Political Demands and Conclusions in Light of the Financial Crisis

Market participants' appeals to continue to rely on the ability of CRAs to regulate themselves were partially taken on board by those in positions of political responsibility. Though state regulation was called for, this was to be based on the IOSCO Code. On 29 January 2008, for example, a joint communiqué by the leaders of France, Germany, Italy, and UK and the President of the European Commission called for “… improvements in the information content of credit ratings to increase investors' understanding of the risks associated with structured products, and for action to address potential conflicts of interests for rating agencies. While preferring market-led solutions, such as the amendment of the IOSCO Code of Conduct, if market participants prove unable or unwilling to rapidly address these issues we stand ready to consider regulatory alternatives” (Office of the Prime Minister of the United Kingdom, 2008).

At a relatively early stage, therefore, policymakers put pressure on the CRAs to propose concrete improvements and demonstrate that steps were being taken to eliminate shortcomings. Some governments, however, most notably that of France, went as far as to demand that CRAs be tightly regulated.

And as the financial crisis deepened, the will to regulate became increasingly entrenched. The foundations for regulatory measures were laid by the G-20 summits in Washington, DC and London. In the final declaration of the Washington summit, the participants stated: “We will exercise strong oversight over credit rating agencies, consistent with the agreed and strengthened international code of conduct” (G-20 2008). In the view of the G-20 leaders, the objective of state regulation was to prevent conflicts of interests. The G-20 resolutions published in London on 2 April 2009 fleshed out the steps to be taken and made them more binding by setting an implementation deadline. By the end of 2009, for example, a system of supervising and registering CRAs was to be established in all G-20 states (G-20 2009).

Both before and after the G-20 summits, various national and international bodies put forward a number of proposals reflecting an astonishingly broad range of potential forms of regulation.

In Germany, the Issing Committee (2008) proposed measures in the following areas:

• Rating performance should be monitored by regulators, applying high statistical standards. Rating performance relative to outcomes should be published regularly (e.g., annually).
• To minimize rating shopping, unsolicited ratings should be encouraged (e.g., by mandatory rating disclosure).
• The use of structured finance ratings in public regulation, e.g., Basel II or consumer protection regulation, should be reconsidered (and dropped if necessary) in order to limit the pressure on CRAs.
• Agencies should be encouraged to adjust their rating methodology to innovations in the financial industry, e.g., to flag structured finance ratings or reveal incentive alignment and first loss piece retention as part of rating information.
• Rating fees should be linked to rating performance.
• An annual report on rating practices and rating competition by a central oversight body might help both to monitor market quality and draw attention to outstanding analytical uncertainties of which investors might be unaware.
• The activities of CRAs should be monitored, among other things by implementing a code of conduct.

Ahead of the G-20 London summit, the Issing Committee (2009) went a step further and proposed, in addition, that

• internationally active rating agencies should be registered with an institution entrusted with capital market oversight, e.g., the International Monetary Fund (IMF) or Bank for International Settlements (BIS);
• on a regular basis, agencies should deposit their rating assessments with the entrusted institution, which should undertake a thorough statistical analysis of this data and publish regular rating default and rating migration tables;
• these assessments should be disclosed to markets and investors; and
• a high-level, open annual event should discuss the status of the rating industry and its performance. The use of designated expert panels in a public dialogue with issuers, investors, and regulators should help to maintain the right level of awareness and to stimulate regulatory and industry debate about rating practices.

While the Issing Committee recognized that only globally consistent regulation would improve the stability and efficiency of the international financial markets, the de Larosière Report sought to provide the European Commission with a basis for the EU Regulation on Credit Rating Agencies, which was already under preparation. The report's recommendations were as follows (de Larosière Group 2009):

