Hearing of the U.S. Senate Committee on Banking, Housing, and Urban Affairs "Assessing the Current Oversight and Operation of Credit Rating Agencies"

Hearing of the U.S. Senate Committee on Banking, Housing, and Urban Affairs "Assessing the Current Oversight and Operation of Credit Rating Agencies"

Statement of Richard Shelby

Today the Banking Committee continues its review of credit rating agencies. These entities wield extraordinary power in their role as gatekeepers to the bond markets. Although the rating business has existed for almost a century, recently there has been a renewed interest in how the industry operates and how it is regulated due to its increased importance in today's markets and because of the well-publicized failures to warn investors about the bankruptcies at Enron, WorldCom, and other companies.

The modern rating industry was established in 1975 when staff of the Securities and Exchange Commission first issued no-action letters, essentially regulatory licenses, to a select number of rating firms. With the addition of only a few more firms, these "nationally recognized statistical rating organizations," or NRSROs, have since provided almost all of the ratings used in the markets.

While their market share has remained steady at near 99%, the industry has grown considerably as regulatory changes have consistently increased the need for ratings issued by firms with the NRSRO designation. It is almost impossible for a rating firm to compete in this industry without the designation. I believe that it is important for us to consider the manner in which the designation is awarded.

The single most important factor in the SEC staff's NRSRO process is the national recognition requirement. As many commentators have noted, this presents an obvious dilemma for firms seeking to do business in this industry. To receive the license, a firm must be nationally recognized, but it cannot become nationally recognized without first having the license.

There are other key questions with respect to the NRSRO regime. For example, what is the SEC staff's definition of the term "NRSRO"? There are no objective standards. What constitutes the application process? What is the time frame involved for a decision? Once a firm is approved, is there any way for investors to know that an NRSRO continues the meet the requirements necessary for the designation? What amount of ongoing oversight by the SEC occurs? There is no transparency in the process.

The Commission has studied ways to improve and clarify the NRSRO system for more than a decade but has failed to act in spite of two Concept Releases, two Proposed Rules, a comprehensive report mandated by the Sarbanes-Oxley Act, two days of public hearings, and an investigation of the NRSROs triggered by the Enron scandal that revealed numerous problems at the then-three NRSROs, including potential illegal activity.

Considering the artificial barriers erected by the NRSRO system, it is not surprising that the rating industry is highly concentrated. It is even more concentrated than the accounting profession, which is controlled by four firms. Here, only two companies dominate the business. The Big Two, Standard & Poor's and Moody's, generate unusually high operating profits for their publicly traded parent corporations. The profit margins are among the highest in the corporate world.

Some describe the market penetration of these companies as remarkable, even astonishing. Both S&P and Moody's rate more than 99% of the debt obligations and preferred stock issues publicly traded in the U.S. Given their profit margins and market penetration, it is understandable why the Big Two have been called a shared monopoly, a partner monopoly, and a duopoly. Their 99% market share suggests that they do not actually compete with each other, particularly in the corporate bond market.

These conditions raise questions regarding the impact of the NRSRO system on investors and the markets. Has the absence of competition affected the quality of ratings, as some have suggested? Were NRSRO failures to downgrade Enron, WorldCom, and others in a timely manner a result of the current system's fundamental weaknesses?

The existing regime also raises critical questions regarding the treatment of conflicts of interest. In addition to the inherent conflict of debt issuers paying rating agencies for ratings, there have been suggestions that NRSROs are marketing ancillary, fee-based consulting services to their issuer clients. This practice, if true, raises questions about the independence and objectivity of the rating agencies.

Of course, it is difficult to assess some of these criticisms of NRSROs because they are so lightly regulated and they conduct a great deal of their activities with minimal scrutiny. For instance, information with respect to rating fees is limited. We do not know whether, and to what extent, NRSROs are marketing additional services such as consulting to their issuer clients or engaging in anticompetitive practices such as notching. We do not know whether the firms are complying with their procedures and ethics codes. We do not know any of these things because the SEC does not conduct periodic inspections of the NRSROs.

Three decades after granting a few firms privileged status with protection from competition, senior SEC staff recently questioned whether the Commission even has the statutory authority to oversee NRSROs. It is quite clear that the U.S. Congress has a decision to make regarding this essentially self-regulated yet non-competitive industry with duopoly profits.

The Committee welcomes a distinguished panel of witnesses. From left to right, we will hear from Mr. Paul Schott Stevens, President, Investment Company Institute; Mr. Glenn Reynolds, Chief Executive Officer, CreditSights, Inc.; Ms. Vickie Tillman, Executive Vice President for Credit Market Services, Standard & Poor's; Mr. Frank Partnoy, Professor of Law, University of San Diego School of Law; Ms. Colleen Cunningham, President and Chief Executive Officer, Financial Executives International; Mr. Damon Silvers, Associate General Counsel, AFL-CIO; Mr. Jeffrey Diermeier, President and Chief Executive Officer, CFA Institute; and Mr. Alex Pollock, Resident Fellow, American Enterprise Institute.

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