ECON committee own initiative report on the future perspectives of Credit Rating Agencies
06 December 2010
Rapporteur Wolf Klinz (DE, ALDE) is of the opinion that in order to reduce the reliance on external credit ratings, it is necessary to increase the disclosure of information to investors in order to enable them to fulfil due diligence and fiduciary duties.
Network of CRAs
He also suggests fostering the establishment of a network of European CRAs. The cooperation of nationally active CRAs to use the available staffing and resource capacities would potentially increase competition in the industry by covering a wide range of assets and different markets that allows being on a similar level as the big globally active CRAs. A need to create an incentive or a framework that will encourage smaller and regional CRAs to move to a partnership structure should be carefully discussed.
Sovereign Debt Ratings
CRA use smoothing techniques in order to make their sovereign ratings less prone to volatility. This is due to high potential costs involved for market players if ratings are adjusted (connected to potential sell or buy decisions). This makes ratings more procyclical and exhibits "cliff effects". The timeliness of sovereign ratings is problematic as governments publish different data at different times and the reliability of data can sometimes be questionable. Sovereign ratings have only started playing a major role in the past years. The rapporteur is of the opinion that in the case of sovereign debt ratings there is very little need to rely excessively on external credit ratings as almost all information is available to the public. Hence all sizeable and sophisticated market participants should rate sovereigns themselves and not rely solely on external credit ratings.
Payment Models
The issuer-pays model has replaced the subscriber-pays model that was prevalent until the 1970s and has become the new norm. All payment-models have flaws or practicability questions which make them difficult to consider as true alternatives.
The disadvantages of the issuer-pays model with intrinsic conflicts of interest can be addressed by prohibiting CRAs to provide advisory services and making the board of directors more independent.
The subscriber-pays model has intrinsic problems: large investor could try to influence CRAs to provide lower ratings (higher yield) or in turn financial institution that wants to push capital requirements down may exert pressure for higher rating due to regulatory requirements. The subscriber-pays model neglects the fact that ratings have become a quasi public good. This type of model would also lead to a large free-rider problem of non-subscribers in a global and information based society.
The performance-based pay model that only charges a small up-front fee and the remainder of the fee is earned over time based on the accuracy of the rating, fits with the approach in other regulation such as remuneration in CRD, but this concept needs a substantial amount of work on the regulatory and supervisory side to make it feasible.
The rapporteur favours the existence of various models in the market as long as inherent conflicts of interest are addressed by regulatory means.
In a well-functioning competitive market, reputation is enough to ensure the quality of credit ratings. But as the current structure is oligopolistic, CRAs face an intrinsically 'guaranteed market' which means that the effect of a loss of reputation is negligible, i.e. there exists no credible threat to loose reputation.
The rapporteur considers that credit ratings are not just pure opinions but that CRAs should be accountable for their ratings and that therefore their exposure to civil liability should be enhanced in order to provide a credible threat.
As the introduction of liability poses certain questions like when a CRA becomes liable and for which failures as well as how this can be set-up without introducing another additional barrier to entry to the market, this aspect merits a particular thorough discussion.
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