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US on Course for SEC Mandated Crackdown on Ratings Agencies

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Following the discussions earlier this year by US Congress to overhaul the beleaguered credit ratings agency business, this week the US Treasury released proposals aimed at reducing conflicts of interest within these agencies. The idea to change their fee structures was first tabled in April during a Securities and Exchange Commission (SEC) roundtable and these new proposals would also give regulatory backing for the SEC to get more hands on in this particularly controversial corner of the market.

This should please SEC chairman Mary Schapiro to no end, as she has long been critical of the pay structures used by these agencies, which she claims have the potential to encourage them to put profits ahead of ratings quality. Currently, firms must subscribe to an issuer-paid model, which means they must pay to be rated and this accounts for approximately 98% of ratings. The agencies will also be faced with new disclosure rules in order to enhance transparency into their ratings practices.

The ratings agencies have come under heavy fire from the regulatory community and the market in general over recent years for contributing to the financial crisis by failing to provide adequate risk assessments for subprime mortgage securities. As a result, the regulatory community has been in intensive discussions over the last few months about how to ensure the industry is less reliant on ratings and that there is more transparency about how they have been determined.

To this end, the US government is suggesting that current legislation that mandates the use of ratings for areas such as risk management be repealed. The proposals would also bar ratings agencies from providing consulting services to any company they rated and would require them to disclose fees for a rating. This is to prevent “ratings shopping’’ in which a company solicits “preliminary ratings’’ from multiple agencies but only pays for and discloses the highest.

Agencies will also be required to use different symbols for structured finance products, which are perceived to be riskier than other instruments.

However, it is expected that the new rules will not force the ratings agencies to completely overhaul their business models. The proposals have therefore already been criticised for not going far enough to tackle the underlying problems inherent within the ratings themselves and for not introducing more competition into the market.

The big three agencies, Moody’s, Standard & Poor’s and Fitch, dominate the sector and have thus far been supportive of the flavour of the proposals. This is unsurprising, as the proposals represent a somewhat more lenient approach than others have suggested.

The SEC will not be taking its job lightly, however, and has already created a crack team of experts to closely monitor the sector. Moreover, earlier this year the regulator banned analysts from negotiating fees based on their ratings. The rules, which were introduced in December, specifically banned the rating agencies from advising investment banks on how to package securities to secure favourable ratings, accepting gifts of more than US$25 from clients and providing ratings to firms that have already received advice such as corporate structuring recommendations.

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