EU Leaders Look at Credit Rating Agencies; Praise Hedge Fund Working Group

European Union political leaders have called for reform of the credit rating agency process and better risk management in the wake of the recent market turbulence triggered by the sub-prime crisis. While supporting a market-driven solution, the leaders said that regulation and legislation will be on the table if an appropriate market response is not forthcoming. In addition, the EU heads urged regulators to engage in cross-border cooperation and information exchange to prevent and manage financial market crises. With a nod to market-orientated solutions and the involvement of market participants, the EU leaders praised the recent voluntary best practice standards presented by the Hedge Fund Working Group, which dovetails with the Financial Stability Forum's five recommendations on hedge funds.

More immediately, however, the EU stressed that investor confidence must be rebuilt by increasing the transparency of financial markets, financial institutions, and the complex financial instruments that they trade in. Specifically, financial institutions must improve the quality of the information available to investors on derivatives and other complex structured products, including their valuation. At the same time, risk management must be enhanced and conflicts of interest avoided.

In particular, the EU leaders emphasized the need to improve the information content of credit ratings to increase investor understanding of the risks associated with derivatives and structured products. Action must be taken to address the potential conflicts of interest for rating agencies. While preferring market-led solutions, such as the IOSCO code of conduct, the leaders warned that, if market participants prove unable or unwilling to rapidly address these issues, regulatory alternatives will be considered.

Currently, the European Commission has tasked CERS with reporting on conflicts of interest and credit rating agencies. In earlier remarks, Commissioner for the Internal Market Charlie McCreevy recommended a governance structure involving a direct reporting line from fully ring-fenced rating assessment functions to a supervisory rating sub-committee of independent directors of the rating agency boards. He also urged rating agencies to give serious thought to this and other ways that will help to quickly and effectively restore trust in the process. They must create a framework under which conflicts of interest are properly and more effectively managed, he emphasized. The commissioner has been skeptical that a rating agency can give an objective rating to a bank’s structured securitized product if it has advised that same bank on how to structure that same product.

The involvement of this high a level almost assures an intense scrutiny of the role of credit rating agencies in the sub-prime crisis.