Moves to reduce reliance on credit ratings and improve the rating process make sense, but going cold turkey may not, according to a state pension fund executive.

Gregory Smith, chief operating officer of the Colorado Public Employees’ Retirement Association, Denver, talked about the current effort to root references to credit ratings out of federal financial services regulations today at a hearing organized by the oversight subcommittee of the House Financial Services Committee.

Smith, a board member of the Council of Institutional Investors, Washington, Dodd-Frankappeared at the hearing a day after members of the U.S. Securities and Exchange Commission (SEC) voted unanimously to adopt new rules to remove credit ratings as eligibility criteria for companies seeking to use the simpler “short form” registration when registering securities for public sale.

The SEC developed the regulations to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 that call for federal agencies to shift away from use of credit ratings.

Traditionally, issuers of debt securities have paid the big “nationally recognized statistical rating organizations” (NRSROs) to rate the securities. Lawmakers added the NRSRO provisions to the Dodd-Frank Act in response to arguments that faulty ratings assigned by rating agencies with conflicts of interest contributed to the severity of the credit market crisis that started in 2007.

Smith noted that Colorado PERA has never relied solely on NRSROs when making investment decisions.

“Credit ratings are used as a part of the mosaic of information we consider during the investment process,” Smith testified, according to a written version of his remarks provided by the House Financial Services Committee.

Colorado PERA is looking for alternative measures of risk to further reduce reliance on ratings, Smith added.

“We fully agree with the conclusions of the Financial Crisis Inquiry Commission and many others that

‘the failures of credit rating agencies were essential cogs in the wheel of financial destruction,” Smith said.

Smith noted that issuers of 98% of U.S. credit ratings are paid by the issuers to assign the ratings.

But it is not feasible or practical for Colorado PERA and other institutional investors to simply stop using credit ratings altogether, and “it may not be feasible or practical for federal agencies to strike, in one fell swoop, ratings from all of their rules and regulations,” Smith said. “Mandates to use ratings have become part of the fabric of financial regulations, and cannot be unwoven instantaneously.”

It would be more practical for the SEC and other agencies to continue to work to reform the credit rating industry with rules promoting transparency, accountability and efforts to avoid conflicts of interest, Smith said.

If the SEC simply eliminates credit ratings before effective substitute tools come along, that could increase the level of risk for investors and financial institutions, Smith said.

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