European regulation of credit rating agencies could backfire

The Association of Corporate Treasurers (ACT) appreciates the intentions of proposals announced yesterday, Tuesday, 15th November, by Internal Market Commissioner Michel Barnier to toughen the framework for credit rating agencies regulation as part of the European Union’s continuing response to commitments made by the G20.

The Association continues to be concerned however, that some proposals could have unintended consequences leading to a reduction in the number of agencies, deterioration in ratings quality and to fewer ratings being published. This would lead to an overall reduction in information flowing to the market.

This matters because rating agencies are a fundamental utility for companies trying to raise funds in the corporate market, providing essential information about their credit standing to investors. According to Senior Financial Sector Expert, International Monetary Fund, "The ratings they issue allow many of those borrowers [access to] global and domestic markets they would not otherwise have, enabling them to attract investment funds. As a result, ratings add liquidity to markets that would otherwise be highly illiquid." Altering that process as severely as the European Commission proposes risks causing disruption to commercial and industrial firms and increasing the cost of companies’ funding significantly.

Although rating agencies’ performance with regards to complex financial products has been undoubtedly poor and required action, the rating of corporate debt has served the market well for many years. The corporate debt market will be a key source of finance for business at a time when traditional lines of credit are being restricted, which is why it is vital to keep it functioning efficiently.

We welcome the Commission’s decision to reflect further before proposing power to suspend sovereign ratings at times of crisis which the ACT regards as a critical time for consistent flow of information to markets to avoid panic. We hope they will decide not to take the proposal any further.

The ACT looks forward to the opportunity to offer the considered views of its members once draft legislation is published.

Commenting, John Grout, Policy and Technical Director at the ACT, said:

 We can well understand why the Commission thinks that competition is inadequate between rating agencies. On behalf of our members, who are customers of the agencies as both issuers and investors, we are all in favour of improved competition. However, the nature of the market is that it is difficult for new entrants to build up a reputation and many of the measures announced today will in fact create high new barriers to entry. 

The European Union has already moved to deal with issues of governance in rating agencies and many other aspects in the Regulation of 2009. Some of the measures announced today can contribute in a small way to improving the way credit rating agencies work, but the ACT sees some of the policy changes in the new proposals as having the potential to be very damaging.

Key proposals from the ACT’s perspective:

The proposed rotation of rating agencies is not very practical.
The quality of ratings may decline as an incumbent agency will have little incentive to put a long term effort into understanding the intricacies of an issuer’s business, knowing it is to be dismissed after one to three years or, at most, six years. As each new agency appointed on rotation gets up to speed with details of the issuer and its business there will be an inevitable loss of experience. It takes many years – a complete economic cycle at least – for investors around the world fully to accept a newly created rating agency. The time taken by Fitch after its merger with IBCA to develop even its current coverage illustrates the difficulty.

If an issuer of corporate debt does not have confidence in the experience and credibility of a new agency needed for rotation, the reaction of companies may well be to cease having a rating at all. We are concerned that investors may find difficulty with many agencies rating a long-term issue during its life. Rotation limiting the value of consistent long-term tracking of opinions in measuring rating agency performance.

Proposals to impose civil liability on ratings agencies even in restricted circumstances would lead to rises in prices since agencies would need to charge for the costs of insurance.
Rating agencies are mostly small businesses with similarly small capital and new ones are likely to start small. The combination of capital required and insurance based on no history of risk would be prohibitive and a major disincentive to new entrants. Small companies potentially exposed to existential threats to survival from the action of a malicious employee would see a great discouragement. Rating agencies themselves may withdraw from the European markets under those circumstances. The costs for companies to address financial markets are likely to increase and their ability to raise funding diminished.

Proposals to extend disclosures on the basis for corporate ratings.
We look forward to seeing details of this proposal as it is essential that rating agencies not be obliged to divulge confidential information disclosed to agencies by companies.

Commission proposals: http://ec.europa.eu/internal_market/securities/agencies/index_en.htm

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