Which Propositions to Reform Rating Agencies?
In the framework of its mission, momagri instigated the 2009 creation of a rating agency for agriculture to provide the necessary indicators to achieve better decision making, notably at the international level, and to allow agricultural policies and strategies to best answer food security and economic competitiveness objectives1.
The project can appear to go against the tide in the current context of serious financial crisis, when rating agencies are regularly placed in the accused dock because of their alleged responsibilities in the excesses and dysfunctions leading to the sub-prime lending crisis. Indeed, the three leading agencies––Standard & Poors, Fitch Rating and Moody’s Investors Service––were not able to perceive the risks of “toxic” loans, such as the sub-prime loans, and intensified investors’ panic by harshly downgrading a massive amount of fixed-income securities once the crisis had begun.
However, even as we are witnessing an increasing governmental disengagement, the agencies responsible for rating lending issues and policies––and more generally global economic risk––are now more than ever crucial to the operation of free markets since they provide functional and critical data. Thus today, many are those who, far from wanting to do away with these agencies, insist on reforming their operations that were, until now, governed by a mere “code of good conduct”. Consequently, what is really at stake is not the existence of these agencies but their operating mode. This is why the rating agency which momagri proposes to establish is now more needed than ever, in as much as it will immediately adhere to a code of ethics including the reforms for transparency and fairness called for by many observers.
Covering this particular topic and among the various opinions raised on both sides of the Atlantic, the French National Assembly’s Information Report presented by one of its members, Daniel Garrigue2 , and registered with the Assembly’s Presidency on December 3, 2008, brings together a body of propositions for regulation and mainly focuses on the plan proposed by the European Commission on November 12, 2008, and scheduled for discussion by the European Parliament in the spring of 2009. We are presenting below an excerpt.
“The role of credit rating agencies is to formulate independent recommendations on default or anticipated loss probabilities for corporate issuers, sovereign nations and a wide range of financial products. Available to investors, borrowers, issuers and public authorities, these “ratings” play a capital role in financial markets. Many investors rely on rating agencies as they do not benefit from the expertise or the required resources to complete credit risk analyses on their own.
By underestimating the credit risk inherent to structured credit products, even if they very often have access to data not widely accessible, rating agencies were a factor to the serious market disorders. As a result, most of the risky real-estate loans (“sub-prime lending”) received high notations… Moreover, when market conditions deteriorated, rating agencies did not rapidly adapt their ratings accordingly. The current crisis exposed weaknesses in the methods used by these agencies.
On November 12, 2008, the European Commission proposed a ruling to oversee rating agencies operating within the European Union. The text recommends the introduction of a registration procedure for rating agencies to allow European security authorities to monitor the operations of agencies whose ratings are used by credit institutions, investing companies, insurance and re-assurance corporations, collective investment organizations and pension funds within the boundaries of the European Union.
This proposition represents a turning point for the European Commission: In a March 2006 communication, the Commission stated that there was no need to legislate the matter and instead referred to the provisions of the good conduct codes prepared by the International Organization of Securities Commissions (IOSCO).
Under the pressure of Member States, the European Commission had to revise its position since the “roadmap” on the European Union’s reaction to the financial crisis adopted by the Economic and Financial (“Ecofin”) Council in October 2007 included evaluating the role of rating agencies. In addition, the European Council meetings of June 20, 2008 and of October 16, 2008 requested drafting a legislative proposition to strengthen regulations applicable to these agencies and their supervision.
Since 2007 at the international level, the IOSCO and the Financial Stability Forum published reports on the matter. Rating agencies themselves began to work on reforming their operations. For example, Standard & Poor’s presented the draft of a reform that notably included a yearly public control of its governance by an independent company and Moody’s implemented measures to improve the quality of data used in the rating process.
In the United States––home of the parent companies of most rating agencies actively doing business in the European Union––these agencies are submitted to regulations and controls that had been updated since June 2007. The US Credit Rating Agency Reform Act, adopted in 2007 and implemented on June 27, 2007, introduced a legal framework to register agencies wishing to obtain the status of Nationally Recognized Statistical Rating Organization (NRSRO). It was thus crucial to level out competition conditions between the European Union and the United States by establishing in Europe a regulatory structure similar to the American system.
The European Commission opted to propose a regulation and not a ruling, so that the structure could be immediately implemented without any transition period. If the regulation proposal is adopted in its current condition, rating agencies will be bound by strict regulations, so that ratings are not influenced by interest conflicts and rating agencies remain attentive to the quality of rating methods and of ratings themselves in addition to operating in full clarity.
The proposed new major regulations include: :
> Prohibiting rating agencies to also provide counseling services;
> Preventing agencies to rate financial issues if they do not have sufficient quality and quantity data to base their rating;
> Requiring agencies to make public the models, methods and main hypotheses on which they base their ratings and to submit such methods to regular inspections;
> Compelling each agency to publish a yearly transparency report;
> Insisting on the implementation of an internal control procedure regarding the quality of their ratings;
>Including in their boards or directors, or steering boards, at least three members whose compensations are not indexed to the economic performance of the agencies. These members will be appointed for a sole term of a maximum of five years and will only be revoked for professional misconduct. At least one of these members must be a specialist in securitization of debt and structured credit.
Some of the regulations proposed by the European Commission are based on the IOSCO code of conduct, thus giving them a constraining feature that was missing until now. Negotiations of this proposal are already under way and final enactment could take place before the end of 2008.”
In an increasingly complex world, rating agencies will therefore play a growing role and propositions to improve their activities by greater independence and increased efficiency are indeed crucial. In this respect, one must note the European Commission propositions aiming to reform their governance, in particular the requirement to make public the models, methods and major hypotheses on which they base their ratings.
Nevertheless, one can regret that the Commission did not act further regarding its project of resolution, in as much as it steers clear of the two main criticisms made to rating agencies:
> The implementation of a rating by two teams, one of whom would never be in contact the issuer––such as in audit cases since the Enron matter––to guarantee the final rating’s integrity;
> Most importantly, the need to contribute to the development of several agencies to breakdown the oligopolistic structure of the industry.
By establishing a rating agency specific to agriculture, momagri also intends to remedy to the deficiency of the current system leading to mimetic ratings that lack genuine independent judgment.
French National Assembly
Information Report No. 1291
presented by Daniel Garrigue, Member from Dordogne 2nd District
1 Please consult momagri’s article of January 5, 2009, “Why is it Imperative to Set up a Rating Agency for Agriculture?”
2 “L’Europe face à la crise financière”, December 3, 2008.