EU wants curbs – but not stops – on sovereign ratings

When the shot came, it fell short of its threatened power of penetration. The European Commission is laid out paid to regulate the credit rating industry in quite fundamental ways, but not quite so fundamentally as the commission itself had trailed in the weeks before the announcement. Credit rating agencies already have to register to do business in the European Union. If the commission's plans go ahead, they will need to do a lot more than that. The commission's plan seeks to achieve four main goals:

• Reduce investor demand: Institutional investors use credit ratings in lieu of making their own analysis. So the commission wants to eliminate many references to ratings in the Capital Requirements Directive and then require financial institution "to do their own due diligence".
  
• More transparency and frequency: Ratings of sovereign debt will need to be issued at least every six months, not once a year, as it is at present. Moreover, agencies will need to inform investors and governments of the reasons for the ratings. Ratings should only be published after close of business to avoid disrupting the market.
  
• Reduce conflicts of interest: The commission wants greater diversity of ratings and greater independence. So it proposes that borrowers rotate their ratings agencies every three years. Two ratings would be required for more complex structured products, and a big shareholder of a credit rating agency should not simultaneously be a big shareholder in another credit rating agency.
  
• Greater accountability: Ratings agencies should liable for infringements of the planned "regulation", if they did so intentionally or with gross negligence, and thus harm the investor who relied on the rating. Investors "should bring their civil liability claims before national courts", it said. "The burden of proof would rest on the credit rating agency."

The plan involves both a "directive" and a "regulation". In the parlance of the European Union, a directive is only outline legislation, which member states then "transpose", giving the law its final form. A regulation is fixed; member states have to enact it as is. The directive here concerns how investors use ratings. The regulation affects the agencies themselves.

Internal Market Commissioner Michel Barnier said: "Ratings have a direct impact on the markets and the wider economy and thus on the prosperity of European citizens. They are not just simple opinions." Indeed, they are not simple at all. "We can't let ratings increase market volatility further. My first objective is to reduce the over-reliance on ratings, while at the same time improving the quality of the rating process," he added. "Credit rating agencies should follow stricter rules, be more transparent about their ratings and be held accountable for their mistakes. I also want to see increased competition in this sector."

Barnier said, correctly, that rating agencies have made serious mistakes, too. But others of his concerns seem less clear-cut. He worried, for example, about the timing of announcements of rating changes. Why did the agencies make rating changes during the negotiations about an international aid programme for a country? Why? Because the risk profile of the borrower that changed materially, which might materially impair investors' assets.

Source document: The project website has links to the news release and related documentation.