Egan-Jones: the problems of breaking into the ratings industry

April 25, 2012

The SEC has filed charges against the ratings agency Egan-Jones “for material misrepresentations and omissions in the company’s July 2008 application to register as a Nationally Recognized Statistical Rating Organization (NRSRO)” (see SEC press release).

The list of charges addresses factually missing, contradictory or inaccurate information in the application—this includes information about the company’s experience working with asset backed and government issuer securities—but does not evaluate the substantive content or effectiveness of the agency’s ratings or ratings methodology.

Nevertheless, the nature of the charges casts doubt upon the company in an industry where reputation is seen to be a crucial component of doing business.

The SEC’s attack, which damages reputational capital, is a vivid illustration of the politics of ratings.

Under free market policies, the government can not meddle with the process of assessing the quality of assets.  This leaves regulators in a peculiar position—they must find a way to implement prudential regulation without imposing an exogenous definition of ‘safe’ or ‘low-risk’ on the markets.

The NRSRO designation created by the SEC in the 1970s is the solution to this problem.  The designation allows regulators to exercise oversight over firms that provide ratings for legal compliance with prudential rules such as, for example, Rule 15c3-1. (15c3-1 yoked minimum net capital requirements to the quality of bonds held in a broker-dealers’ portfolio.)

In other words, regulators appoint private firms whose ratings can be used to administer regulatory rules, but do issue any instructions for over how the ratings should be made.

In the early 2000s the big three (S&P, Moody’s, Fitch)—each of which was founded at the turn of the last century—were the only NRSROs in business.  In 2006, under pressure from critics (see Sinclair 2005) Congress passed ‘The Credit Rating Agency Reform Act’ which increased competition in the industry by formalizing the application process for NRSRO status.

Founded in 1995, Egan-Jones received its NRSRO designation following these reforms.  But the SECs charges filed yesterday show just how difficult it is for a younger player to truly break in against the long-standing, historical incumbents in the industry.


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