Thursday, November 29, 2012

The Rating Agencies

There is a fascinating piece of news that I have just stumbled upon in Bloomberg, regarding the EU and the ratings agencies:

Credit rating companies face curbs on when they can assess government debt and restrictions on their ownership under draft plans agreed upon by the European Union to limit the industry’s influence and tackle conflicts of interest.

Investors will also get the right to sue ratings companies if they lose money because of malpractice or gross negligence in the plans agreed upon yesterday by lawmakers from the European Parliament and Cyprus, which holds the rotating presidency of the EU.
The interesting point here is that the Basel banking regulations entrenched the ratings agencies within the financial system. Essentially, the ratings agencies became the key to the level of capitalisation of the banking system. The small detail that the ratings agencies were paid by said same banks to undertake the ratings did not cause concern in the bizarre world of banking regulation. No doubt there will be many who will applaud the EU for taking action against the agencies; they really are, in some respects, the guys with the black hats. However, we must also remember that their power in the market was underpinned by a regulatory framework; the Frankenstein that created this monster was the regulators.

The problems with this latest move from the EU is that it does not seem to be founded in a genuine motivation for reform, but rather to de-fang the major ratings agencies, which are coincidentally downgrading sovereign debt. One suspects that the motives here are not entirely about the aim stated in the article, which is about 'financial stability'. The reason I am doubtful about the intentions is that the stated aim is to address conflicts of interest. This is the most simple problem to fix, and does not require this rather odd approach. It is so absurdly simple to fix the conflict of interest that the solution given absolutely must have different motivations; the absurdly simple answer to resolve conflicts of interest would be to ban any rating of any financial product that is paid for by the issuer of the product. It does not matter whether the product is a personal pension, or a complex derivative product.

Also, with regards to sovereign ratings, this is one of the few areas where (relatively) there is little conflict of interest. How curious is it that this is the focus of the attention of the EU? The following passage from Bloomberg tells the story:

On sovereign debt ratings, lawmakers and officials agreed that each credit rating firm must pick three days a year when they would be allowed to give so-called unsolicited assessments of governments’ creditworthiness, according to Jean-Paul Gauzes, a lawmaker involved in the talks. Ratings firms may get a chance to issue unsolicited ratings -- those that haven’t been requested and paid for by a client -- outside those dates if they can justify it to regulators.

“Credit rating agencies will have to be more transparent when rating sovereign states, respect timing rules on sovereign ratings and justify the timing of publication of unsolicited ratings,” Barnier said. “They will have to follow stricter rules which will make them more accountable for mistakes.”
Here we have the distinctly curious situation of the lawmakers seeking to restrict the access to the ratings when the ratings are paid for by entities that need an independent rating; it is the very opposite of the absurdly simple solution to conflict of interest. Just as the rating of a derivative should be paid for by the potential purchaser, the same with bonds. In this case, this is exactly what the ratings agencies are doing. They may be useless at their job, which is not the point of this post, but they are in this case presumably acting in the interest of the purchasers, not the issuer. This is how the system should work, but that is what is being attacked. In summary, this is simply an attempt for the EU to try to bury the crisis that is threatening the EU and the Euro project.

The news should be greeted with outrage, but the visceral ant-ratings agency feeling will probably see applause from many quarters. Whilst I would like to see the agencies de-throned, this is not the solution, and it tells us more about the terror being felt in the upper echelons of the EU than it does anything substantive to fix the agencies.


  1. I would have liked to seen the ratings agencies held to account for their part in the 2008 fiasco, but I'm not holding my breath upon it.
    However, this as you so rightly point out, seems to be more politically motivated rather than from a practical/fiscal point of view.
    This is more about hiding the EU debt mountain rapidly accumulating across the Channel.

  2. My barnacled friend is, as usual, correct. This episode is explicable only on political grounds.

    One feature of not just the EU but every supra-national body (both governmental and corporate) is their sensitivity to criticism.

    Multinational corporations often seek to stifle bad news about their practices but they have no power to prevent criticism before it has been made. Their method of self-protection is to threaten legal action against complainants safe in the knowledge that few such complainants will have the time or money to fight the case.

    Governmental bodies have the power to enact laws that limit both the ability to examine their activities and to seek any form of redress once mistakes have been identified. That is the pattern followed by every dictator in history and when it appears we must be wary of the risk of dictatorship - however benign it might consider itself to be.

    I happen to think the EU is a thoroughly corrupt institution although I am happy to acknowledge that the failed domestic politicians who occupy its upper echelons of power might think they are acting in the best interests of the little people.

    To my addled mind the great concern is that their judgments are not subject to scrutiny and their prejudices are not subject to democratic examination.

    We have plenty of idiots in the UK Parliament but they are our idiots and they are legitimate decision-makers because they have a democratic mandate. If we find them too idiotic we can vote them out. More than that, their idiocy can be exposed by our news media. They can progress no further up the ladder of power than the combined forces of voters, media and Prime Ministerial whim will allow. The same forces of moderation do not apply to the EU Commission and they can have only limited effect on the Council of Ministers and the European Council.

    When, as is currently the case, officials of an EU institution seek to prevent examination of some of their activities we have cause to be very concerned because we have no power to stop them doing it and no power to stop them preventing the examination of other of their activities.

  3. Hi. Tried to comment previously, but don't seem to have got through. (If that comment is simply waiting to be checked, please ignore this one.)
    Main point is that I don't see how this sort of restriction can actually be made to work. In a global market, with loads of information floating about, it would be very hard to stop anyone from gauging market sentiment about any particular debt issuer, whether the big ratings agencies were pontificating or not.

    1. Jestersong: Very sorry about the delay/problem with your comment. The system is normally very good, but your previous comment disappeared? I'm not sure why. Apologies.



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