16 September 2011

What reforms for the credit rating industry? A European perspective

Credit rating agencies were the first victim of the crisis, with a regulation adopted in a period of six months – a record by EU standards. The regulation subjects EU-based CRAs to a mandatory license and strict conduct of business rules, whereas, unlike in the US, no rules had been in place before. The article concludes that the regulation should have impacted the business model of ratings agents more fundamentally.

As the financial crisis erupted, the developments recounted above and others rapidly led to a policy consensus that rating agents should be regulated at EU level. The proposal for a regulation was published in November 2008, and adopted in April 2009, a minimum interval in EU decision-making. The regulation was the first new EU legislative measure triggered by the financial crisis. It is also one of the first financial services measures to be issued as a regulation, meaning it is directly applicable, rather than a Directive, which has to be implemented in national law.

In 2006, in a report for the Commission, the CESR concluded that the rating agents largely complied with the IOSCO Code. But concerns remained regarding the oligopoly in the sector, the treatment of confidential information, the role of ancillary services, and unsolicited ratings. In a follow-up report published in May 2008, focusing especially on structured finance, the CESR strongly recommended following the international market-driven approach by improving the IOSCO Code. Tighter regulation would not have prevented the problems emerging from the loans to the US subprime housing market, according to the CESR. Notwithstanding the CESR’s advice, the Commission went ahead and issued a proposal in November 2008, after two consultations in July and September 2008. The EU regulation:

• requires CRAs to be registered and subjects them to ongoing supervision;
• defines the business of the issuing of credit ratings;
• sets tight governance (board structure and outsourcing), operational (employee independence and rotation, compensation, prohibition of insider trading, record keeping) and conduct of business (prohibition of conflicts of interest in the exercise of ratings or through the provision of ancillary services to the rated entity) rules for CRAs;
• requires CRAs to disclose potential conflicts of interest and its largest client base;
• and requires CRAs to disclose their methodologies, models, and rating assumptions.

The EU’s regulation does not alter the fundamental problem that CRAs pose from a public policy perspective: 1) the oligopolistic nature of the industry, 2) the potential conflict of interest through the issuer-pays principle and, 3) the public good of the private rating. The EU approach seems to be a second-best solution. A more fundamental review is needed of the business model of the CRAs, and for which other industry sectors could provide useful alternative models.

On the structure of the industry, the EU increases the barriers to entry by introducing a license and setting tight regulation, rather than taking the oligopolistic nature as one of the fundamental reasons for the abuses. In addition, since statutory supervision of the industry may increase moral hazard, it gives a regulatory “blessing” and will further reduce the incentives for banks to conduct proper risk assessments. It creates the illusion that the industry will live up to the new rules, and that these will adequately supervised.

During the sovereign debt crisis, European and national policymakers have repeatedly raised the possibility of “creating” local CRAs, eventually even government-sponsored entities. A state-controlled CRA would lack independence, and hence credibility, and, as demonstrated above, it is not necessarily more competition that will solve the problem.

Considering the policy alternatives outlined above, the EU and the US should probably have considered the specificities of the sector more carefully before embarking upon legislation. The legislation that was adopted does not alter the business model of the industry and gives rise to side effects, the most important of which is the supervisory seal. Given the depth of the financial crisis and the central role played by ratings agents, certainly in the EU, a more profound change would be useful, towards the “platform-pays” model or a long-term incentive structure, as discussed above.

The EU regulation, as adopted, consolidates the regulatory role of CRAs in the EU system, but the price is high. It fragments global capital markets, as it introduces a heavy equivalence process, and requires a local presence of CRAs and endorsement of systemically important ratings. It is at the same time protectionist. Under the new set up, CESR and its successor, ESMA, are given a central role in the supervision of CRAs, but the question is whether they will be able to cope. The supervisor needs to check compliance with the basic requirements to decide on a license and to verify adherence to the governance, operational, methodological, and disclosure requirements imposed upon CRAs. This is a heavy workload, especially considering that no supervision had been in place until a few months ago. Given the present debate on the role of CRAs in financial stability and the need for technical expertise, the European Systemic Risk Board could have been involved, but this seems not to have been considered, at least for now.

On the other hand, the advantage of having a regulatory framework in place is that the Commission’s competition directorate can start scrutinising the sector from its perspective. To our knowledge, the competition policy dimensions of the CRA industry in Europe have not been closely investigated so far, as no commonly-agreed definitions and tools were available at EU level, and since the sector is essentially of US parentage. EU registration for the large CRAs will allow the authorities to check their compliance with EU Treaty rules on concerted practices and abuse of dominant position.

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