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SEC Shouldn’t Regulate Credit Ratings, Cato Researchers Say

The U.S. government should stop regulating credit-rating companies, researchers from the Cato Institute said.

Standard & Poor’s, Moody’s Investors Service and Fitch Ratings have become a “de facto oligopoly” due to rules that forced banks and other investors to use their ratings to determine the riskiness of holdings, according to the paper, published today by the Washington-based public policy research organization, which says it promotes free markets.

Credit-rating companies should be “subject to competitive market pressures,” wrote Emily Ekins, a research fellow, and Mark Calabria, director of financial regulation studies. “Such pressures would most effectively be brought to bear by a reduction in regulatory barriers to entry and the removal of artificial demand due to various compliance requirements.”

Regulators shouldn’t decide which rating companies are approved for use and should stop using the ratings themselves in rules, according to the Cato researchers. That would force the firms to compete based on quality, they said.

“The message we need to send market participants is there is no seal of approval behind the ratings,” Calabria said in a telephone interview.

Financial Crisis

After inflated credit ratings for risky mortgage bonds were blamed for helping cause the worst financial crisis since the Great Depression, policy makers have been searching for a way to ensure the grades are accurate. The Dodd-Frank Act instructed regulators to stop relying on ratings and increased oversight of the ratings companies. The U.S. Securities and Exchange Commission should stop regulating the companies instead, the Cato researchers said.

“Dodd-Frank is a bit schizophrenic,” Calabria said. “It says we want to reduce reliance on rating agencies but we’re going to further embed them.”

In 1936, the Office of the Comptroller of the Currency banned banks from holding bonds that were below investment grade. The SEC began using ratings in its rules in 1975, specifying that the only companies whose grades could be used were S&P, Moody’s and Fitch. Those firms were designated nationally recognized statistical rating organizations, or NRSROs. There are now nine.

“Despite the good intentions of the uses of the NRSRO designation, it is not worth the cost and should be abolished,” Ekins and Calabria wrote.

Ending credit-rating regulation wouldn’t stop mutual funds and pension funds from using the grades in guidelines which determine which bonds they buy. About two-thirds of the biggest pension funds require that any bonds they buy have ratings from S&P, Moody’s or Fitch, according to Kroll Bond Ratings Inc., a competing firm that issued its first assessments last year.

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