August 31, 2021
Credit Rating Agencies: Regulation and Recent Developments
Credit rating agencies (CRAs) provide investors with
of applications. NRSRO applicants and registered NRSROs
evaluations of the creditworthiness of debt (i.e., how likely
are required to disclose information, including ratings
a debt is to be repaid in full) issued by a wide spectrum of
performance, conflicts of interest, and the procedures used
entities, including corporations, sovereign nations, and
to determine ratings. Under the law, the SEC was also
municipalities. Their ratings are typically a letter
authorized to conduct annual deficiency and compliance
hierarchical format (e.g., AAA as the safest, and
examinations at NRSROs, which are not publicly identified.
progressively lower grades—AA+, AA, AA-, A+, A, A-,
BBB, all the way down to D—representing greater risk).
The Financial Crisis and Dodd-Frank Regulation
For regulatory and investment purposes, ratings are placed
In the run-up to the financial crisis of 2007-2009, the
into one of two broad categories. Investment grade debt is
provision of investment-grade ratings by the three dominant
rated BBB- or Baa3 (depending on the CRA) or higher.
CRAs—S&P, Moody’s, and Fitch—for structured finance
Noninvestment grade debt (also known as “high yield,” or
securities was widely seen as a critical part of the process of
“junk” bonds) has a rating below these benchmarks and is
structuring the residential mortgage-backed securities
generally associated with higher risk firms. This In Focus
(MBS) and collateralized debt obligations that held
examines CRAs, their regulation, and recent developments.
subprime housing mortgages. The issuance of private MBS
reportedly grew from $126 billion in 2000 to $1.145 trillion
Earlier Regulation
in 2006.
Adopted by the Securities and Exchange Commission
(SEC) in 1975, the designation of a nationally recognized
Various reporting, including the 2011 Financial Crisis
statistical rating organization (NRSRO) was originally used
Inquiry Report, argued that the three leading CRAs
as a part of the agency’s determination of capital charges on
fundamentally failed in their rating of these securities,
different grades of debt securities held by broker-dealers
exacerbating the market collapse. During the housing boom
under the SEC’s net capital rule (Rule 15c3-1 under the
preceding the financial crisis, the CRAs often gave top-tier
Securities Exchange Act of 1934). The rule is aimed at
AAA ratings to many structured securities only to
ensuring that broker-dealers maintain sufficient liquid
downgrade many of them later to levels often below
assets to promptly satisfy their liabilities if needed.
investment grade. CRA ratings on corporate bonds
reportedly did not encounter the same problems. Criticism
When it began using ratings to enforce the net capital rule
of the CRAs, however, was not universal. A frequent
in 1975, the SEC staff, in consultation with agency
defense of their failings was that their rating missteps could
commissioners, determined that the ratings of the three
be traced in part to their view that rising housing prices
dominant agencies—Standard & Poor’s (S&P), Moody’s,
would be sustained, a perspective also said to be held by a
and Fitch—were nationally used and are thus generally
number of respected financial market observers at the time.
considered NRSROs with respect to SEC enforcement of
the net capital rule. Between 1975 and 2000, the SEC added
One reason put forward for the perceived overly favorable
four more NRSROs to the original three. The SEC never
ratings in place heading into the crisis is that CRAs are
defined the term NRSRO or specified how a CRA might
typically paid by the issuers of the securities being rated by
become one. Its approach was essentially described as one
the agencies. This issuer pays model is often seen as a
of “we know it when we see it.” Currently, there are nine
potential conflict of interest (Financial Crisis Inquiry
NRSROs.
Report, 2011). Rating-structured finance became a
substantial revenue generator for the CRAs. For example,
In 2006, Congress passed the Credit Rating Agency Reform
according to some reporting (Morgenson, New York Times,
Act (P.L. 109-291), which amended the Securities
2008), by the first quarter of 2007, such ratings constituted
Exchange Act of 1934 to try to improve ratings quality for
53% of Moody’s total revenue. In addition, “ratings
the protection of investors by fostering accountability,
shopping”—wherein structured finance issuers shopped for
transparency, and competition in the credit rating industry.
CRAs offering potentially more favorable ratings—may
Among other things, P.L. 109-291 added Section 15E to the
have played a role (Zhou and Kumar, 2012). Other possible
Securities Exchange Act, which established SEC oversight
causes of the allegedly inflated structured product ratings
over those credit rating agencies that register as NRSROs. It
included:
also provided the SEC with examination authority and
established a registration program for credit rating agencies
High concentration in the CRA industry (Financial
seeking NRSRO designation, defined eligibility
Crisis Inquiry Report, 2011). According to recent SEC
requirements, prescribed the minimum information
data, S&P, Moody’s, and Fitch issued about 95% of
applicants must provide in their application, and established
outstanding ratings.
a time frame and parameters for SEC review and approval
https://crsreports.congress.gov
Credit Rating Agencies: Regulation and Recent Developments
Despite high profits, the CRAs reportedly suffered from
private rights of action while no longer shielding them from
inadequate staffing, exercise of due diligence, use of
“expert liability” status, which imposes liability on
internal controls, and a failure to properly update their
accountants and other experts for material misstatements or
rating models (Brookings, 2017).
omissions in corporate registration statements. Historically,
The CRAs encountered challenges from reportedly
CRAs were shielded from that expert liability due to the
significant levels of mortgage fraud and lax mortgage
view that their ratings issued were opinions and entitled to
underwriting protocols (Brookings, 2017).
protection under the First Amendment.
