By Anne Sherry, J.D.
Two SEC staff reports on credit rating agencies find that the 10 registered NRSROs show improved compliance, increased resources devoted to information technology, and continued competition between the seven smaller firms and the three larger ones (Fitch, Moody’s, and S&P). The staff’s annual report discusses competition, transparency, and conflicts among NRSROs, while the annual exam report summarizes staff examinations of each rating agency.
Competition. The annual report reveals that the three large rating agencies together account for 96.4 percent of outstanding ratings, down from 96.5 percent as of the end of 2015. The change is due to the fact that smaller NRSROs have gained market share in the asset-backed securities rating category. Specifically, the smaller agencies have gained ground by rating asset-backed securities backed by newer or unique asset types, or “esoteric” asset-backed securities. Some of the smaller NRSROs have also gained market share in rating more traditional types of asset-backed securities; for example, DBRS, Inc., rated nearly two-thirds of the transactions backed by student loans that priced during the report period.
The report also cautions that measuring outstanding ratings may not provide the most comprehensive picture of the state of competition. The larger rating agencies have a longer history of issuing ratings, and that history includes those for debt obligations and obligors that were rated well before the newer agencies entered the field. Other limitations to the use of this measure stem from the facts that some NRSROs specialize in particular rating categories; the reported information does not include categories in which an NRSRO is not SEC-registered; and NRSROs’ determinations of the ratings categories and numbers are not consistent from one firm to the next. For a fuller picture of competition, the staff suggests considering the information about gained market share in the esoteric asset-backed securities categories.
Even so, the staff’s analysis based on the number of outstanding ratings suggests that the NRSRO industry is a “highly concentrated” market, equivalent to an industry with 2.67 firms having equal market share. Although barriers to entry continue to exist, the report cites progress with respect to minimum ratings requirements and investors’ openness to securities rated by a wider group of agencies. The SEC also attempted to address concerns about compliance burdens on smaller agencies in the adopted version of the NRSRO rule amendments under the Dodd-Frank Act, which allow rating agencies to tailor requirements to their business models, size, and methodologies.
Transparency. The SEC’s NRSRO Amendments also sought to improve transparency by requiring rating agencies to disclose standardized statistics, consolidated information about rating histories, clear definitions of symbols and scores used in the rating scale, and other information. The annual report also notes that several NRSROs published commentaries and research that shed further light on their viewpoints on particular securities, ratings, or asset classes.
Conflicts of interest. Potential conflicts inhere in both business models under which NRSROs operate. Under the “issuer-pay” model, the credit rating agency may be influenced to determine higher ratings in order to keep the client. In the “subscriber-pay” model, the rating agency may be aware that a key subscriber holds a position that could be advantaged by a particular rating. In another scenario, a subscriber may be prevented by internal guidelines from buying a particular security unless the rating is upgraded. During the report period, staff issued letters to NRSROs’ compliance officers to emphasize that policies and procedures should provide for a look-back review when a former analyst participated in rating his or her new employer in the preceding year.
OCR examinations. In examining the ten NRSROs, the Office of Credit Ratings staff focused on information technology; new and amended NRSRO rules; performance challenges; the use of XBRL; and quantitative models. The examiners observed that the rating agencies had refined their policies, procedures, and controls related to the new NRSRO rules and that personnel displayed a better understanding of the rules. In general, the staff saw improvements in the compliance monitoring and internal audit functions of the agencies. Rating agencies self-identified conduct not in compliance with legal requirements or weaknesses in policies and procedures. In some cases, they took corrective action before staff learned of the conduct or weakness. However, the bulk of the report describes the staff’s essential findings of areas in which the rating agencies fell short in eight review areas.
OCR statement. "NRSROs are continuing to display a greater awareness of their obligations as regulated entities," said Jessica S. Kane, acting director of the Office of Credit Ratings. "The staff will continue to engage with the firms and monitor potential risks to promote compliance, strengthen governance, and ensure that NRSROs provide robust disclosure for the benefit of investors."