How to Manage the Conflicts of Interest Inherent in National Credit Rating Agencies

In Finance, Law by Alon K.

The Business of National Credit Rating Agencies

Credit rating agencies (“CRAs”) provide services that can be categorized into credit rating services and ancillary services.  Credit ratings are the primary service that CRAs provide and are designed to give investors a general sense of the risk level of a security.  Ancillary services are typically consulting services that the CRA may provide to clients by tapping into the expertise of its employees – the credit ratings analysts.  NCRAs are a subset of CRAs, and currently there are ten NCRAs registered with the SEC.[1]  This section provides an overview of how credit ratings work, what role NCRAs serve, and what conflicts of interest arise in this business.

Credit Ratings

Whenever a new security is issued, investors will need to assess the risk associated with the issuance, and CRAs provide a centralized way to perform the risk analysis.  The SEC identifies five classes of issues with credit ratings:  financial institutions, brokers or dealers; insurance companies; corporate issuers; issuers of asset-backed securities; and issuers of government securities, municipal securities or securities issued by a foreign government.[2]  Regardless of the class, a credit rating is designed to convey the probability of default (“PD”) or expected loss (“EL”) of an issue – whether it is the PD or EL depends on the methodology used by the rating agency.[3]

As a first step, rating agencies typically use a mathematical model to determine a credit score that represents the PD or EL for an issue.  Then that issue is grouped with other issues that received similar scores, and an analyst determines how to rank these issues against one another, typically incorporating qualitative considerations at this step.  Finally, all the issues are broken down into buckets that represent the best rated issues, second best, and so on.  These buckets are more conventionally known as the credit rating.

For example, Standard & Poor’s ratings for corporate issues represents the EL of the issue, and the best rating is expressed as AAA, followed by AA, A, BBB and so on.  Moody’s and Fitch Ratings use a similar taxonomy for corporate issues but their ratings represent the issue’s PD.  Ratings for other classes are generally the same, although the underlying model or procedure used to assess the PD or EL will likely differ.

Finally, while the credit rating is typically made publicly available to [2]everyone with the issuer bearing the CRAs research cost, CRAs may provide more detailed analysis to investors for a fee.  However, some CRAs may also charge investors for their credit ratings.


CRAs play a critical role in the securities investment industry.  For example, funds use ratings to set cutoffs on what type of securities fund managers can incorporate into the fund’s portfolio.  But far more importantly, the ratings of certain CRAs can be used to satisfy the regulatory capital requirements of banks and other financial institutions.  Depending on the credit rating assigned to an instrument, banks can assign better risk weights on investment grade assets to calculate capital ratios, or apply lower haircuts when using that asset as collateral.

The use of credit ratings for regulatory purposes is typically reserved to CRAs that the market deems to be reliable and credible.  Although the Reform Act specifically prohibits registered NCRA from making certain representations about their status as NCRAs,[4] NCRAs can claim that they are a registered NCRA.[5]  Thus, registering as a NCRA opens a CRA to new business potential.

By this framework, credit ratings turned into a big business industry, namely three big businesses – S&P, Moody’s and Fitch – who together hold almost 95% market share of the credit rating services.[6]  Additionally, the SEC recognizes seven other NCRAs, for a total of ten.

Conflicts of Interest

Because of the issuer-backed payment model, and the ancillary services the NCRAs typically provide, these organization face a wide array of potential conflicts of interest.  This section reviews the most prominent and controversial of these conflicts and how they are currently handled by U.S. laws.

The most reported potential conflict is that NCRAs are typically paid by issuers to issue a credit rating, and that they may also receive indirect compensation by rendering other consulting services to the issuer, which in some cases these consulting services are designed to improve the issuer’s credit rating.  The problem here arises from the issuer’s goal of receiving the best possible credit rating, and the NCRA could seemingly be paid to inflate these ratings rather than maintaining independence.  Additionally, NCRAs compete with one another for business, and this competition may [2]not only be based on the cost of rating an issuer, but also on the NCRAs willingness to provide better ratings.

