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Industry split over regulation of credit rating agencies Back  
Charlie McCreevy, the European Internal Markets Commissioner, recently announced at the Finance Dublin Conference his intention to table legislation in the autumn to regulate the activities of credit rating agencies. However industry response to the move has been more mixed with some seeing regulation as a way to restore market confidence and others see problems with the regulation of credit rating agencies is unlikely to prevent future crises.
In light of McCreevy’s announcement to regulate credit rating agencies and the SEC’s refinement of its approach to regulating the rating agencies, experts in the industry are questioning the logic behind the move. Sheila Duignan, partner, Financial Services Advisory at Grant Thornton, says, “I am not sure whether the EU plans to regulate credit rating agencies is the correct move going forward. It is worth noting that rating agencies are already regulated in the US by the SEC. The issue is a complex one which is partly structural and partly commercial and therefore, the regulation of credit rating agencies in Europe will not in isolation, solve the problem. The structural problem arises from the inherent conflict of interest in fee payments from the issuers to the rating agencies, as well as the lack of transparency about the distinction between ratings applicable to corporate credits and ratings applicable to structured products. In addition, the over-reliance upon ratings by investors is itself a consequence of the existing regulatory regime. The rating agencies themselves cannot be blamed for that.”

Dermot Hardy, head of treasury, Aareal Bank AG, adds that while [the proposed regulation] is a noble aspiration in practice, there are some issues which need to be addressed. ‘Rating agencies are profit maximising firms, they make profits by selling their products which are consulting services and credit ratings. While no one can deny the acceptability of splitting consulting and rating services, there is an issue with the provision of ratings. The current model is one of issuer pays. Investors can also subscribe to the rating agencies and will have greater access to research and the ability to talk directly to analysts. Smaller investors find it difficult to justify this additional expenditure relative to their overall cost. It is debatable if investors could
afford to completely offset issuer fees with a significantly increased level of investor fees.’

He believes that there are a number of structural economic issues which must be borne in mind when looking at the possible regulation of the credit rating agencies. ‘One of the main issues is that the rating agencies are an oligopoly. While it has always been the case that credit ratings were an essential part of investment management parameters, the SEC gave them a central role by limiting the number of Nationally Recognised Statistical Rating Organizations (or NRSROs), and the Capital Requirements Directive gave the agencies quasi regulatory authority through the prominence of ratings provided by External Credit Assessment Institutions (or ECAIs) in determining the level of bank capital,’ Hardy adds.

Fergal McGrath of Dexia, says he does not believe the rating agencies can be solely blamed for the current financial crisis. The main cause of the crisis he says is ‘primarily as a result of the large amount of leverage which existed within the market and now as the market is undergoing large scale deleveraging via asset sales and/or raising of capital we are seeing the effects.’ He says however that, ‘there is no doubt that there exists a loss of confidence in securitised ratings among the investor community and it is quite clear that the rating agencies need to restore confidence by increasing transparency and the need to react to the mistakes which have been made in the past.’

He asks if the rating agencies under pressure to maintain market share and whether issuers and underwriters were ‘arbitraging’ the agencies ? And highlights the concern, why were many of the assumptions on certain deals such as U.S mortgage products completely incorrect ? and was there a clear segregation of duties between the teams which assigned the ratings and the teams which marketed and sold the various services offered by the agencies. These issues are currently being investigated by various committees which should shed more light in due course.

‘We all know that not all ‘AAA’s are created equally but what the market needs is a clear view of the strength of the rating, e.g. a view of the volatility of the rating and a publication of the probability of maintaining the rating over time,’ says McGrath.
The role of the rating agencies will play a key role in restoring market confidence and transparency in the future, however I personally believe that the agencies will need to be regulated or at least continue to function under a new set of rules /code of conduct going forward, however the Agencies are keen to address these Issues and restore confidence.

Neil Warman, finance director of Homeloan Management, however, says that investors rely heavily on the rating agencies to make informed decisions. ‘Some may say there are isolated instances that have resulted in them not taking a further detailed review of risk. The changing climate we are now in focuses clearly on risk and it was only a matter of time for such legislation to be tabled’

Duignan says that ideally, one would like to see a return to good old fashioned credit analysis and independent research, where the existence of a rating was an additional piece of information and not the primary arbiter of whether a credit is a good or bad one. ‘It will be interesting to see what proposals the EU come up with but in the absence of more stringent due diligence in the investment process, the regulation of rating agencies is unlikely of itself to prevent similar future crises.’

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