In the pantheon of financial crisis villains Fred Goodwin and the former Royal Bank of Scotland board stand tall, especially in the UK. But elsewhere in Europe the rating agencies jostle for position. Following a less than glorious performance in the subprime debacle, their unhelpful downgrades of European sovereign debt have kept them firmly in the line of fire. Any politician on the stump in France, Italy or Greece can raise a cheer by promising retribution.
The European Commission has already shot these tiresome messengers twice, with regulatory measures known as CRA I and CRA II. The new rules roughly parallel moves in the US to promote competition and improve the transparency and informativeness of ratings, especially those applying to securitisations. There is also a useful global initiative, led by the Financial Stability Board, to diminish the role of ratings in regulation. There has been too much “hard-wiring” of ratings in banking regulation, though reversing this is not straightforward.
These changes are still being digested by the agencies and by the financial markets. It is too early to assess how effective they are. The Commission has nonetheless proposed to shoot the messengers again, and this time it is a machine-gunning that threatens to injure innocent bystanders as well. It opens up clear blue water between the EU and US regimes, which will make life difficult for investors and those seeking to raise capital. It could in the long run damage Europe’s capital markets.
The most intrusive proposal advanced by Michel Barnier, European commissioner for internal market and services, which would allow regulators to suspend the issue of sovereign ratings in certain circumstances, was wisely rejected by other commissioners. But there are signs that the European parliament may try to reinstate it. Other elements of the current draft are also problematic, especially the rotation requirement, and the proposed oversight of rating methodologies by the European Securities and Markets Authority.
It is proposed that an agency can only provide a solicited rating for three consecutive years. It must then withdraw for a period at least as long. So issuers who want to have continuous ratings will have to switch agencies regularly, potentially to firms that lack detailed knowledge of their business. The idea seems to be derived from similar proposals for mandatory audit rotation. But the supporting evidence is weak. Recent research from Italy suggests that there are no beneficial effects of mandatory audit rotation. And an International Monetary Fund paper on recent US experience concludes that “event studies suggest that the arrival of an additional credit ratings agency to a market has led to lower rating quality/higher ratings”. It could also be argued that a mandatory rotation requirement amounts to an unreasonable restraint of trade.
Regulatory oversight of rating methodologies could also have perverse effects. The consequence could well be pressure for a standardised methodology, which would run counter to the aims of reducing the market power of individual agencies, and creating greater diversity of approaches.
While the political mood remains hostile to rating agencies – which, it must be said, have not done themselves many favours – there is a clear risk that ill-considered proposals are legislated in haste. The Danish government in particular appears to want to declare a quick victory in this area. It should think again. The views of corporate issuers and investors need to be heard before Europe rushes into new legislation given that the impact of the earlier directives has not yet been assessed.
The writer is a former chairman of the Financial Services Authority and former deputy governor of the Bank of England. He is professor at Sciences Po in Paris