EU To Rein In Rating Agencies

Citing rating agencies' conflicts and overoptimistic assessments that it said led to the global financial turmoil, the European Commission has put forward proposals for new regulations for the agencies.

Moody's said it was hopeful the new proposals released Wednesday would permit them flexibility. Standard & Poor's said they were examining them to see if they permitted independence and consistency.

The commission noted that the proposal is one of a number of concepts put forward to deal with the financial crisis and adds to Commission's proposals on Solvency II, Capital Requirements Directive, Deposit Guarantee Schemes and accounting.

It said the new rules are designed to ensure high-quality credit ratings that are not tainted by the conflicts of interest which are inherent to the ratings business.

“These very exacting rules are necessary to restore the confidence of the market in the ratings business in the European Union,” said Internal Market and Services Commissioner Charlie McCreevy in a statement, which said the proposal “goes further than the rules which apply in other jurisdictions.”

The proposal introduces a registration procedure for credit rating agencies with the Committee of European Securities Regulators.

According to the Commission, this will enable European supervisors to control the activities of rating agencies whose ratings are used by insurance, assurance and reinsurance undertakings, credit institutions, investment firms, collective investment schemes, and pension funds within the European Union.

It would require credit rating agencies to comply with rules to make sure that ratings are not affected by conflicts of interest, that agencies are vigilant on the quality of the rating methodology and the ratings, and that they act in a transparent manner.

The proposal also includes a surveillance regime whereby European regulators will supervise credit rating agencies.

New rules include the following:

o Credit rating agencies may not provide advisory services.

o They will not be allowed to rate financial instruments if they do not have sufficient quality information on which to base their ratings.

o They must disclose the models, methodologies and key assumptions on which they base their ratings.

o They will be obliged to publish an annual transparency report.

o They will have to create an internal function to review the quality of their ratings.

o They should have at least three independent directors on their boards whose remuneration cannot depend on the business performance of the rating agency.

The directors will be appointed for a single term of office which can be no longer than five years. They can only be dismissed in case of professional misconduct. At least one of them should be an expert in securitization and structured finance.

It was explained that some of the proposed rules are based on the standards set in the International Organization of Securities Commissions (IOSCO) code. The proposal gives those rules a legally binding character.

Also, in those cases where the IOSCO standards are not sufficient to restore market confidence and ensure investor protection the Commission has proposed stricter rules.

The Commission started work in 2007 to propose rating agency legislation when it said there were first “indications of malpractice in the ratings business.”

According to a working document with the proposal, the commission had input from 13 credit rating agencies, and 52 other submissions that included banks, and investment funds. Seventeen securities regulators and national finance ministers contributed.

The working document mentioned that in 2004, after financial scandals in the United States and the European Union, the European Parliament had considered putting new rating agency rules in place, but had held off.

According to the commission, the latest evidence showed that rating agencies “performed markedly worse in assigning ratings to innovative, structured products than in issuing traditional ratings,” and potential conflicts when structured products linked to U.S. subprime housing loans were rated “have not been avoided or managed satisfactorily.”

It was noted that commentators have also drawn attention to the potential conflicts of interest faced by agencies who earn consultancy fees from entities they are rating, and earlier this year, a Securities and Exchange Commission investigation identified a number of shortcomings to be addressed by the ratings agencies, including the need for greater disclosure of the ratings process.

S&P said in a statement. “We share the Commission's goal of bringing greater transparency and confidence to the markets and are examining its latest proposals to see if they support ratings opinions that are independent and internationally consistent.”

The company said, “Many of the requirements being proposed are already standard practice at S&P Ratings Services, such as analyst rotations, prohibition of consulting or advising, and delinking analyst compensation from fees paid by issuers they rate.”

Moody's, said, “We believe any regulatory oversight in the EU should protect the independence of credit opinions, permit sufficient flexibility to adapt to market changes and promote regulatory consistency across the globe.”

“We are hopeful that the outcome of this process will reflect these principles, and we will continue to work constructively with European regulators and policymakers to that end throughout the legislative process.”