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.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.
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 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:
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.
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.”
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.
