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Fears that Europe rating regulation could backfire

The FSA, National Association of Pension Funds and the European Parliament have all raised concerns over the European Commission’s proposals to regulate credit rating agencies and firms’ use of their services.

In November, the EC put forward a directive – credit rating agencies 3, which targets an “over-reliance” on ratings. The proposals call for institutional investors, including credit institutions, investment firms, insurers and reinsurers, occupational pension providers, management firms and alternative investment fund managers to do their own due diligence on investments and rely less on external ratings.

EU member states’ sovereign debt would be rated every six months instead of annually and rating agencies would become liable for losses resulting from ratings which failed to meet the new rules.

Firms being rated would be required to rotate the agency they use and have complex structured financial instruments rated by three different agencies.

Agencies would be required to pass all their ratings to the European market regulator, the European Securities and Markets Authority, which would compile them in a European ratings index. Any changes to methodologies used to work out ratings would have to be cleared by Esma.

The European parliament and council are considering their responses.

In December, the Treasury select committee launched an inquiry into credit rating agencies.

In an evidence session with the select committee last week, FSA acting director for markets David Lawton said the EC’s proposals could undermine competition.

He warned the committee that although the regulator backs CRA3’s stated goals of diminishing risk to financial stability, enhancing transparency and improving competition, it fears the actual policies will not achieve them.

Lawton said: “We have concerns that this comes too hard on the heels of significant new regulation in CRA1 and 2 and that it is unclear whether the measures designed to achieve those goals will succeed.”

Much of the criticism during the evidence session was aimed at the proposal that firms should rotate the agency they use every three years, or every year if they make more than 10 consecutive ratings on the same issuance.

Lawton said instead of boosting competition, the policy risked giving big agencies a “minimum market share, come what may”.

He said: “If the policy is introduced, more agencies will be needed. If they are not in place in time, then the system will freeze.”

NAPF chairman Mark Hyde Harrison said: “The proposal risks instability in credit ratings and it will add costs to companies in terms of work needed to get new agencies up to scratch.”

Legal & General head of credit research Georg Grodzki said: “We are concerned the proposals would make life more difficult for corporate investors because of the noise of rating agency changes and also because costs would go up.”

The NAPF said the proposal that makes agencies liable for losses resulting from ratings which fail to meet the new rules “goes too far”. Harrison said: “It would produce a lot of financial risk for those entities in a way which is unhelpful for the market.”

European Securities and Markets Authority chair Steve Maijoor admitted there are “tensions” raised by the prospect of ESMA approving change to methodologies used by agencies to make ratings, including of member state sovereign debt.

Last week, Bank of England monetary policy committee member Adam Posen said credit ratings are not the “be all and end all” of credibility.

If the European proposals are introduced, rating agencies could see their influence wane.

Association of Corporate Treasurers policy and technical director John Grout told the committee: “The internal costs from the point of view of time, monetary costs and the sheer grief of it all would probably mean solicited ratings would disappear completely.”

During a European parliament economic and monetary affairs committee debate last week, Leonardo Domenici, the Italian MEP guiding the European parliament’s response to the commission’s proposals, said the proposals do not go far enough.

He suggested banning “unsolicited” sovereign debt ratings and called for the creation of a new independent European Credit Ratings Agency to rate member states.

The European Commission’s proposals, known as credit rating agencies 3, would require:

  • Credit institutions, investment firms, insurers and reinsurers, occupational pension providers, management firms and alternative investment fund managers would need to do their own due diligence on investments and rely less on external ratings.
  • EU member states would be rated twice a year instead of once, with more information provided about how decisions are made. The commission is considering whether it should have an ability to suspend sovereign ratings.
  • ’More and better’ information would be made available on methodologies used by CRA’s to calculate ratings. Any changes to methodologies would have to be approved by the European Securities and Markets Authority.
  • Companies being rated would have to rotate agencies and have complex structured financial instruments rated by three separate agencies.
  • CRAs would have to pass all their ratings to Esma which would then publish a European ratings index.
  • CRA’s would also become liable for any losses that result from a rating which, intentionally or with gross negligence, infringes any of these rules. The burden of proof would rest with the CRA.

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