Europe faces a difficult challenge of reducing its dependence on credit rating agencies, while there may be no immediate solution, there are some interesting avenues for reform, says Marie-France Baud.
Marie-France Baud works on financial issues for the think-tank Confrontations Europe and is editor-in-chief of 'La Revue'.
This commentary was first published in Confrontations Europe's monthly newsletter 'Interface'.
"This question asked by President Jean-Pierre Jouyet of the French Financial Markets Authority (AMF) is a very hard one to answer. A fact revealed at the public hearing organised by the European Parliament's Committee on Economic and Monetary Affairs, where the hot topic of debate was sovereign debt. Can the financial sector avoid over-dependence on the three main rating agencies?
The Commission's latest proposal on rating agency reform, CRA3, opens up avenues that merit further investigation. While there is a general consensus on the need to break with the quasi-monopoly enjoyed until now by Moody's, Standard & Poor's and to a lesser extent Fitch and to increase disclosure and prevent conflicts of interest, a certain number of points remain open to doubt.
Starting with the mandatory rotation principle, which, while laudable on paper, would not encourage competition but on the contrary cement the position of the American duopoly. The national and regional agencies will need time to build up their credibility and to meet the conditions set by the European Securities and Markets Authority (ESMA), warns its Executive Director Verena Ross.
Susan Launi, representing Fitch, confirms: it took Fitch 20 years and one billion dollars to be able to compete with Moody's and S&P on a global scale. What's more, the new entrants may be tempted to offer higher ratings or to use dumping practices, which would compromise the quality of the rating process.
The European Banking Federation sees this as a crucial problem for the banking sector given the weight attached to ratings by the financial market, regulators and the European Central Bank.
In addition, the sector is one of the largest users of credit ratings in terms of both volume and frequency of issue; European banks need to issue over €1.5 billion of new bonds every year, and debt instruments are linked directly to the issuer's rating.
It is impossible to separate the two, or to have different rotation periods for issuers and their bonds. As in the United States, asset managers require ratings from three locally-registered agencies. Bearing in mind that about half of the top 100 global managers are not based in Europe, this rotation principle would compromise their refinancing capacity.
So how can we reduce our dependency on ratings? Economist and independent consultant Norbert Gaillard believes that ratings are no substitute for the internal evaluations that the major financial institutions must conduct according to a pertinent procedure approved by ESMA and national regulators. Thierry Philipponnat, Secretary General of Finance Watch, suggests a middle ground to avoid sudden market upheavals by introducing a system based on opinions that reflect a quantified probability of default, supported by a solid and objective text from which all reference to ratings is removed. Numerous different rating agencies would express their opinions, which would be used to feed the European Rating Index (EURIX) managed by ESMA as proposed by the Commission. An average probability of default could thus be calculated for use by market participants.
As for harmonising the rating scale, to at least ensure comparability, under the supervision of ESMA, this would simply overwhelm the regulator who is clearly not equipped for the job, says Markus Krall, partner at Roland Berger, who also warns against the risk of standardising methodologies (see subprimes). According to this expert, the solution lies in pursuing a third avenue, that of an investor-based payment platform. A concept that nonetheless needs to be defined much more clearly.
Makoto Utsumi, President of Japan Credit Rating Agency JCR, points out that despite their private status, rating agencies should give consideration to the public interest and political responsibility. What tips the balance when evaluating sovereign debt is how determined policymakers are and the endurance of the people, because it is on this that a country's destiny will ultimately depend. Which is precisely what the US agencies failed to realise, he adds.
Needless to say, the draft report of Italian Socialist Leonardo Domenici, scheduled for 28 February, is eagerly awaited."