Credit Rating Agencies: Background and Regulatory Issues
Updated April 9, 2024
Credit Rating Agencies: Background and Regulatory Issues
Credit rating agencies (CRAs) provide investors with
Under the law, the SEC was also authorized to conduct
evaluations of the creditworthiness of debt (i.e., how likely
annual deficiency and compliance examinations at
a debt is to be repaid in full) issued by a wide spectrum of
NRSROs, which are not publicly identified.
entities, including corporations, sovereign nations, and
municipalities. Their ratings are typically a letter
The Financial Crisis and Dodd-Frank Changes
hierarchical format (e.g., AAA as the safest, and
In the run-up to the financial crisis of 2007-2009, the
progressively lower grades—AA+, AA, AA-, A+, A, A-,
provision of investment grade ratings by the three dominant
BBB, all the way down to D—representing greater risk).
CRAs—S&P, Moody’s, and Fitch—for structured finance
For regulatory and investment purposes, ratings are placed
securities was widely seen as a critical part of the process of
into two broad categories. Investment grade debt is rated
structuring the residential mortgage-backed securities
BBB- or Baa3 (depending on the CRA) or higher.
(MBS) and collateralized debt obligations that held
Noninvestment grade debt (also known as “high yield” or
subprime housing mortgages. The issuance of private MBS
“junk” bonds) has a rating below these benchmarks and is
reportedly grew from $126 billion in 2000 to $1.145 trillion
generally associated with higher risk firms. This In Focus
in 2006.
examines CRAs, their regulation, and related policy issues.
Various reporting, including the 2011 Financial Crisis
Background and Early Regulation
Inquiry Report, argued that the three leading CRAs
fundamentally failed in their ratings of these securities,
In 1975, the Securities and Exchange Commission (SEC)
exacerbating the market collapse. During the housing boom
adopted the designations of nationally recognized statistical
preceding the financial crisis, the CRAs often gave top-tier
rating organizations (NRSROs). NRSROs were originally
AAA ratings to many structured securities only to
used to help determine capital charges on different grades
downgrade many of them later to levels often below
of debt securities held by broker-dealers under the SEC’s
investment grade. CRA ratings on corporate bonds
net capital rule (Rule 15c3-1 under the Securities Exchange
reportedly did not encounter the same problems. Criticism
Act of 1934). The net capital rule is aimed at ensuring that
of the CRAs, however, was not universal. A frequent
broker-dealers maintain sufficient liquid assets to promptly
defense of their failings was that their rating missteps could
satisfy their liabilities if needed.
be traced in part to their view that rising housing prices
When the SEC began using ratings to enforce the net capital
would be sustained, a perspective also said to be held by a
rule in 1975, the SEC staff, in consultation with agency
number of respected financial market observers at the time.
commissioners, determined that the ratings of the three
Critics of CRAs argue that overly favorable ratings were in
dominant agencies—Standard & Poor’s (S&P), Moody’s,
place heading into the crisis because of the issuer-pays
and Fitch—were nationally used and were thus generally
model used by the CRAs. CRAs are typically paid by the
considered NRSROs with respect to SEC enforcement of
issuers of the securities being rated by the agencies, which
the net capital rule. Between 1975 and 2000, the SEC added
many see as a conflict of interest (Financial Crisis Inquiry
four more NRSROs to the original three. The SEC never
Report, 2011). Rating structured finance became a
defined the term NRSRO or specified how a CRA might
substantial revenue generator for the CRAs. For example,
become one. Its approach was essentially described as one
according to some reporting (Morgenson, New York Times,
of “we know it when we see it.” As of March 2024, there
2008), by the first quarter of 2007, such ratings constituted
were 10 NRSROs—three categorized by the SEC as “large”
(S&P, Moody’s
53% of Moody’s total revenue. In addition, “ratings
, and Fitch) and garnering 91% of
shopping”—wherein structured finance issuers shopped for
revenue—three as “medium,” and four as “small.”
CRAs offering potentially more favorable ratings—may
In 2006, Congress passed the Credit Rating Agency Reform
have played a role (Zhou and Kumar, 2012). Other possible
Act (P.L. 109-291), which amended the Securities
causes of the allegedly inflated structured product ratings
Exchange Act of 1934 to try to improve ratings quality for
included the following:
the protection of investors by fostering accountability,
transparency, and competition in the credit rating industry.
• The CRA industry is highly concentrated (Financial
Among other things, P.L. 109-291 added Section 15E to the
Crisis Inquiry Report, 2011). According to recent SEC
Securities Exchange Act, which established SEC oversight
data, S&P, Moody’s, and Fitch issued about 95% of
over those CRAs that register as NRSROs. It also provided
outstanding ratings.
the SEC with examination authority and established a
• Despite high profits, the CRAs reportedly suffered from
registration program for CRAs seeking NRSRO
inadequate staffing, exercise of due diligence, and use of
designation. NRSRO applicants and registered NRSROs
internal controls and a failure to properly update their
were required to disclose ratings performance, conflicts of
rating models (Brookings, 2017).
interest, and the procedures used to determine ratings.