Pursuant to the Reform Act and the Dodd-Frank Act, the SEC enacted several rules to deal with this conflict.  First, NCRAs must design and disclose procedures for managing conflicts that arise from being paid for ancillary services by issuers, underwriters or obligors (henceforth, collectively, “issuers”) when the NCRA was also paid by that issuer to determine a credit rating[7] – note that investors are still able to pay NCRAs to issue credit ratings with no such restriction.  Additionally, the NCRA must manage conflicts when anyone pays the NCRA for access to credit ratings or any other service, where that person receives a statutory or regulatory benefit from the NCRA’s credit ratings.[8]  And so, the SEC chose the policy of managing and disclosing such conflicts rather than prohibiting the conflict altogether.  However, NCRA’s are prohibited from issuing or maintaining a credit rating solicited by anyone that provided 10% or more of the NCRA’s total net revenue in the previous fiscal year[9] – this prohibition is likely to disproportionately affect smaller NCRA issuers, so the SEC is allowed provide exemptions to smaller organizations on a case by case basis.[10]

 Another controversial conflict that arises in the course of rating an issuer is that NCRA analysts would provide issuers with advice on how to structure a deal so as to improve the rating of the issue.  Under the new rules, NCRAs are prohibited from issuing or maintaining a credit rating with respect to an obligor or security where the NCRA or employee of the NCRA made recommendations to the issuer or sponsor of the security about the corporate or legal structure, assets, liabilities, or activities of the issuer.[11]  The industry has been particularly critical of this rule, claiming that it compromises the honest attempt of issuers in structuring safer securities.  However, this claim is merely a pretense from issuers trying to achieve high ratings in the most cost-effective way that avoids adhering to other possible credit enhancing procedures.[12] Thus, the SEC’s overall approach to dealing with conflicts of interest in the NCRA industry is to create barriers between research and sales[13] – in a similar fashion to how Sarbanes-Oxley addressed this issue.[14]  This resulted in NCRAs splitting their organization into a credit ratings unit, and a consulting unit.  However, none of these rules address the conflict inherent from the issuer-paid model that the larger NCRAs use, and the next section proposes ways to solve this problem.

Read on to the next section…

[1] See SEC, Report to Congress: Credit Rating Agency Independence Study 7 (Nov. 2013), available at:

[2] See Press Release, SEC, SEC Adopts Credit Rating Agency Reform Rules (No. 2014-178, Aug. 27, 2014), available at:

[3] A similar, although not identical, way of thinking about these two approaches, at least where corporate issuances are concerned, is whether the credit rating is specific to an issue or generic to an issuer.

[4] 15 U.S.C § 78o–7(f)(1).

[5] 15 U.S.C § 78o–7(f)(3).

[6] See Council on Foreign Relations, The Credit Rating Controversy (Feb. 19, 2015), available at:

[7] 17 C.F.R. § 240.17g-5(b)(3).

[8] 17 C.F.R. § 240.17g-5(b)(4).

[9] 17 C.F.R. § 240.17g-5(c)(1).

[10] 15 U.S.C § 78o–7(h)(3)(B)(i).

[11] 17 C.F.R. § 240.17g-5(c)(5).

[12] The simplest analogy of this conflict is to that of a municipality that uses hidden police cars to enforce speed limits.  The effectiveness of using hidden enforcers is that drivers will not know their locations, and thus will be more likely to adhere to speed limits everywhere.  However, drivers that know the exact locations of all hidden police officers will only obey the speed limits in those areas, thus compromising the purpose of enforcing the speed limit.

[13] The new regulation also includes “look-back” rules that are designed to manage how employees of NCRAs may be incentivized to inflate credit ratings.  See 15 U.S.C § 78o–7(h)(4).  However, this paper will not examine these rules because they do not deal with organizational issues discussed in this paper.

[14] See Sarbanes-Oxley Act supra n. 5.