2). These reforms are intended as reassurances to nervous European consumers and investors to prevent future financial crises (Hughes & Augier, 2014).
Recent changes to CRA regulations. In the United States, number of issues that may affect investors may be unregulated to some extent absent further regulatory or legislative action including the unregulated nature of the methodology used by CRAs (Mierzwinski & Chester, 2007). In the European Union, though, revised rules adopted in May 2013 included mandatory rotation of CRAs and approval of the methodology they use in assigning credit ratings (Update on regulation of credit rating agencies, 2013).
Credit Rating Agency Reform Act of 2006. In 2006, Congress passed the Credit Rating Agency Reform Act that required the U.S. Securities and Exchange Commission (SEC) to promulgate clear guidelines to identify credit rating agencies that would qualify as Nationally Recognized Statistical Rating Organizations (NRSROs) (Credit reporting agencies, 2014). The Credit Rating Agency Reform Act also authorized the SEC to regulate NRSRO internal processes concerning record-keeping practices, guidelines for preventing conflicts of interest, and established the protocol whereby NRSRO determinations were subject to review (Credit reporting agencies, 2014). It is important to note, though, that the Credit Rating Agency Reform Act specifically prohibits the SEC from regulating the rating methodologies used by NRSROs (Credit reporting agencies, 2014).
After the 2008 housing bubble. Credit rating agencies use a business model that is characterized by a fundamental conflict of interests (New rules will fail to reform ratings agencies, 2014). In a painful reminder that greed can infect an entire industry, the 2008 housing bubble focused attention squarely on the CRA sector. According to Baker (2008), prior to the 2008 housing bubble burst, “Banks paid for the rating of their bonds by credit agencies,” a practice that “should have prompted more concern from regulators” (2008, p. 73). These lax practices resulted in enormous profiteering at the expense of the American taxpayer. In this regard, Baker notes that, “This situation was a recipe for abuse” (2008, p. 73). Indeed, a representative from Standard and Poor’s emphasized that, “Securities backed by faulty mortgages were an ‘epicenter’ of the crisis, leading investors astray by ‘wrapping serious financial risks in a thin veneer of creditworthiness (cited in Regulators OK overhaul of credit rating agencies, 2014, p. 3). Prior to the 2008 housing bubble burst, investment bankers and securities issuers practiced what is known as “ratings shopping” and hired the CRA that would provide them with the most advantageous ratings (New rules will fail to reform ratings agencies, 2014). Although regulators have encouraged CRAs to offer unsolicited ratings on issuances they have not been hired to rate, ratings shopping has been revived (New rules will fail to reform ratings agencies, 2014).
Most industry analysts agree that the CRAs were responsible for causing the financial crisis, with the overarching motivation being greed (New rules will fail to reform ratings agencies, 2014). For instance, one analyst suggests that, “Financial institutions that created residential mortgage-backed securities (RMBS) needed strong CRA ratings in order to sell their financial products, since many investors…
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