement of Ratings: What's Wrong and How We Can Fix It

Article

Jan 2009

Charles W Calomiris

Executive Summary This paper poses and answers three sets of questions that lie at the heart of the public controversy over rating agency performance and reform. (1) What is the evidence that rating agencies have been performing badly in measuring credit risk on the debts that they rate? The evidence relates to two separate phenomena: inflated ratings and low-quality ratings. The inflation of ratings is defined as the purposeful over-rating (under-estimation of default risk) on rated debts. Low-quality ratings, defined as ratings based on flawed measures of underlying risk, are a related but logically distinct phenomenon. The recent collapse of subprime-related securitizations revealed both problems in the extreme, but these problems have been present in securitized debt instruments for decades. (2) What are the causes of those deficiencies? Have rating agencies been suborned, and if so, by whom and to what purpose? Low-quality ratings could reflect innocent errors associated with learning about new products, but there is evidence that severe errors are often predictable. These severe, predictable errors in ratings reflect agency problems among buy-side investors that lead them to encourage rating agencies to purposely build inaccurate models that ignore or underestimate important risks. I review the evidence that suggests that important modeling errors in the recent crisis were predictable, and that they reflected buy-side investors' demand for inaccurate and inflated ratings. Both of these phenomena (rating inflation and low-quality ratings) are legitimate targets of reform. Ratings inflation, while sometimes harmless, undermines the regulatory use of ratings to limit risks undertaken by institutional investors. Low-quality ratings, resulting from agency problems, can generate disastrously large system-wide losses for ultimate investors (the clients of institutional investors), and extreme disruption to markets, as in the recent crisis. (3) What do policy makers propose doing to improve rating agency performance to eliminate ratings inflation and low-quality ratings? Do those reform proposals make sense, and if not, what would work better? Existing policy proposals would tinker with the rating process in ways that have little hope of fixing either the ratings-inflation or low-quality ratings problems. The regulatory solution that I propose – to create credible penalties that link the fees credit rating agencies receive to their actual performance in predicting defaults – would address both the incentive problem that gives rise to ratings inflation and the incentive problems that encouraged faulty rating methodologies.

Certificates and Computers: The Remaking of Wall Street, 1967 to 1971

Article

Jun 2000
BUS HIST REV

Wyatt Wells

Events in the late 1960s reshaped the securities industry. Trading volume increased sharply, with the number of shares changing hands on the New York Exchange growing from five million a day in 1965 to twelve million a day in 1968. This expansion overwhelmed the mechanisms brokers used to transfer securities and keep records, which relied heavily on paper and pen. They responded by purchasing computers, but these machines were expensive and demanded more sophisticated management than most firms could provide. Accordingly, many companies botched the process. Moreover, trading volume declined sharply in 1969 and 1970, cutting deeply into brokerage revenue. These factors combined to create a crisis that had, by the end of 1970, forced nearly a sixth of the nation's brokerage firms out of business. Yet this crisis also opened the way for large, integrated companies, which, by the 1990s, dominated the securities industry and conducted business on a scale unimagined thirty years earlier.

The Effect of Bond-Rating Changes on Bond Price Performance

Article

May 1997

The price reaction of publicly traded industrial bonds to Moody's Investors Service and Standard & Poor's bond-rating changes is investigated using a database of month-end trader quotes from Lehman Brothers for March 1985 through March 1995. All Standard & Poor's and Moody's rating changes are studied in a period from up to 12 months before the rating change to 12 months after. A unique feature of this study is the use of a data set containing recent firm-specific information that also provides a long event window. Downgraded firms reveal a significant announcement effect in both the announcement month and preannouncement period. The magnitude of downgrading effects increases dramatically as the sample moves from investment-grade to non-investment-grade firms. Samples that are restricted to rating changes that are not preceded by any rerating within six months reveal that the market reacts reliably as much as six months before an event. Upgrade effects are much weaker in magnitude and significance.

A Monetary History of United States

Article

Jan 1966

Credit Rating Agencies in Capital Markets: A Review of Research Evidence on Selected Criticisms of the Agencies

Article

Mar 2006

Carol Ann Frost

This study assesses the validity of widespread criticisms of the large, nationally recognized credit rating agencies (CRAs). The criticisms focus on these CRAs' (1) disclosure practices (such as related to the assumptions underlying their ratings decisions); (2) potential conflicts of interest; (3) alleged anticompetitive or unfair practices; and (4) diligence and competence. This paper focuses on two questions. First, to what extent does empirical evidence support the criticisms? Second, what additional evidence might be useful? Although little rigorously-gathered empirical evidence supports the criticisms, the absence of such evidence does not indicate that the criticisms are invalid. First, powerful tests related to potential conflicts of interest and alleged unfair practices are exceptionally difficult to design. Second, criticisms related to the adequacy of CRAs' disclosure practices have not yet been, but could be, investigated by empirical researchers. Third, many criticisms, particularly those focusing on the adequacy of CRAs' disclosure practices, diligence, and competence, are based on subjective benchmarks that are difficult to quantify (and that themselves are open to question). Empirical evidence does support the view that the large CRAs' dual roles of (1) providing timely information to market participants; and (2) serving regulatory and contracting functions, create conflicting incentives. Note, however, that the costs of these conflicts may be less than those of other alternatives. Researchers should further investigate how conflicting incentives affect CRA practice, and develop and test models of how CRAs optimize across their conflicting rating goals. Researchers have many other opportunities to make important contributions. For example, further study of factors that influence characteristics of credit ratings, such as timeliness, stability, and accuracy, is warranted.

Why Did Anyone Listen to the Rating Agencies After Enron?

Article

Aug 2009

Claire A. Hill

Enron was rated investment grade by Moody’s, Standard and Poor’s, and Fitch until four days before it declared bankruptcy - scarcely a ringing endorsement of the agencies’ acumen. Even before Enron, the rating agencies had come in for significant criticism. Yet many investors who lost considerable sums in the financial crisis are saying that they relied on the rating agencies. How can this reliance be reconciled with what preceded it? I argue that an adaptive trait - incorporating new data that potentially conflicts with one’s pre-existing worldview so as to preserve as much of that worldview as possible - proved to be maladaptive in this circumstance. There was a plausible story investors could tell themselves about why the rating agencies could ‘get it right’ about the complex securities at issue while having gotten it spectacularly wrong about Enron. It will be interesting to see how, and how much, the agencies’ recent failures affect investors’ beliefs and practices.

An Analysis of Federal Financial Regulation Creating an Environment for Credit Rating Agency Oligopoly and its Subsequent Effect on the 2008 Financial Crisis

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