The EU vs. the credit rating agencies
Ralitsa Kovacheva, 4 August 2011
After months of tension between the European Union and the credit rating agencies (CRAs), after some unambiguous threats by the agencies and sharp comments by Brussels, the European Union officially announced that it would pursue “the line of reducing the over-reliance on external credit ratings”.
What are the CRAs?
In fact, there are three major credit rating agencies, which dominate the global financial market - Moody's, Standard & Poor's and Fitch. It depends on their assessment into what financial instruments investors will put their money. The assessment is expressed in credit ratings (of countries, financial institutions and structured finance instruments), prepared by the agencies, which represent the degree of risk taken by the investor or in other words - the probability of default of the issuer. The higher the rating, the lesser the risk. Currently the word of the three rating agencies is the only criterion for investment decisions.
Moreover, since the ratings are used by regulators and financial institutions in their regulatory requirements, the power of agencies is growing enormously - to the extent to hold the financial stability of entire economies hostage. The example of Greece and the debt crisis in the eurozone as a whole is eloquent enough, and during the negotiations to increase the US debt ceiling the rating agencies have sent some unambiguous threats. This led us to a situation where we wonder whether the agencies assess the real situation or actually they cause it, by triggering certain moods in the financial markets so their forecasts become self-fulfilling prophecies.
The analysts have not yet conclusively answered the question why the power of the rating agencies continues to be so great, and their views are still taken so unconditionally, despite their obvious mistakes before and during the financial crisis. They not only did not foresee the crisis but they helped it, by generously giving the highest credit rating to financial instruments backed by risky mortgage loans and to financial institutions that failed under the pressure of their toxic assets.
What provoked the "war"?
Against the background of their sluggishness in the midst of the financial crisis, the credit rating agencies stirred into action noticeably when the debt crisis shook the euro area. Any attempt by the EU to show solidarity and to suggest confidence to the markets was fenced off by another downgrade of some of the “rescued” countries. Even EU Commissioner for Internal Market and Services Michel Barnier asked whether not to ban the agencies from rating countries with bailout programmes.
Tensions peaked when the EU announced that the private sector would take some of the losses in restructuring the Greek debt – a condition set by some member states (Germany and the Netherlands especially) for Athens to obtain a second loan from the EU and the IMF. The credit rating agencies warned that when the deal were to happen, they would declare a Greek default. However, the EU decided to take the risk. To send even a clearer message, at the same summit of the eurozone, where decisions on Greece have been taken, the Euro leaders announced a course to reduce the excessive dependence on external credit ratings.
A la guerre comme a la guerre
In 2009, the EU adopted a regulation to make the CRAs subject to supervision and regulation. They are required to register with European regulators and submit to monitoring by national authorities; to disclose how they determine risk; to make changes in their corporate governance to prevent conflicts of interest. The regulation is far from exhaustive and actions in this direction continue.
On July 20, 2011 the European Commission proposed new rules to better regulate the banking sector, part of which is reducing dependence on external credit ratings. “We are too dependent on credit rating agencies. As a result, I wish to suppress as much as possible the reference to credit ratings in the prudential rules. This is essential for financial stability,” Commissioner Michel Barnier said. He explained that the goal is “the banks to lead their own risk analyses, without relying mechanically on credit rating agencies.” The Commission will come forward soon with a new legislative initiative, dedicated to sovereign debt ratings.
In June, the European Parliament adopted a resolution on the matter, based on a report by Wolf Klinz MEP (ALDE, Germany). The paper identifies several key problems in terms of the CRAs: the lack of competition and oligolistic structures; the lack of accountability and transparency; the payment model (“the issuer-pays”) and the conflict of interests; the over-reliance on external credit ratings by the regulators.
Sovereign debt rating
Although the resolution refrains from significantly reducing the scope for private CRAs to rate sovereign debt, as was advocated by the MEPs from the left, the paper stresses the need for greater information and transparency in the work of the CRAs in this sensitive area. The lawmakers are critical of the sovereign debt ratings, which “should be designed to be stable and not fluctuate on the basis of market sentiment,” but in fact in recent months we have seen rather the opposite. Moreover, “ratings tend to be procyclical and to lag behind financial market developments,” the document notes.
“CRAs shall use clear criteria to score country performance” and “the actual rating is not a mechanical weighting of these factors,” the European Parliament believes. In recent months, the agencies have often been criticized for not taking into account the efforts of individual countries and of the EU as a whole to tackle the debt crisis. When Moody's downgraded Greece, literally days before the adoption of the government’s medium-term fiscal strategy and the signing of the Memorandum with the EU and the IMF, the Greek Ministry of Finance defined the decision as a result “more by market rumours rather than objective facts”.
The resolution calls for eliminating the regulation that “hardwires buy or sell decisions to ratings” so to “reduce the negative ‘cliff effects’ in prices and spreads that rating changes imply”.
According to the MEPs, a key factor in overcoming the dependence on external ratings is to encourage all market participants to develop their internal risk assessment models and to ensure that investors won’t make investment decisions if they are not able to asses alone the potential risks. In this sense, the Parliament urges the Commission to “consider whether, under certain circumstances, the use of two obligatory ratings is appropriate” and to explore the advantages and disadvantages of the “investor-pays” model as a way to reduce the conflict of interests. Under the current “issuer-pays” model the agencies are highly motivated to define a higher rating, moreover because the issuer uses also their consulting services.
European Credit Rating Foundation
The Parliament calls on the Commission to explore the options for the creation of a “fully independent European Credit Rating Foundation (ECRaF) which would expand its expertise into all three sectors of ratings”. According to deputies, the start-up funding should cover the first three to maximum five years and then the ECRaF should move towards self-financing because “financing costs should under no circumstances be borne by taxpayers”. It should be structured in a way that guarantees its independence from “the Member States, the Commission and all other public bodies as well as the finance industry and other CRAs”. The Parliament also proposes to establish a European rating index (EURIX), which incorporates all ratings of registered CRAs that are available on the market.
The good news for the European attempts to regulate the sector is that they are not isolated - the United States and the other partners in the G20 are moving in the same direction. The bad news is that the effects of the undermined market confidence in the euro area are irreversible, and the reactions of the European Union to the market expectations remain too slow. More than a year after the beginning of the Greek crisis, the EU acknowledged for the first time “the systemic nature of the sovereign debt crisis” and demonstrated will to solve it, Commission President Jose Manuel Barroso admitted in a recent statement. The purpose of the statement was to urge the national authorities in the member states to speed up the work on the practical implementation of the decisions taken by the eurozone leaders on 21 July.
While the EU is satisfied with having finally a clear vision of what to do with Greece, the markets are already expecting Ireland and Portugal to seek second loans, and the pressure on Italy and Spain is growing every day. So instead of waiting for another threat to the credit rating of Madrid or Rome, the EU must act quickly, decisively and in a concrete manner to defeat its greatest enemy and most powerful engine of market speculation – the obscurity.