Unlike largely homogeneous and seasoned corporate
bonds, the highly complex structured finance
In 2010, when newly subject to the expert liability status,
instruments had relatively little experience over multiple
the three major CRAs opposed giving their consent to their
economic cycles and were heterogeneous individualized
ratings appearing in issuer prospectuses and registration
products (Levitan and Wachter, 2011).
statements for asset-backed securities such as MBS. This
Potentially flawed assumptions in CRA predictive
raised the prospect of a shutdown of the securitization
quantitative models (McNamara, 2012).
market. The SEC responded with “no action” letters that
The CRAs did not use data from more applicable
effectively indefinitely rescinded the NRSROs’ “expert
historical periods in which housing prices were in
liability” status for ratings of asset-backed securities.
decline (Levitan and Wachter, 2011).
Various CRA quantitative models were
The act also attempted to reduce reliance on credit ratings
opportunistically reverse engineered by some of the
by directing federal agencies to remove specific references
issuers of structured instruments seeking favorable
to NRSRO-assigned credit ratings in their regulations and
ratings (Brookings, 2017).
guidance while also adopting alternative schemes. In the
The CRAs were immune from legal liability for
ensuing years, most agencies have reportedly done so.
misstatements in registration statements under the
However, a Federal Reserve response to the economic and
Securities Act of 1933 (Partnoy 2010).
financial turmoil from the COVID-19 pandemic stood in
contrast to the move away from ratings references in
The Dodd-Frank Wall Street Reform and Consumer
regulation. In early 2020, the Fed created several
Protection Act (P.L. 111-203) was enacted, in part, to help
emergency corporate lending facilities. Under them, a
ensure that another financial crisis did not occur and to
corporate recipient was required to have investment grade
“promote the financial stability of the United States by
debt rated by “major NRSROs.” (See CRS Insight
improving accountability and transparency in the financial
IN11327, Federal Reserve: Emergency Lending in
system.” Among other things, the act provided for an
Response to COVID-19, by Marc Labonte.)
assortment of regulatory measures aimed at addressing
factors widely perceived to have played a role in the CRAs
Recent Market and Regulatory Developments
alleged ratings inflation of structured securities.
In recent months, CRAs upgraded hundreds of billions of
dollars of domestic corporate debt, a partial reversal of their
The act contains provisions aimed to enhance SEC
significant downgrades in March and April 2020 at the
regulation of credit rating agencies. Among these, it
outset of the pandemic. Some analysts and investors had
established the SEC Office of Credit Ratings; imposed new
criticized those downgrades as excessively harsh, a charge
reporting, disclosure, and examination requirements on
that CRAs said lacked merit.
NRSROs; required NRSROs to disclose their ratings
methodology; required ratings analysts to pass qualifying
In November 2019, then-SEC Chair Jay Clayton said that
exams and undergo continuing education; gave the SEC
NRSROs should be “continually” monitored and expressed
authority to deregister a NRSRO; and required that half or
interest in exploring whether there were “alternative
more (but not fewer than two) of the directors of an
payment models” that would better align the interests of the
NRSRO’s board, which approves NRSRO procedures and
CRAs with investors. A more supportive view, however,
rating methodologies, be independent of the NRSRO.
came from a June 2021 report on CRA performance during
the pandemic-induced economic instability of 2020. The
In addition, in an attempt to help remedy the perceived
study from the Committee on Capital Markets (a research
issuer-payer model bias, the act directed the SEC to study
organization composed of leaders from finance, business,
alternative approaches to NRSRO compensation. After the
law, accounting, and academia) concluded that in 2020,
study, the SEC was authorized to do rulemaking for a
“the agencies responded to evolving market and economic
system that randomly assigned NRSROs to do initial credit
conditions promptly and performed their role well as
ratings and then provide subsequent ratings monitoring for
independent providers of forward-looking information.”
structured finance products. The 2012 SEC staff study
found that the random assignment model could mitigate
On June 1, 2020, the SEC’s Credit Ratings Subcommittee
issuer-payer conflicts but also might fail to do so because
of the Fixed Income Market Structure Advisory Committee
issuers could continue “rating shopping” and hire other
recommended some NRSRO reforms: (1) expanding
NRSROs to provide supplemental credit ratings. At the
NRSRO disclosure, (2) enhancing issuer—corporate and
time, the SEC opted not to pursue rulemaking on the
securitized—disclosures, and (3) adopting a scheme for
random assignment mechanism.
bondholders to ratify issuer-selected NRSROs. Soon
afterward, on July 21, 2021, the House Financial Services
To help enhance CRA rating’s accountability, the act also
Committee held a hearing that examined NRSROs.
assigned liability to NRSROs through the provision of
Gary Shorter, Specialist in Financial Economics
https://crsreports.congress.gov
Credit Rating Agencies: Regulation and Recent Developments
IF11916
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