• CRAs must be regulated effectively to ensure that their ratings are independent, objective, and of the highest possible quality.
• The CESR should be entrusted with the task of licensing and supervising CRAs in the EU.
• A fundamental review of CRAs' economic models should be conducted, notably in order to eliminate the conflicts of interests that currently exist. The modalities of a switch from the current “issuer pays” model to a “buyer pays” model should be considered at the international level.
• Consideration should be given to the ways in which the formulation of ratings could be completely separated from the advice given to issuers on the engineering of complex products.
• The use of ratings required by some financial regulations should be significantly reduced over time.
• Regulators should keep a close eye on the performance of CRAs with the recognition and allowable use of their ratings made dependent on their performance. CESR should, on an annual basis, approve those CRAs whose ratings can be used for regulatory purposes. Should the performance of a given CRA be insufficient, its activities could be restricted or its license withdrawn by CESR.
• The rating of structured products should be changed, with a new, distinct code alerting investors to the complexity of the instrument.
• Supervisors should check that financial institutions have the capacity to complement the use of external ratings (on which they should no longer excessively rely) with sound independent evaluations.⁹

Early 2009 also saw concrete proposals on regulating CRAs emerge from the UK. The Turner Review, which set out the proposals of the UK Financial Services Authority (FSA) for ensuring a stable global banking system, included some recommendations concerning CRAs. Basically, the FSA supported the main points of the European Commission's draft regulation. In addition, it saw a need to ensure that ratings were only used for purposes to which they were suited. In particular, the FSA (2009: 78) took the view

• that the rating agencies themselves should improve communication relating to the purpose of ratings, emphasizing that they cannot be treated as carrying inferences for liquidity and price; and that
• public policy should avoid unnecessary requirements for investing institutions to hold securities of a specific rating.

At the same time, the FSA warned against undue expectations of what regulation could achieve. It pointed out, in particular, that regulating CRAs would have only limited success in reducing the procyclical impact of prudential rules. While changes in regulatory policy relating specifically to rating agencies had an important role to play, the FSA nevertheless believed that other factors might have a bigger influence on the use of ratings and on the extent to which procyclical dangers could be offset.

As well as advocating state regulation of CRAs, policymakers also called for more competition in the industry. Especially popular among German politicians is the idea of establishing a European CRA as a counterweight to the Anglo-Saxon agencies currently dominating the market. This proposal has been discussed in Germany for many years and has most recently been touted at the highest level as a solution to the shortcomings displayed by CRAs in the financial crisis. Not only Finance Minister Peer Steinbrück, but also Chancellor Angela Merkel has championed the plan.

In summer 2008 Chancellor Merkel told the Financial Times (2008): “Europe has developed a certain independence thanks to the euro [but] in terms of the rules, the transparency guidelines and the entire standardisation of financial markets, we still have a strongly Anglo-Saxon-dominated system … I think that in the medium term Europe will need a working rating agency because the robust currency system of the euro has not yet secured sufficient influence over the rules governing financial markets.”¹⁰

There was some amount of European agreement on this point. At the beginning of the financial crisis, the French Finance Minister Christine Lagarde also called for a European alternative to existing CRAs. Germany even made a proposal at the G8 summit in Japan to establish a European CRA to compete with market leaders Moody's and Standard & Poor's. And while debating the European Commission's proposal for a Regulation on Credit Rating Agencies, the European Parliament discussed various legislative options for forcing investors to use ratings issued by a European credit rating agency.

The idea of a European CRA first needs to be assessed against the objective of encouraging competition in an oligopolistic market. Given the mistakes made by the CRAs in rating structured products, calls for more reliable ratings were inevitable. In a “normal” market, improvements in quality are driven by competition. Demands for additional CRAs to compete with the players dominating the market are therefore understandable. It is unlikely, however, that competition to provide the best quality can be achieved by means of a European rating agency protected and supported by European regulation. This is not the way to promote the emergence of a strong competitor. The notion that such an agency would issue better (and more Europe-friendly) ratings is based on a fundamental misconception about the role and functioning of CRAs.

Contrary to policymakers' intentions, the creation of a European CRA could result in investors considering the ratings of European companies and structured finance products to be of lower quality than the ratings of companies in other regions. This would have an adverse effect on the funding opportunities and costs of European firms and would weaken the EU financial market. An inappropriate attempt of this kind to boost competition in the ratings market could thus damage the reputation of credit ratings as a whole and fly in the face of the actual objective of state regulation.

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