Following the fiasco of the American sub-prime mortgage crisis and the failure of credit rating companies to predict or prevent it, the European Commission has proposed tough rules designed to improve the functioning of credit rating companies (CRAs,) whose misjudgments were partly to blame for the global financial crisis. The proposals, put together during the space of a year by European Internal Market Commissioner Charlie McCreevy, are designed to “restore market confidence” by imposing strict conditions on agencies wishing to operate in the European Union.

CRAs play a key role in finance by assessing the likelihood that a company or government will not pay back its debt. The safest investments typically receive an AAA rating, but they have been assailed for being asleep at the wheel and letting poor performers slide without a warning. The US-based Lehman Brothers, for instance, still enjoyed a fairly positive A2 rating from many of the world’s most influential CRAs just days before its huge exposure to the sub-prime mortgage crisis forced it to file for bankruptcy, on September 15. “It would be unjust and insensitive to single out the rating agencies as the single cause for the financial turbulences, but they have played their part,” McCreevy said as he unveiled his proposals.

The European Union’s executive wants to avoid a repeat of such mistakes by ensuring that future ratings are “objective, independent and of the highest quality.” McCreevey said, “On this issue we are adopting a leading role.” He added that, “While we are setting standards for the EU we want these to become global standards and we will discuss them with our main international partners with that objective in mind.” The role of CRAs was to be discussed at the November 15 financial summit in Washington, which will bring together leaders of the world’s 20 leading economies.

If approved by member states and the European Parliament, CRAs operating in the EU will be placed under the control of European supervisors. This will be done by forcing American companies like Moody’s or Standard & Poor’s to register subsidiaries in the EU. However, McCreevy’s decision to entrust national authorities with the role of supervising their operations has drawn criticism from some European lawmakers. Since rating agencies operate across borders, “We should quickly establish EU-wide supervision,” said Markus Ferber, a conservative MEP from Germany.

According to the Commission’s proposals, potential conflicts of interest deriving from the fact that agencies are paid by the banks whose debts they rate will be tackled by forbidding them to act as consultants. Moreover, every agency will be required to appoint at least three independent directors tasked with ensuring that conflicts of interest are properly identified, managed and disclosed. In order to improve the quality of their appraisals, CRAs will no longer be allowed to assess financial instruments if they do not have good enough information on which to base their ratings on.

CRAs will have to become more transparent by disclosing “the models, methodologies and key assumptions on which they base their ratings,” a Commission statement said. McCreevy said the new rules were needed because the voluntary code of conduct that had been put in place for CRAs had turned out to be “a toothless tiger.” The proposed EU regulation is one of a series being drafted by officials in Brussels in order to avoid future credit crunches. MEPs REACT Members of the European Parliament immediately responded to the proposals, with Gay Mitchell of the United Kingdom, a member the Economic and Monetary Affairs Committee (ECON) giving a guarded welcome to the ideas.

The agencies were called before ECON at Mitchell’s request earlier this year and had questions to answer on potential conflict of interest. For example, structured finance ratings were among the largest and fastest growing business segments for the three leading CRAs and have developed into an important revenue source for them. Structured finance activity generates between 40 percent and 50 percent of overall sales at the main rating agencies. Moody’s annual report for 2003 shows that structured finance, at USD 460 million accounted for 40 percent of revenues.

Between 1996 and 2003, structured finance revenue grew at an annual compound rate of nearly 30 percent, he said.. The 2003 annual report of FIMALAC SA, the parent company of Fitch Ratings, indicates that Fitch earned more than 50 percent of its revenues from rating structured finance transactions. The public reports of McGraw-Hill suggest the revenues for Standard and Poor’s is comparable, Mitchell said. He asked: does the dependence of these agencies for such a significant segment of their revenue give rise to concerns? The fact that ratings are paid for by the issuers does not imbue confidence at this critical time, he said.

Other questions such as transparency over the CRAs’ rating methodologies and their independence from the parent or owner of CRAs must be considered, he added. However, while greater transparency rules seem attractive it was these very rules that allowed financial Institutions being rated in the past to go so far as obtaining computer software from Rating Agencies showing how to put together a product to meet a specific rating, Mitchell said. This resulted in products being built to rating and including the maximum amount of risky product consistent with the rating the wanted.

The Alliance of Liberals and Democrats for Europe (ALDE) in the parliament said they support the McCreevey proposal, citing four major aspects: l Prevent conflicts of interest and guarantee the independence of ratings l Reassure the quality of ratings l Set clear transparency and disclosure obligations l Set up an effective registration and surveillance regime MEP Wolf Klinz of Germany, coordinator of the ALDE-Group in the ECON, said: “The Commission’s proposal follows the right direction and will ensure an orderly admission of rating agencies, more transparency and an enhanced cooperation between the national supervisory authorities.

I also welcome the strengthening of the Committee of European securities regulators, the EU’s platform for national securities regulators. “However, the proposal does not yet solve the problem of the lack of competition. In this regard we will have to improve it, as we must achieve, particularly in Europe, significantly lower market entry barriers. We should encourage companies, which so far have been active only at a national scale, to further engage in cross–border activities,” Klinz noted.