Summary
The task force should elicit not only comments from industry sources -- who after all have deep vested interests -- but independent experts with no axe to grind who argue that the Municipal Securities Rulemaking Board (MSRB) precedent can be adapted to devise a new conflict free system of payment for ratings from a fund fed by a fee from investors and issuers on each new issue and each secondary market trade in the short and long term public (and possibly private) capital markets.
Analysis
Our view is that the latest legislation proposals (Investor Protection Act of 2009 Title IX) before congress are a step in the right direction but the proposals do not go far enough. The proposed law makes helpful suggestions -- to have greater disclosure on ratings, including preliminary ratings, to enhance the capacity of SEC to regulate rating agencies, and empower SEC to make rules on issues that include compensation and conflicts. But the proposed law fails to address the fundamental flaw in the currently dominant compensation model, which is fraught with conflicts, and punts this central issue to a future study due in 30 months after enactment of the law. Accurate ratings depend on a better way that relies not on payments by the sell side or the buy side but on both the buy side and the sell side, via a transactions charge, as discussed in our proposal, previously shared with you.
The critical issue is whether further disclosure and reporting requirements without a change in the way rating agencies are paid can fix the conflicts of interest in the issuer and investor pay models of the ratings business. We don’t think so. We believe that the power of the purse is too strong and will skew as -- it has in the run up to the financial crisis -- the quality and accuracy of ratings. The problem is that the existing rating agency models rely for compensation either on the sell side or the buy side and no reforms to date address – as our proposal does address -- this glaring and long standing weakness. While the issue is difficult to address, our proposal is to have both sides pay for ratings via an industry fund such as has been established successfully and for a long period of time though on a smaller scale and for a more limited purpose by the Municipal Securities Rulemaking Board (MSRB) for the municipal securities markets. No solution to the conflict of interest problem will be simple but the current legislation fails to get at this fundamental, long standing and well-recognized problem, being content to rely on disclosure and a study it expects to take two and half years – which is far too long. It is not as if we did not know about this conflict! The problem is that it continues and will continue to bias as it has in the past the judgments of the agencies.
Such a new compensation system funded by both issuers and investors would break the lock of the issuer / banker pay model on ratings used in the debt capital markets and lead rating agencies to produce see--through-the business cycle ratings versus procylical ratings such those that exacerbated if not helped produce the current financial crisis. We have proposed such a mechanism in a more detailed paper available to interested parties on request.
This author consults with leading institutions through GLG
Analyses are solely the work of the authors and have not been edited or endorsed by GLG.
