This guest post was contributed by engineer27, a longtime reader of and frequent commenter on this blog. (I had exams this past week, which is why I haven’t posted in a while.)
This Thursday, the Senate added two amendments to the Financial Regulation in process that deal with Nationally Recognized Statistical Rating Agencies (NRSROs), which are blamed for being a factor in the financial crisis of 2008. The most widely cited problem with the NRSROs is the inherent conflict of interest which resides in the “issuer pays” model currently in use. However, even supporters of doing something are stymied when trying to envision a workable solution. The two (perhaps contradictory) amendments each try to implement a proposed solution that runs into some of the critiques. The Franken amendment has rating agencies assigned to debt issues by a neutral arbiter; critics maintain that lack of competition may reduce the quality of analysis. The LeMieux amendment removes legal mandates to obtain a NRSRO rating and the preferential treatment those issues currently receive. However, it leaves out details about whose advice agencies and public trusts should seek out instead.
This is not such a difficult problem. We already have an example of a successful private rating agency, whose imprimatur is desired or in some cases required by law, that is paid for by fees on the seller, and has been operating since 1894: Underwriters Laboratory. The UL publishes safety standards for almost 20,000 different types of products, many of which are adopted by other standard-setting organizations like ANSI (American National Standards Institute) and Canada’s IRC (Institute for Research In Construction). Although generally not actually required by federal law, the sale of many types of products in the US would be difficult without UL listing. Also, many local jurisdictions responsible for building and fire codes mandate the use of UL approved products. In all cases, the manufacturer must submit samples and pay fees to UL in order to win approval.
The comparison to NRSROs is apt. In both cases, a third party sets standards based on theory, models, and best practices. In both cases, the issue is the assessment of risk by experts in that type of risk. In both cases, approval is desired by the market or required by local ordinance or rules. And in both cases, the seller pays the fees; so the third party might be led to relax their standards in order to capture some extra fee income. Yet in the case of fire safety the model has been functioning well for over 100 years, but in financial safety there has been a rash of fires as one rated product after another has blown up. Why?
There are a few key differences. Until 2007, UL was completely non-profit, so as long as user fees covered their costs there was little incentive to chase extra revenue by relaxing standards. There is no real competition in the US market for UL (although Europe has its own standard-setting body that manages the ), so manufacturers have little leverage to push for easier standards. The LeMieux amendment could allow for the creation of a not-for-profit entity to take the place of NRSROs, while the Franken amendment would reduce competition, limiting it to delivering a better, more reliable rating rather than adjusting standards to capture fees.
Critics of the amendments, including those who support a buyer-pays model, need to address the question of why the UL model for risk assessment has worked well, and why it can’t be applied to debt rating. Is the model broken? If so, I expect a rash of building fires any day. Is rating of financial safety fundamentally different than, say, electrical safety?
We should applaud the Senate for including important reform of NRSROs in the Financial Regulation package. If they are retained, collated and reconciled in Conference Committee, the door will be open to emulate a successful model that provides a comfortable revenue stream to fund improvements in service, and safety and soundness for all.