European Parliament’s proposes to regulate credit ratings agencies

22 June 2012

Members of the European Parliament (MEPs) have voted in favour of legislation to tighten the regulation of credit ratings agencies (CRAs), reduce the reliance on agency ratings and restrict the scope for conflicts of interest.

MEPs in the Economic and Monetary Committee in Brussels supported the draft CRA reform legislation earlier this week, arguing that the proposed legislation would inject more responsibility, transparency and independence into credit rating activities. This would, in turn, help to enhance the quality of ratings issued in the European Union (EU), thereby improving protection for users and investors.

“The debt crisis in the eurozone has shown that CRAs have gained too much influence, to the point of being able to influence the political agenda. In response we have strengthened rules on sovereign debt ratings and conflicts of interest,” said Leonardo Domenici, the MEP steering the proposed reform through the European Parliament. Domenici represents the Italian Democratic Party and is a member of the Socialists and Democrats (S&D) parliamentary group.

The proposed reforms include regulation of the quality, timing and frequency of sovereign debt ratings, which MEPs noted directly affect the credibility of states, and hence their borrowing costs. MEPs also want ratings to reflect each country's specific characteristics, and not to serve as an advocate for policy changes.

The move follows widespread dissatisfaction in Europe with the way CRAs, principally of course the big three consisting of Moody’s, Fitch and Standard & Poor’s, have handled the eurozone crisis and particularly the 2008 financial crash when many Collateralised Debt Obligations (CDOs) and other such financial instruments were erroneously rated as triple A.

Future rules
The MEPs have inserted amendments that would require CRAs in future to prepare and publish an annual timetable of dates for publishing their sovereign ratings, so as to give states time to prepare for them. The timetable would have to comply with the general rule that sovereign credit ratings may be published only after close of business in all trading venues established in the EU and at least one hour before they reopen.

MEPs also took the first step towards developing an internal public rating capacity at EU level. The task of creating an independent EU creditworthiness assessment will be entrusted to existing EU institutions, which will provide investors with all relevant, publicly-disclosed data and ratings regarding the sovereign debt and key macroeconomic indicators.

There was also agreement among MEPs that over-reliance on ratings should be reduced. Regulated financial institutions – including banks, insurance companies and investment fund managers – would be required to develop their own rating capacities, to enable them to prepare their own risk assessments and thus not rely entirely on external ones. Furthermore, no EU law would be permitted to refer to credit rating for regulatory purposes, and regulated financial institutions would not be permitted to sell assets automatically in the event of a downgrade.

MEPs are also proposing that CRAs are required by law to ensure their ratings are impartial and of high quality. They could be held liable for them in civil law, so that any investor whose interests were harmed when buying or selling a rated instrument could sue the rating agency if it could be shown that it had made methodological mistakes or committed other infringements specified in the EU regulation. The civil law rules applicable would be those of the investor's country of residence when the damage occurred.

The European Securities and Markets Authority (ESMA) would check rating methodologies, and ratings themselves would have to be presented in numbers. They would also have to indicate the probability of default and be accompanied by an explanatory statement.

By Neil Ainger

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