Risk & Compliance

Europe Regulator Targets Rating Agencies

The current code of a conduct governing the credit-rating agencies is a "toothless wonder" that should be buttressed by improved internal governanc...
Alan RappeportJune 16, 2008

Credit-rating agencies will not be able to seek safe haven in Europe, according to Charlie McCreevy, European commissioner for internal markets and services, who called on Monday for “meaningful but targeted” measures to regulate the firms largely blamed for this year’s credit crisis.

McCreevy’s comments, at a conference in Dublin, came a week after the U.S. Securities and Exchange Commission and the New York Attorney General moved swiftly to create more transparency for the agencies and greater independence of them from the companies they rate. Those proposed new rules followed heated criticism the agencies for boosting the magnitude of the subprime mortgage crisis and resulting credit crunch. Critics contend that the agencies overrated securities backed by bad loans, leading investors to take on more risk than they could handle.

The European Union now also appears ready to act. “I said before that I would not wait indefinitely for the credit-rating agencies to come forward with meaningful proposals to put their houses in order. And I mean what I say,” McCreevy said, calling their existing code of conduct a “toothless wonder.”

To be sure, the current code of conduct was designed by the International Organization of Securities Commissions, a group of regulators. McCreevy said that these standards need to be buttressed with reforms of the rating agencies’ internal governance and strengthened external oversight. He said that the changes that the agencies have proposed are not sufficient and that that suggested that it is time for Europe-wide regulations.

McCreevy said it was crucial to create a system in which pay and incentive packages for ratings analysts did not erode confidence in the ratings that they produce. He also embraced recommendations from the European Securities Markets Expert Group to balance the need for quality standards and the need for firms to still be profitable. Structured finance required special attention because of its complexity, he added.

However, McCreevy said, greater oversight did not mean that regulators should have the ability to meddle with the models or tools that credit rating agencies employ. “Regulators should not be in the business of opining on individual rating content,” McCreevy said.

The European Commission’s plans to deal with the ratings agencies appear to be in earlier stages than those of the SEC. The proposal of America’s securities regulator would bar the agencies from issuing ratings on structured products unless they have sufficient information about the underlying assets of those products. It would also prevent them from structuring the same products that they rate. In the future, if the SEC gets its way, the agencies would not be able to negotiate the fee of a rating with an issuer and also determine the rating. The practice of issuers “shopping around” for quality ratings or asking agencies how to structure a product to ensure a good rating has been blamed for inflated ratings.

Disclosure would also be improved. The SEC is proposing that credit rating agencies make all their ratings publicly available to keep them from being overly optimistic. They would have to disclose the information that they use to make a rating and publish regular performance statistics. The ratings agencies would also have to publish an annual report of all the ratings actions that they took and maintain that information in an interactive database.

The SEC has made another proposal that would create labels to differentiate between complex asset-backed securities and more traditional corporate bonds. “The complexity of the structured products themselves, combined with the lack of quality information about the underlying assets, make it exceptionally difficult for anyone to determine a credit rating at all,” SEC chairman Christopher Cox said last Wednesday.