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Credit Rating Agencies: Background and Regulatory Issues
• The CRAs encountered challenges from reportedly
In 2010, when newly subject to the expert liability status,
significant levels of mortgage fraud and lax mortgage
the three major CRAs opposed giving their consent to their
underwriting protocols (Brookings, 2017).
ratings appearing in issuer prospectuses and registration
• Unlike largely homogeneous and seasoned corporate
statements for asset-backed securities such as MBS. This
bonds, the highly complex structured finance
raised the prospect of a shutdown of the securitization
instruments had relatively little experience over multiple
market. The SEC responded with “no action” letters that
economic cycles and involved heterogeneous
effectively indefinitely rescinded the NRSROs’ “expert
individualized risks (Levitin and Wachter, 2012).
liability” status for ratings of asset-backed securities, and
• The CRA predictive quantitative models contain
these rescindments are still in effect.
potentially flawed assumptions (McNamara, 2012).
•
The act also attempted to reduce reliance on credit ratings
The CRAs did not use data from more applicable
by directing federal agencies to remove specific references
historical periods in which housing prices were in
to NRSRO-assigned credit ratings in their regulations and
decline (Levitin and Wachter, 2012).
•
guidance while also adopting alternative schemes. In the
Various CRA quantitative models were
ensuing years, most agencies have reportedly done so.
opportunistically reverse-engineered by some of the
However, a Federal Reserve response to the economic and
issuers of structured instruments seeking favorable
financial turmoil from the COVID-19 pandemic stood in
ratings (Brookings, 2017).
•
contrast to the move away from ratings references in
The CRAs were immune from legal liability for
regulation. In early 2020, the Federal Reserve created
misstatements in registration statements under the
several emergency corporate lending facilities. Under them,
Securities Act of 1933 (Partnoy, 2010).
a corporate recipient was required to have investment grade
debt rated by “major NRSROs.”
The Dodd-Frank Wall Street Reform and Consumer
Protection Act (P.L. 111-203) was enacted to help ensure
Later Market and Regulatory Developments
that another financial crisis did not occur and to “promote
In February 2024, the SEC’s annual report on NRSROs
the financial stability of the United States by improving
warned of several financial risks that staff found through
accountability and transparency in the financial system.”
their NRSRO assessments. One was that the increase in
Among other things, the act provided for regulatory
interest rates since 2022 had increased debt service
measures to address factors perceived as playing a role in
payments for highly leveraged companies, putting them
the CRAs’ alleged ratings inflation of structured securities.
under financial stress and rendering NRSRO’s monitoring
The act contains provisions aimed at enhancing SEC
of low-rated or highly leveraged companies an important
regulation of CRAs. Among these, it established the SEC
area for SEC examination. Another area flagged for SEC
Office of Credit Ratings; imposed new reporting,
examination was NRSRO’s surveillance of collateralized
disclosure, and examination requirements on NRSROs;
loan obligations and securitizations backed by auto loans
required NRSROs to disclose their ratings methodology;
and consumer assets, given potential impacts on credit
required ratings analysts to pass qualifying exams and
quality from the interest rate increases. In its examinations
undergo continuing education; gave the SEC authority to
of NRSROs, the SEC also found a number of material
deregister an NRSRO; and required that half or more (but
deficiencies. These included nine instances of failures to
not fewer than two) of the directors of an NRSRO’s board,
sufficiently address conflicts of interest; eight findings
which approves NRSRO procedures and rating
implicating poor disclosure; six findings related to internal
methodologies, be independent of the NRSRO.
control issues; three findings on insufficient retention or
production of records; and two findings regarding the
In addition, in an attempt to help remedy the perceived
misuse of material, nonpublic information—indicating that
issuer-pays model bias, the act directed the SEC to study
some problems still percolate within the industry.
alternative approaches to NRSRO compensation. After the
study, the SEC was authorized to issue rules for a system
On June 1, 2020, the SEC’s Credit Ratings Subcommittee
that randomly assigned NRSROs to do initial credit ratings
of the Fixed Income Market Structure Advisory Committee
and then provide subsequent ratings monitoring for
recommended some NRSRO reforms: (1) expanding
structured finance products. The 2012 SEC staff study
NRSRO disclosure, (2) enhancing issuer—corporate and
found that the random assignment model could mitigate
securitized—disclosures, and (3) adopting a scheme for
issuer-payer conflicts but also might fail to do so because
bondholders to ratify issuer-selected NRSROs. On July 21,
issuers could continue “rating shopping” and hire other
2021, the House Financial Services Committee held a
NRSROs to provide supplemental credit ratings. At the
hearing that examined NRSROs. One academic witness at
time, the SEC opted not to pursue rulemaking on the
that hearing called for further reforms of NRSROs to
random assignment mechanism.
address continued issues such as conflicts of interest
through the issuer-pays model, lack of liability, high
To help enhance CRA ratings’ accountability, the act also
concentration, and lack of transparency in the industry.
assigned liability to NRSROs through the provision of
private rights of action while no longer shielding them from
The author gratefully acknowledges Gary Shorter, now
“expert liability” status, which imposes liability on
retired, for his work on the original version of this product.
accountants and other experts for material misstatements or
Rena S. Miller, Specialist in Financial Economics
omissions in corporate registration statements. Historically,
CRAs were shielded from that expert liability due to the
IF11916
view that their ratings issued were opinions and entitled to
protection under the First Amendment.
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Credit Rating Agencies: Background and Regulatory Issues
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