Capital Markets

EU Ups the Ante on Rating Agency Reform

Commissioner Charlie McCreevy says Europe's proposal goes further than U.S. regulations, banning raters from providing consulting work.
Sarah JohnsonNovember 12, 2008

The European Commission has proposed several rules for ridding the credit rating agencies of the conflicts of interest that critics say have tainted their assessments in recent years.

The drafted rules come on the heels of the heavy criticism lobbed against the major agencies — Fitch Ratings, Moody’s Investor Service, and Standard and Poor’s — for not providing quicker and more accurate grades of mortgage-backed securities before the credit markets imploded and they clamored to make thousands of downgrades. Because of the inaccurate ratings, they have been blamed by lawmakers and investor advocates for being a major player in the credit crisis.

In a speech today, European commissioner Charlie McCreevy said the proposed rules will balance the agencies’ need for independence with “effective oversight” and are stronger than U.S. regulations. “This proposal goes further than the rules existing in any other jurisdiction in the world,” he said. “On this issue we are adopting a leading role.”

To be sure, the U.S. Securities and Exchange Commission has proposed rules that attempt to solve the industry’s conflicts of interest, along with investors’ apparent ignorance over the different risks involved among various types of asset-backed securities. But commissioners have yet to vote on a final set of rules. If approved, the SEC’s changes would require all rating agencies to publicly release all their ratings, and share the information on which they are based. In addition, the agencies could no longer structure the same products they rate.

The EU’s proposed regulations seem to go a bit deeper by explicitly prohibiting the agencies from providing any advisory services. “In order to avoid potential conflicts of interest credit rating agencies should limit their activity to the issuing of credit ratings,” the drafted rules state.

The proposed rules are largely based on voluntary, code-of-conduct guidelines the International Organization of Securities Commissions put out last year. IOSCO’s members, which includes the SEC, regulate more than 90 percent of the world’s securities markets.

Unlike IOSCO’s guidelines, these new rules would be binding — reflecting a regulatory approach that will certainly win the favor of the CFA Institute Centre for Financial Market Integrity, a research and policy organization that has been asking for the conduct code to become mandatory. Earlier this year, McCreevy called the code a “toothless wonder.”

His proposal would require raters to disclose any rated entities or retail third parties that contribute more than 5 percent of their annual revenue. And they would need to employee three independent directors, including an expert in securitization and structured finance. Violators could be sanctioned and lose their license. “CRAs will no longer be able to use the defense that credit ratings are just opinions,” McCreevy said.

For their part, the major rating agencies say they welcome consistent regulations across borders but could have reservations about some of the proposed rules. “While Fitch will continue to search for common ground on a few key provisions in the proposals, we will engage in a balanced and constructive way with the Commission, the European Council and the European Parliament as the approval process moves forward,” said Fitch CEO Stephen Joynt.

Added an S&P spokesman, “We share the commission’s goal of bringing greater transparency and confidence to the markets and are examining its latest proposals to see if they support ratings opinions that are independent and internationally consistent.” S&P already follows many of the proposed requirements, such as analyst rotations and doesn’t provide consulting services, he said.

“We believe any regulatory oversight in the EU should protect the independence of credit opinions, permit sufficient flexibility to adapt to market changes and promote regulatory consistency across the globe,” said a Moody’s spokesman. “We are hopeful that the outcome of this process will reflect these principles.”