Wednesday, July 27, 2011

SEC Official Details Efforts to Reform Rating Agencies to a Congressional Panel Concerned with International Coordination

Noting that credit ratings of mortgage-related and other structured finance instruments played a significant role in the financial crisis, SEC Deputy Director of Trading and Markets John Ramsay told a congressional panel that the Commission’s is addressing conflicts of interest, making more transparent the process for rating structured securities, and promoting competition among rating agencies. In testimony before the House Oversight and Investigations subcommittee, he said that the SEC has proposed regulations under the Dodd-Frank Act designed to strengthen the existing conflict of interest rule for rating agencies to more completely separate the credit analysis function from sales and marketing activities.

The regulations would prohibit an NRSRO from issuing or maintaining a credit rating when an employee who participates in sales or marketing activities also participates in determining a credit rating or in developing the procedures or methodologies used to produce the credit rating. They would also create a mechanism for a small NRSRO to seek relief from this absolute prohibition if, due to the size of the NRSRO, the separation of sales and marketing activities from the production of credit ratings is not appropriate. The proposals also set forth findings the Commission would need to make to suspend or revoke the registration of an NRSRO upon a finding that the NRSRO violated the conflict of interest rule. The SEC also proposed a new rule requiring a rating agency to have procedures addressing the potential for a credit rating to be influenced by a credit analyst seeking employment with the entity being rated or the issuer, underwriter, or sponsor of the securities being rated.

Another proposed regulation would require a rating agency to have policies designed to improve the integrity of its credit ratings procedures and methodologies. More specifically, the proposal would require procedures reasonably designed to ensure that the methodologies the NRSRO uses to determine credit ratings are approved by its board of directors and that such methodologies are developed and modified in accordance with the policies and procedures of the NRSRO and that any material changes to the methodologies are applied consistently, and that they are applied to currently outstanding credit ratings within a reasonable period of time. The rating agency would also have to promptly publish notice of material changes to rating methodologies and of any significant errors that are identified in a rating methodology.

Subcommittee Chairman Randy Neugebauer (R-TX) said that the debt ceiling negotiations and the long-term fiscal health of the U.S. have brought a renewed focus on the credit rating agencies. On the one hand, the Dodd-Frank Act attempts to de-emphasize the role of credit rating agencies in federal regulations and, on the other hand, the Act further entrenches the government-sponsored oligopoly of the big three credit rating agencies. The former approach to reduce reliance on credit rating agencies enjoys widespread bipartisan support, the Chair noted.

Section 939A of the Dodd-Frank Act directs the Commission, along with all other federal agencies, to remove references to credit ratings from its rules and forms and to substitute such alternative standards of creditworthiness as the Commission determines to be appropriate. Mr. Ramsay said that in each case the SEC’s goal is to reduce undue reliance on credit ratings and to encourage independent assessments of creditworthiness.

Chairman Neugebauer asked if the agencies have published standards of creditworthiness. The regulators, the SEC, OCC and Fed, described the effort as tricky and complicated. One challenge is around bank capital rules, and there is complexity because bank capital rules are inter-agency, and are also negotiated internationally and international accords contain credit references. Chairman Neugebauer likes the interagency approach, the approach needs to be standardized. He emphasized that the US cannot talk about Basel accord harmonization until it has its own coordinated plan.

Financial Services Committee Chair Spencer Bachus (R-ALA) acknowledged that 939A is giving regulators some problems. Section 939A replaces reliance on credit ratings with alternative methods, he noted, which could include ratings as part of the mix.

Chairman Bachus also noted that the European Union is making great efforts to end their reliance on rating agencies. He referred to recent remarks by EU Commissioner for the Internal Market Michel Barnier that the Commission has as a top priority addressing reliance on credit ratings. Commissioner Barnier said that credit ratings are too embedded in legislation and that he intends to reduce as much as possible the references made to those ratings in prudential rules.

Chairman Bachus urged the SEC, OCC and Fed to coordinate with the European Commission’s efforts. Chairman Bachus also conceded that it is a complicated job and that Congress intended to give discretion to expert regulators, but that Congress also intended to give direction. Section 112 of Dodd-Frank is such direction and pursuant to it he urged the regulators to use the Financial Stability Oversight Council as a coordinating body for efforts to remove reliance on ratings in agency regulations.

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