Europe Aims to Regulate Credit Rating Agencies

Joonatan Jakobs is skeptical whether European reforms efforts will improve competition in the credit rating market.

Among the many culprits appearing after the great recession were the credit rating agencies. Their negative effect on the financial system has been well documented, both externally and internally by the agencies themselves. Indeed, the quick updates on European sovereign debt are justified by arguing that the industry wants to mend the mistakes of the recent past in that it was not responsive enough. The international community is actively working on ways to regulate the credit rating agencies because of the weaknesses that were revealed after the crisis and the effect that rating downgrades have had on the fragile debt situation of a number of European countries.

Originally set up to rate the probability of a company, country or financial institution defaulting, the current scope of their involvement in the economic system is far greater. What has proven especially important is the way the agencies operate and the artificial power they have obtained over deciding who is allowed to invest in a company or country. The agencies are so powerful because Basel II, the international framework for banking rules (now supplanted by Basel III) requires a positive rating from the agencies in order for public and pension funds to invest in them. In effect, if a country does not have a positive rating, it may not be eligible for investment by other sources.

One of the more radical ideas proposed by the European Union is the creation of a “European Credit Rating Foundation” that would decrease the power of the three main raters of sovereign debt which are all American. Yet its creation seems ill devised and an attempt to solve a political problem that is to a large extent caused by a flawed regulatory framework to begin with. If one of the main problems of the current system could potentially be solved by removing the regulatory power of the rating agencies, it is questionable if setting up a new ratings agency would be a valuable part of a solution.

An important aim to credit rating regulation is improving competition. This is partly justified by the fact that the “big three” — Moody’s, Standard and Poor’s, Fitch — make up 95 per cent of market share and their earnings are well above anything suggesting a healthy market. Strengthening competition, it is argued, would increase transparency and prevent the big three from dominating the market.

Some European politicians also argue that since the companies are all based in the United States, they are not in a position to rate European markets properly while the timing and content of recent downgrades may have been politically motivated.

The first and more serious problem is complicated by the fact that increased competition has a host of other problems, mainly that it may exacerbate the issue of customers picking the rating agency that would give them the highest rating. The more firms there are to chose from, the bigger the chance of rating inflation.

The second part deserves less attention — the credit raters have offices in Europe, with European staff and have had the habit of buying up successful local European agencies with the knowledge and expertise they provide. The introduction of a European foundation, or any other agency for that matter, need not be an answer to the proposed problem.

The aim to regulate the credit rating market is nothing new as the EU has pursued this goal since the early 1990s. The agencies’ prevalence in today’s headlines shows how sensitive the market is to uncertainty and the power the ratings agencies have when downgrading sovereign debt. Thus they are heavily criticised for deciding on ratings days before important political negotiations take place, further increasing uncertainty. European regulation states that this is one of the main problems with the framework, outlining how a host of structured financial instruments had their ratings radically downgraded when the financial crisis occurred, implying both a lack of stability and a flawed system that did not provide accurate ratings.

True as this certainly is, one needs to remember that the situation did not apply to sovereign debt ratings which did not come out of the recession with the same tainted reputation. It is also important to consider how sensitive markets would be to perceived political influence if the EU were to be seen to exert pressure on a new agency. The purpose of it entering the market could therefore quickly be seriously damaged.

Considering these issues — Basel II rules giving credit rating agencies power over creditworthiness, the likelihood of ratings inflation with increased competition, the sensitivity of perceived political pressure over ratings — the EU could do better by partly or completely reducing the power given under Basel II (which the big three don’t oppose) so that investors are not told what to do and need to take other factors into consideration. This, as well as working on ways to reduce the inherent conflict in having issuers pay the agencies for a ratings could reduce many of the problems faced by them. This seems to be a situation where the EU can do so much more with less.