It is time for an independent European agency to provide sovereign debt ratings – ending the dominance of Fitch, Moody’s and Standard & Poor’s, argues Sven Giegold MEP.
Ever since the railway expansion in 19th century America, credit rating agencies have played an increasingly important role in guiding and directing investments. Today, ratings play the central role in assessing the creditworthiness of sovereign states or bonds, on the one hand, and the quality of financial products on the other hand.
Three agencies dominate the global market – Fitch, Moody’s and Standard & Poor’s. Originally, investors would pay for the ratings. But, the last few decades have been dominated by the issuers-pay model – creating major conflicts of interest. On top of this, CRAs started advising issuers on how to construct the financial products they would then subsequently rate – adding another layer of conflicts of interest.
Through the Basel Committee rules on banking regulation and the European Union translation into the Capital Requirements Directive, credit ratings have become a neuralgic point in the process of building up systemic risk. How much funds a financial institution needs to retain is calculated in accordance with rating a financial product receives. With the outbreak of the financial crisis, it became clear that highly risky products such as structured finance instruments – including asset backed securities and collateral debt obligations – concerning re-securitised mortgages, were rated as very safe and little or no capital needed to be retained. This in turn facilitated the risk accumulation of financial institutions and became a determining factor of the financial crisis.
States fund their deficits by issuing bonds. The interest paid depends on the signals investors receive through ratings. Rapid downgrading, as in the case of Greece, can accelerate the downward spiral of a country’s economic condition. After the outbreak of the financial crisis, the first ever regulation on credit agencies was agreed in April 2009 – and reinforced in December 2010. It contains an obligation to register with the European Securities and Markets Authority leading to direct EU supervision and the prohibition to offer consultancy services – resolving one key conflict of interest – as well as an endorsement regime for rating from ratings outside the EU and a framework for fines, and higher transparency requirements.
What else is needed? Well, the European Commission is preparing a more fundamental revision of the regulation on credit rating agencies. The Greens believe some key elements of the US regulatory system should be integrated into the EU’s rulebook. There is a need for far-reaching transparency requirements for ratings of financial products, in particular, and strict rules for analysts switching jobs.
There is also a need to strengthen liability regimes, to ensure that extreme volatility of ratings should trigger an investigation by ESMA – and to ensure that the rating exercise is not confined to financial risks, but should also cover the environmental dimension – as recent disasters in Fukushima and the Gulf of Mexico have brought to the fore. A big leap forward would be the creation of an independent European agency, which should provide a compulsory additional rating for sovereign debt amongst other things. The European Parliament has supported the Green proposal for a European rating foundation and called on the commission to assess the feasibility of an EU agency.
There is also a need to ensure there are more actors in the market, to get away from the damaging dominance of the big three. The commission needs to take steps to ensure greater competition in the rating agency market. But, the biggest challenge of all is to overcome the dominant payment and allocation model. “Issuer pays” is a fundamentally flawed system that inevitably leads to conflict of interest, with entities being rated effectively paying the rating agencies for the ratings they get. Ideas such as reverting to the investor-pays model, creating a deferred payment or “payment upon result” model and random allocation or allocation by an independent body – are all alternatives that should be considered. The commission must thoroughly assess these options, examine their feasibility and integrate the most appropriate rules in the upcoming revision of the regulation on credit rating agencies.
Sven Giegold is a German MEP and finance spokesman for the Greens/European Free Alliance Group in the European Parliament