September 5, 2008
To the Securities and Exchange Commission:
Thank you for the opportunity to comment on the Securities and Exchange Commissions (SECs) proposed rules: Release No. 34-58070, File No. S7-17-08 Release No. 33-8940, Release No. 58071, File No. S7-18-08 Release No. IV-28327, Release No. IA-2751, File No. S7-19-08. These proposed rules would eliminate references in existing SEC regulations to Nationally Recognized Statistical Rating Organizations (NRSROs) or to the rating levels of NRSROs, such as the use of the terms investment grade or non-investment grade for certain types of securities.
Because the spirit of all three sets of proposed rules is basically the same, I will enter one set of comments that will address all three sets of proposed rules. These comments should be considered as a supplement to the comments that I offered to the SEC on Release No. 34-57967, File No. S7-13-08, on July 25, 2008.
I congratulate the SEC on proposing a set of steps that will take the SECs regulations, the SECs regulated financial institutions, and the bond rating industry in a sensible direction: loosening the deadlock grip that a specific, handful of ratings firms (the firms that the SEC has designated as NRSROs) have had on the quality assessments of securities that the SECs regulated financial institutions have been required to make. In making those quality assessments (usually with respect to the safety and/or liquidity of the debt securities that were in their portfolios), the regulated financial institutions have been required to use exclusively the NRSROs ratings of those securities.
As the SEC has noted in its proposals, since its establishment of the NRSRO category in 1975, many other regulatory agencies – e.g., bank regulatory agencies -- have imposed similar types of requirements on their regulated financial institutions.
The consequences of these existing requirements – when combined with the SECs past restrictions on (and the SECs past opacity of process of) certifying new NRSROs that prevailed until 2006, when the Credit Rating Agency Reform Act pushed the SEC in the direction of greater freedom of entry and greater transparency – has been to protect a handful of rating firms, who thereby have had a guaranteed market for their ratings. This guaranteed market was the consequence of the regulated financial institutions required reliance on these few rating firms ratings, which led the financial markets more generally to rely on these few ratings firms ratings. It is surely not surprising that this protection and guaranteed market led to sluggish and careless behavior, and to the lack of market discipline, on the part of the protected incumbent rating firms.
The proposed rules will eliminate this automatic, deadlock grip. As the SEC notes in a number of places, the proposed rules need not eliminate the regulated financial institutions reliance on ratings firms. If a financial institution believes that a rating firm provides it with reliable information about the quality of certain types of securities, then the financial institution will have the ability to continue to use that rating firms ratings as part of its justification for holding that category of securities in its portfolio. But the financial institution will have to provide some additional information and rationale for why it believes that that rating firms ratings are reliable. The financial institution will not be able simply to point to the NRSRO designation of the rating firm and conclude that the NRSRO designation alone is sufficient justification for reliance.
Alternatively, of course, the financial institution could do its own research as to the quality of the securities in their portfolios and be prepared to show and defend this research if asked to do so by the SEC in some kind of regulatory audit or examination. But (contrary to the conclusions of some of the hostile commenters on these proposed rules) the regulated financial institution need not do its own research. It could obtain its research from others – including ratings firms – so long as it could provide a basis for its belief that the information that it was receiving was reliable. This removal of the NRSRO references may well open the field of information provision to new firms who need not obtain the NRSRO designation.
Although this removal of the references to NRSROs (and their ratings) is a welcome first step, I urge the SEC to go further and to eliminate the NRSRO category entirely. After all, under the proposed rules the SECs regulated institutions cannot just rely on the NRSRO designation of a rating firm as an automatic seal of approval for whatever ratings that rating firm produces but must instead provide additional justification for their reliance on the source or sources of information that they believe to be trustworthy. In that case, there is little point to continuing to maintain the NRSRO designation itself.
If the SEC takes the lead in this direction, then other financial regulatory agencies may well follow or, at least, they will be forced to re-assess their reliance on NRSROs, since the category will no longer exist.
With greater choice as to where they seek information, the financial markets can impose market discipline, based on which rating firms (or other types of information-provision firms) have been the most reliable, which have had the best "track records" in predicting defaults, which have had the least conflict-of-interest problems, which have revealed the most information (e.g., about their methodologies and procedures) that the markets consider important, etc. Competition will work, if given a chance. New ratings forms, procedures, and participants may well emerge. Innovation will have an open field.
In sum, I endorse general spirit of the SECs proposed rules and urge the SEC to go even further and to eliminate the NRSRO category entirely.
I have attached to these comments an "op-ed" piece that expands on these ideas. This article appeared in the online DowJones Newswire "Talk Back" section on June 16, 2008. I would like this article to be included as part of my overall formal comments on these proposed regulations.
Greater details as to my views on these matters can be found in some of my earlier writings on these matters, which are listed at the end of these comments.
Lawrence J. White
Dont Like the Power of the Bond Rating Firms? Basel 2 Will Only Make It Worse, in Bumps on the Road to Basel: An Anthology of Views on Basel 2, Centre for the Study of Financial Innovation, 2002.
"The Credit Rating Industry: An Industrial Organization Analysis," in R.M. Levich, G. Majnoni, and C.M. Reinhart, eds. Ratings, Rating Agencies and the Global Financial System, Kluwer, 2002.
An Industrial Organization Analysis of the Credit Rating Industry, in M.K. Ong, ed., Credit Ratings: Methodologies, Rationale and Default Risk, Risk Books, 2002.
The SECs Other Problem, Regulation, Winter 2002-2003 reprinted in C.H. Rajeshwer and S. Jutur, eds., Credit Rating Agencies: Emerging Issues, ICFAI University Press, 2005.
Good Intentions Gone Awry: A Policy Analysis of the SECs Regulation of the Bond Rating Industry, Policy Brief #2006-PB-05, Networks Financial Institute, Indiana State University.
A New Law for the Bond Rating Industry, Regulation, Spring 2007.
(Attached File #1: s71808-9.pdf)