Junking the Ratings Agencies

by Shane Fitzgerald

Yesterday Ireland joined Greece and Portugal in the credit rating ‘junkyard’ as Moody’s downgraded its debt to Ba1 level. The agency also put the country on a negative outlook, meaning that further downgrades are likely.

Ireland’s response is one of understandable frustration, as it has until now been widely commended for ‘getting with the programme’ and implementing harsh austerity measures. More interesting is the furious reaction of EU leaders, perhaps reflecting the fact that recent downgrades are less a verdict on the Irish or Portuguese economies than a condemnation of Europe’s collective failure to get to grips with a crisis that still threatens to engulf its single currency.

The three big credit rating agencies (CRAs) are Moody’s, Fitch and Standard & Poor’s and together they dominate the business. They have long stood accused of conflicts of interest and incompetence owing to their payment models and opaque procedures. Recently the rhetoric has ratcheted up. Commission President Barroso called the decision to downgrade Ireland “incomprehensible”. Der Speigel reports European Justice Commissioner Viviane Reding as saying that “Europe can’t allow three private US enterprises to destroy the euro”. German Finance Minister Wolfgang Schäuble asks whether “the oligopoly of the rating agencies can be broken up”.

Such tough talk over the role of the agencies is now widespread and comes just as the Commissioner for the Internal Market, Michel Barnier, prepares to announce fresh measures to regulate the sector.

Though the role of the agencies is only a sideshow to the existential drama of the Euro that is now gathering pace, it is still perhaps worth revisiting a March report by MEP Wolf Klinz, Chair of the European Parliament’s CRIS Committee, which made a number of recommendations that Barnier will have considered as he prepares his own plan.

The Klinz report suggests measures that would force investors, financial institutions and central banks to become more engaged in risk analysis, thus reducing their ‘excessive reliance’ on the quasi-oligopoly of the three main agencies.

Questioning the way in which credit ratings have become so deeply embedded in the structure of financial regulation, it also suggests actions to increase transparency in rating decisions and calls for a strengthening of the EU’s supervisory powers, an investigation of alternative payment models, and a focus through the G20 on a global approach.

To foster competition, Dr Klinz proposes the formation of an independent European Credit Rating Foundation. Barnier intends to follow this recommendation and also wants to explore the possibility of creating a network of small and medium-sized agencies. The Munich-based consulting firm Roland Berger is already canvassing  support in an attempt to raise at least €300 million by the end of the year to develop a competitor for the ‘Big Three’.

This is not the first time that Europe has tried to tackle the ratings industry. As Peadar o Broin noted in his recent IIEA blog on this topic, one of the EU’s earliest responses to the financial crisis was to start registering and regulating CRAs; indeed it was the first jurisdiction to do so. Other laws have since been passed ensuring that they are supervised directly by ESMA, the new European Securities and Markets Authority.

There is no doubt that the rating agencies played a harmful role in the global financial crisis and that they are not doing the EU many favours at the moment. But reform of an industry that is so intertwined with market function and confidence is almost certainly a task to be achieved in the medium term, outside crisis mode.

For as the crisis quickens, and crucial policy deadlocks tighten, the danger is that this area could act as a pressure valve for Commissioners and Ministers keen to just do something to resolve Europe’s problems. This could easily lead to bad policy with unpredictable effects. As o Broin notes, if a new European agency “is to be mandated and created on the basis of EU legislation, can it truly be independent in the exercise of its functions, or is it more likely to serve as a fig leaf for sovereigns and strategically important credit institutions receiving downgrades from the established agencies?” And would the effect of such an agency really be to boost global competition in the sector or would it merely serve to further undermine European credibility?

 This article was first published by the Institute of International and European Affairs. Access the original here.