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Ratings regulation

November 5, 2010

The EU called for additional rules to curb ratings agencies, a sector much criticized in the wake of the financial crisis. New EU regulation goes into effect on Jan. 1, but some say it's not enough.

Two 'A's of a Triple A rating crossed out with red X's
Credit rating agencies got blamed for the financial crisisImage: DW

The European Commission wants tighter control on credit agencies in the future that would increase transparency, prevent conflicts of interest and widen competition in a sector dominated by three big players, two of which are American.

The commission, the EU's executive, released a set of proposals on Friday that lay out several concrete steps Europe might take to try to curb rating agencies' influence and improve the quality of their ratings, above and beyond the new rules already adopted that put the industry under increased supervision.

The industry is now dominated by Moody's, Standard and Poor's and Fitch, which together have 92 percent of the market. In fact, the two American firms, Moody's and Standard and Poor's, together have a market share of more than 80 percent. Fitch has headquarters in both London and New York.

The companies found themselves firmly in the line of fire after the mortgage meltdown in the United States and the resulting global financial crisis. They were blamed for failing to spot bad credit on company balance sheets and castigated for giving high ratings to securities which later turned out to be toxic.

"The financial crisis did expose a number of problems with ratings agencies, including major conflicts of interest," Philip Whyte, a senior research fellow at the Centre for European Reform, told Deutsche Welle. "The people that were paying credit rating agencies were the same people whose securities were being rated."

Greek politicians and flag
Agencies' quick demotion of Greece to "junk" status hurt attempts at a rescueImage: picture alliance / dpa

"There's also been a certain amount of disquiet about the power that ratings agencies have," he added.

The anger was reignited when sudden downgrades of Greek sovereign debt pushed that country's borrowing costs into the stratosphere and had other EU nations scrambling to put together a bailout and bolster a tumbling euro.

New regulation

Before the Greece meltdown, the EU had already begun working on new oversight, having passed regulatory measures in 2008.

The regulation, adopted in 2009 and to go into effect on Jan. 1, mandates that credit rating agencies be registered and subjected to ongoing supervision, sets new rules on governance, operations and business conduct, and requires that agencies disclose potential conflicts of interest along with their methodologies.

While the regulation is seen by many as a positive step, others do not feel it goes far enough nor addresses some of the fundamental problems with credit ratings, namely that lack of competition and the conflict of interest inherent in the current issuer-pays model.

"Rating agencies pose a multitude of regulatory problems, none of which can be solved easily," Karel Lannoo, CEO of the Centre for European Policy Studies, wrote in a study of the new regulation last month. "A more fundamental review is needed of the business model."

The EU Commission is taking that advice to heart. Suggestions for further regulation include requiring that agencies give countries several days' warning before issuing a sovereign-debt rating and make their research reports freely available to investors.

Other ideas include introducing a liability regime for rating agencies at the EU level. Such civil liability for agencies was recently introduced in the United States.

The proposals are contained in a consultation document and agencies and others will be given two months to respond.

EU rating agency?

A Fitch logo on a building
Some analysts say a European agency would be a counterbalance to the big threeImage: picture-alliance/dpa

EU Internal Market Commissioner Michel Barnier floated the idea earlier this year of creating an EU credit rating agency, a public body which would increase competition, perhaps specialize in sovereign debt and serve as a counterweight to the big US firms, Moody's and Standard and Poor's. Such an idea is especially favored by Barnier's home country, France.

"There are not enough ratings agencies, not enough competition and not enough diversity," Barnier said in May. "Why should there not be an agency that is more European than those that exist today?"

According to Philip Whyte, that represents an aversion shared by some in continental Europe to the fact that the big three agencies are all from the Anglo-Saxon world and might have a certain prejudice toward continental European countries.

Michael Barnier
Barnier has suggested created an EU-level rating agencyImage: picture alliance / dpa

"But markets might not give ratings coming from a European credit rating agency the same sort of credibility if it is just seen as a cosmetic exercise to cover up problems in countries like Greece and Spain," he said.

Analyst Lannoo shares that opinion. He said proving that such an agency was independent and not subject to political pressure would be difficult. Then there is the question of financing it and establishing a track record.

"It depends so much on reputation," Lannoo told Deutsche Welle. "If the European Central Bank works to establish an agency, it would at least take three or four years before it would have any kind of reputation or authority in the market."

Increasing competition is also seen as a necessity in the ratings industry, and while the new licensing requirements already in place in the EU might make it harder for new players to enter the market, many want to try. In September, 27 companies requested licenses, according to Lannoo.

Spotty history

Internet cafe
Rating agencies didn't see the dot.com bust coming eitherImage: AP

While the debate over credit rating agencies has reached a new volume, questions about their role and responsibilities pre-date the financial crisis.

Chastised, the tarnished sector is no longer as resistant to regulation as it once was. The financial sector sees the industry in a different way as well, according to Whyte.

"The big lesson of the crisis is you can't be too reliant on credit rating agencies," he said. "Now banks and regulators see ratings from agencies as just one of the factors that come into an assessment of risk."

Author: Kyle James

Editor: Sean Sinico