The credit rating industry

Federal Reserve Bank of New York - Quarterly Review, Summer-Fall, 1994 by Richard Cantor, Frank Packer

Nonetheless, the informality of the process and the opaqueness of the acceptance criteria raise serious problems. The requirement that an agency be widely used by major investors before it can be designated as an NRSRO clearly favors incumbents. Given the growing importance of NRSRO status, new entrants in the ratings business who lack this status may find it increasingly difficult to attract a wide following in the investment community. These concerns may become more acute as the SEC considers applications from foreign rating agencies.

At present, the SEC does not require NRSROs to have uniform rating standards. In particular, the Commission has no explicit rule that "equivalent" letter grades must correspond to similar expected default rates. Nonetheless, regulations generally refer directly to NRSRO rating levels without allowances for differences across agencies.(8) Unless the way in which regulations use ratings is changed, all NRSRO ratings of a certain level ought to correspond to the same level of credit risk. To achieve such consistency, the SEC may have to develop additional acceptance criteria and ongoing monitoring capacity. In recognition of these concerns, the SEC has published a "concept release" that invites rating agencies, corporations, and investors to comment on "the role of ratings in federal securities laws and the need to establish formal procedures for designating and monitoring the activities of NRSROs" (SEC 1994a).

RESOLVING DISAGREEMENTS AMONG THE RATING AGENCIES

Most ratings-dependent regulations only require that a bond issue carry a single NRSRO's rating. However, issuers in the United States commonly obtain at least two ratings on publicly issued securities. Since both Moody's and Standard and Poor's rate virtually all public corporate bond issues, a dual rating is fairly automatic. As a consequence, differences of opinion across the rating agencies inevitably arise. Regulators have had to find a way to resolve these differences because most of their rules key off specific letter grades. Their approaches to the problem take two forms--Explicit rules and independent analysis.

The most common approach is to adopt an explicit rule, recognizing either the highest or the second highest rating, regardless of the number or level of the other ratings. The second-highest rating rule attempts to strike a balance between a conservative policy (eliminating the highest rating) and a liberal policy (not necessarily using the lowest rating). When the ratings industry was dominated by Moody's and Standard and Poor's, this rule was effectively conservative since the lower of two ratings was also the lowest rating. As the number of NRSROs has increased and issuers have begun to obtain three, four, or more ratings, the policy is potentially more liberal. Although regulators could conceivably adopt a more conservative rule (such as the lowest rating), in areas such as structured finance where Moody's and Standard and Poor's do not attempt to rate every issue, issuers could respond by dropping agencies that assigned the lower ratings.