Strengthening credit rating integrity
| Pages | 338-353 |
| DOI | https://doi.org/10.1108/JFRC-11-2014-0047 |
| Date | 09 November 2015 |
| Published date | 09 November 2015 |
| Author | Mark Adelson,David Jacob |
| Subject Matter | Accounting & Finance,Financial risk/company failure,Financial compliance/regulation |
Strengthening credit rating
integrity
Mark Adelson
The BondFactor Company, New York, New York, USA, and
David Jacob
Great Neck, New York, USA
Abstract
Purpose – The purpose of the article is to explain the signicance of key features of the SEC’s new
rules for credit rating agencies. Those rules include three key items: they prohibit the inuence of sales
or marketing considerations on criteria development; they include guidance that preserves the ability of
ratings to serve as relative, rather than absolute, measures of credit risk; and they require cross-sector
consistency of rating symbols. When they were released, the signicance of the rules was
under-appreciated because of other, simultaneous regulatory announcements.
Design/methodology/approach – The approach is to consider how effectively the rules address
their target issues. In doing so, the article explores how the nal rules evolved from their original
proposed form and from the statutory specications in the 2010 Dodd-Frank Act.
Findings – The new rules should promote the integrity of credit ratings in the future. They should be
effective in reducing the inuence of sales and marketing considerations on the development of rating
criteria. In addition, they should enhance rating integrity through superior cross-sector consistency in
the meanings of rating symbols while allowing rating agencies to maintain their traditional emphasis
on relative risk.
Originality/value – The authors are not aware of any similar work assessing the selected provisions
of the new SEC rules for credit rating agencies.
Keywords Regulation, Dodd-Frank act, Financial crisis, Credit rating, NRSRO, Rating agency
Paper type General review
Introduction
The new SEC rules for credit rating agencies, issued on August 27, 2014, represent
an important milestone for the US xed-income markets (SEC, 2014b). The rules
cover a broad swath of issues, but three particular items stand out as being
especially important for promoting the integrity and practical utility of credit
ratings. First, the rules include a clear prohibition against allowing sales or
marketing considerations to inuence the development of the criteria for
determining ratings. Second, the rules carefully avoid forcing credit ratings to
embody absolute probabilities of default. Third, the rules require each rating agency
to assign consistent meanings to its rating symbols across sectors. In each case, the
SEC had to navigate difcult issues to come to its nal result.
The release of the new rules was somewhat overshadowed by the SEC’s release on
the same day of its long-awaited update to the rules for asset-backed securities (SEC,
2014c). The latter garnered disproportionate media attention because the ABS rules will
materially affect the work ow of thousands of individuals in the securitization
The current issue and full text archive of this journal is available on Emerald Insight at:
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JFRC
23,4
338
Journalof Financial Regulation
andCompliance
Vol.23 No. 4, 2015
pp.338-353
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-11-2014-0047
industry. By contrast, the rating agency rules have a much smaller impact on day-to-day
workow but a potentially far greater impact on the future of the global capital markets.
The plain text of the new rating agency rules is deceptively simple. Deeper
understanding and appreciation of the rules’ full import requires consideration of both
the interpretive guidance provided in the adopting release and the interplay of the rules
with each other as part of an integrated package.
This article is organized in six parts. The rst is this brief introduction. The
second examines the new prohibition against allowing sales or marketing
considerations to inuence the development of analytic criteria. It explores the
interpretive guidance that reveals how the nal version of the rule is more powerful
than the original proposal. The third part considers how the new rules avoid forcing
credit ratings to embody absolute probabilities of default and how the guidance
supplies essential clarity that cannot be discerned merely from the rule’s wording.
The fourth part discusses the new rule requiring each rating agency to apply its
rating symbols consistently across xed-income sectors. The fth part briey
discusses the system for promoting unsolicited ratings of structured nance
securities, and the sixth part concludes.
Item no. 1: Prohibition against sales or marketing inuence on criteria
development
The new prohibition against sales or marketing inuence on criteria development is cast
in terms of a prohibited conict of interest. The prohibited conict occurs when a person
who participates in developing criteria “is inuenced by sales or marketing
considerations”. The key language appears in clause (c)(8)(ii) of SEC Rule 17g-5 and
reads as follows (SEC, 2014b, p. 55264):
(c) Prohibited conicts. A nationally recognized statistical rating organization is prohibited
from having the following conicts of interest […]:
***
(8) […] where a person within the nationally recognized statistical rating organization who
participates in […] developing or approving procedures or methodologies used for
determining the credit rating […] also:
• Participates in sales or marketing […]; or
• Is inuenced by sales or marketing considerations.
The rule is notable because the explicit inclusion of criteria development (“developing or
approving procedures or methodologies used for determining the credit rating”) goes
beyond the underlying statutory language in § 15E(h)(3)(A) of the Securities Exchange
Act of 1934 (Exchange Act). In addition, the interpretive guidance in the SEC’s adopting
release reveals that the notions of “inuenced by” and “sales and marketing
considerations” should be construed very broadly. Together, these elements give the
new rule a very broad scope.
Until the adoption of the new rule, there was no direct regulatory prohibition against
allowing commercial considerations to inuence a rating agency’s ratings or the
development of its criteria. The closest thing was the model code of conduct for rating
agencies that was promulgated by the International Organization of Securities
Commissions (IOSCO). IOSCO includes the SEC and other securities regulators from
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Strengthening
credit rating
integrity
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