Credit rating regulation

The European Commission on Wednesday unveiled new proposals for regulating credit rating agencies (CRAs), which some analysts blame for exacerbating the turmoil in European financial markets.

The new guidelines provide stricter transparency guidelines, and place CRA regulation under the authority of the European Securities and Markets Authority (ESMA), which the commission established last year and is due to come into force at the start of 2011. The ESMA would have the authority to impose sanctions on agencies, and even withdraw their licenses when they fail to comply with regulations.

The three main credit rating agencies, Standard & Poor's, Moody's and Fitch, had operated with significant latitude before the EU began issuing licenses and demanding a certain level of transparency just last year, according to Karel Lannoo, director of the European Credit Research Institute.

"When the financial crisis started in 2007, it was very clear that the ratings which the rating agencies gave were not based on pure objective facts," he told Deutsche Welle. "There were huge conflicts of interest. That's why the EU was then convinced that there should be a piece of regulation."

Case for regulation

One function of rating agencies is to rate the risk of government bonds, using a scale of AAA for the most secure to D for an almost certain default.

The agencies then sell these ratings to investors and banks. The conflict of interest appears when the agencies rate the very institutions that buy their services, said Robert Halver, stock analyst for Baader Bank.

"The rating agencies finance themselves very strongly with the sale of analytical instruments on pension funds, insurance agencies and banks, because everyone assumes that they have a lot of knowledge about country's risks," he told Deutsche Welle.

Another reason for further regulation is the role CRAs have played in crises related to the public finance of budgets, most notably in Greece but also in Spain, Portugal and Italy, said Lannoo. When ratings agencies devalue government bonds, it creates a problem of "systemic stability."

"All of a sudden these ratings agencies have drastically downgraded the debt of these countries, which as given rise to systemic effects, in the sense that many investors have started to sell the securities or the bonds of these countries," he said.

More competition

Halver said one solution to Europe's problem with CRAs would be the creation of a European rating agency to compete with the "big three," as long as it wasn't under the supervision of a public entity like the European Central Bank (ECB) or the European Commission, as Eurogroup President Jean-Claude Juncker recently suggested.

"Then there would be suspicion that they would exercise their influence and try to sugarcoat negative evaluations," he said. "That cannot happen."

Lannoo said the big three already have a European component in Fitch, whose main shareholder is European. Rather than constructing a new European rating agency, he said regulators should instead make it easier for already-existing agencies to be licensed as CRAs.

"What in fact we need to do is... to lower the entry barriers into the sector," he said. "But what we in fact have done with this European regulation now is just the opposite - we have increased the entry thresholds because it's extremely difficult to be in line with this piece of regulation."

Author: Andrew Bowen
Editor: Rob Turner