European Commission Will Regulate Credit Rating Agencies

In the wake of the SEC’s proposed reform of the regulation of credit rating agencies, the European Commission said that credit rating agencies must be subjected to regulation since, in the words of Internal Market Commissioner Charlie McCreevy, the IOSCO code of conduct for rating agencies has been revealed as a ``toothless wonder.’’ In remarks at a Dublin seminar, he said that no regulator appears to have ``got as much as a sniff of the rot at the heart’’ of the securitized asset rating process before it blew up. He is deeply skeptical that the appropriate response lies in building on and strengthening the IOSCO code. Discounting recent IOSCO task force recommendations as not being enforceable in a meaningful way, the commissioner is now convinced that limited but mandatory, well targeted internal governance reforms are imperative to complement stronger external oversight of rating agencies

European Union political leaders have already called for reform of the credit rating agency process in light of the market turbulence triggered by the sub-prime crisis. While supporting a market-driven solution, the leaders have said that regulation and legislation will be on the table if an appropriate market response is not forthcoming. Regulation is now on the table.
The commissioner is 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. He believes that, in order to effectively restore trust in the process, a framework for rating agencies must be implemented under which conflicts of interest are properly and more effectively managed.

The commissioner is not concerned that regulation of the rating agencies could be seen as some sort of official endorsement of the ratings they disseminate. The rating agencies have already been given recognition, legitimacy, and implicit trust in key pieces of European financial services regulation, he reasoned. Indeed, when so many of the rating agencies have standards of governance that fall so far short of best practice, he continued, the question to ask is whether their ratings should be so embedded and implicitly endorsed in EU legislation without best practice in corporate governance.

In his view, it is absolutely essential to ensure that there are sufficiently strong firewalls between those who are charged with the primary responsibility to shareholders of driving forward earnings and those who must have the primary responsibility for managing the quality and integrity of the rating process. Remuneration and incentive packages for analysts must also be geared to underpinning long term confidence in the ratings they disseminate. Management must be challenged to effectively manage the conflicts of interest arising from the trade off between quality standards and profitability, especially in structured finance, because of the exceptional and disproportionate impact on earnings of the flow of new structured finance ratings issued.

While oversight of policies and procedures of rating agencies is essential, the commissioner assured that the Commission will not pass on the substance of ratings and the design of models. Regulators should not be in the business of opining on individual rating content, he added. However, the Commission will mandate the ring-fenced internal governance of rating content, including statistical modeling and the quality and remuneration structures of analysts and the promulgation of appropriate corporate culture.

Action must be taken to address the potential conflicts of interest for rating agencies. In earlier remarks, Commissioner McCreevy has specifically 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.