New European Commission proposals to force issuers to rotate ratings agencies every three years could lead to less stable and accurate ratings.
Who has been doing what?
The European Commission (EC) unveiled proposals in November 2011 to enhance two previous rounds of regulation on credit rating agencies that were adopted in 2009 and 2010. Prior to the financial crisis in 2008, ratings agencies had not been subject to formal oversight by financial supervisory authorities.
What are the main provisions?
Previous EC ratings agency regulations, CRA I and II, had the laudable aims of tackling potential conflicts of interest for the agencies and requiring more transparency on ratings criteria and reliability. Proposals this time around include:
- Curbing the reliance of fund managers on external credit ratings.
- Obliging ratings agencies and issuers to provide more information to investors about the credit fundamentals that influence the rating.
- More transparent and frequent ratings on sovereign issuers, and possible tighter supervision of sovereign ratings.
- Further steps to eliminate conflicts of interest by requiring frequent issuers to rotate rating agencies every three years, or even annually if the agency rates 10 consecutive debt issues by the same issuer. Sovereign issuers are exempted from rotation.
- Allowing civil liability for any infringement of EC regulations by ratings agencies, so that they could be sued by investors, with the burden of proof resting on the agencies.
What does the industry say?
The rotation proposal has attracted controversy. Barbara Ridpath, chief executive of the International Centre for Financial Regulation and the former head of ratings services in Europe at Standard & Poor’s, thinks rotation will undermine the EC’s efforts to use ratings data and transparency as a way to assess the accuracy of each agency over time.
“The major agencies have different methodologies, so rotating agencies every three years means you will never build up a track record long enough to conduct those rating transition studies. And it is not clear how an agency can assess the default risk on a 10-year bond for just three years,” she says.
One former rater who is now a European credit analyst for the investment arm of a major US insurer fears rapid rotation and a growing mountain of compliance will cause ratings agencies to lose some of the depth of their credit knowledge.
“The advantage of agencies is that they do not just follow market price action, they remain focused on fundamentals. If the analysts’ understanding becomes more short-term and superficial, they are more likely to be sucked in by market developments along with the investors themselves, and ratings will become more pro-cyclical,” he warns.
A whole new conflict of interest?
Part of the problem is one of timing. Ratings agencies were the villains of 2008 because they underestimated the risks on US subprime securitisations, and investors initially welcomed pressure for more transparent ratings on structured finance. But sovereigns mismanaging their finances are the villains now. Ratings agencies have not been backward in downgrading the eurozone governments, which prompts the awkward question – is the EC punishing the raters for being too honest about sovereign debt?
The EC has at least stepped back from its earlier suggestion that sovereign ratings might be suspended altogether while multilateral support packages are negotiated, which one banker described bluntly as “censorship”, but the European Parliament is apparently itching to reintroduce this clause. And a requirement that sovereign rating actions should only be published outside European market hours exactly mirrors an ill-fated rule for French-listed companies imposed by the French regulator AMF a decade ago. This was abandoned when the regulator discovered it merely allowed Asian and US investors to react first to any ratings action.
Can we live without it?
The proposals to punish over-reliance on ratings among fund managers make sense, and the EC plans similar new regulations for the insurance sector later in 2012. But if these proposals work, then all the other elements of CRA III may be unnecessary, and potentially damaging. If investors are no longer over-reliant on ratings, only those agencies that have proven the accuracy of their work are likely to maintain their ratings pipelines. But only the entrenched rating giants might be able to shoulder the growing compliance costs.
“On behalf of our members, who are customers of the agencies as both issuers and investors, we are all in favour of improved competition. However, the nature of the market is that it is difficult for new entrants to build up a reputation and many of the measures announced by the EC will in fact create high new barriers to entry,” warns John Grout, policy and technical director at the UK Association of Corporate Treasurers.
