By Paul GOLDSCHMIDT, former director at Goldman Sachs International, former director at the European Commission, member of the Advisory Board of the Thomas More Institute.
If rumours concerning the Commission’s intent to enter the rating arena have – thankfully – proved unfounded, the announced overhaul of the regulatory/supervisory framework for Rating Agencies could not have come at a worse time. As the EU struggles to bring credible answers to its sovereign debt and interrelated banking crisis, proposing radical measures to further regulate the Agencies can only be interpreted as an attempt to identify scapegoats as well as to hide the deep disarray in which the authorities find themselves.
Once again, policymakers are demonstrating their lack of understanding of markets. The most emblematic of the proposed measures would allow ESMA to suspend “sovereign ratings” in “clearly limited defined circumstances”. In the event of such an occurrence, it should be evident that markets would take it as a red flag and react negatively. The impact is likely to be far more damaging than consequences caused by the normal process of a “downgrade”.
Indeed, implementing such a proposal raises a number of practical questions: is the “suspension” triggered a) by a unilateral initiative of ESMA, b) by the occurrence of an outside event (ex: an issuer applying for financial assistance), c) at the request of an issuer or, d) in the wake of a “specific” rating decision?
Under a) the legal responsibility of ESMA could well become engaged if its decision triggered consequences causing economic hardship to affected bondholders; b) and c) imply simply enforcing automatically the suspension which, while removing legal responsibility, makes the system particularly rigid and inflexible; d) raises the question of its applicability: does it affect the rating of a specific Agency or all Agencies, including those who have not changed their evaluation? Such a situation is likely to create enormous confusion and collateral damage.
Let us now turn to some of the other more farfetched proposed measures, in particular the idea – borrowed from auditing practices – forcing issuers to rotate periodically among Agencies as well as imposing a four year “cooling period” before an Agency can again offer its services. These proposals also create a series of problems:
Ratings serve several purposes: first, to help the “initial distribution” of an issue assisting in the pricing mechanism and helping investors to compare with similarly “rated” securities; second, to facilitate “price/quality” comparisons in the “secondary market” during the life of the issue. If there is a “rotation” of Agencies, who will be responsible for the “ongoing” assessment of securities once the issuer is no longer allowed a contractual relationship with the issuer? If the surveillance remains with the Agency having made the original assessment, who will pay it and how does it gather ongoing reliable information? If the surveillance passes to the new Agency, how is “continuity” ensured? If, in order to ensure continuity, ESMA “approves” only one standard “methodology” why have competing Agencies? In addition, some Agencies may develop specific skills in certain industries or types of securities not necessarily available elsewhere. The quality of the service to investors could be severely impaired. Freedom of choice between Agencies will be further curtailed by the imposed rotation as there is a de facto “oligopoly” in the sector. Imposition of two ratings, as foreseen, will further complicate matters as only three Agencies have, at present, the required resources to rate a sufficiently wide number of issuers to validate comparisons between securities (particularly in the field of sovereign issuers).
If an unexpressed aim of the proposal is to “foster competition” by soliciting new entrants in the rating field, this is bound to backfire as it takes vast resources as well as a long period of time to establish a credibility that issuers will be willing to pay for and investors ready to rely on. There is no chance that credibility of a new Agency can be “imposed” solely through ESMA regulatory supervision. Investors must remain free to select and use the ratings they trust based on their experience.
While earlier efforts by the Commission to improve the regulatory/supervisory framework of Ratings have – appropriately – aimed at curtailing previously widespread conflicts of interest and imposing standards of disclosure regarding rating methodologies, these new proposals carry a high potential for emptying the rating process of any value to investors which in turn will discourage issuers to pay for them. Such a result would necessarily translate into higher issuing costs as well as less reliable comparative data that can assist an investor’s decision making process.
An important aspect of the proposed reforms, that appears to haves been totally overlooked, is the elimination from the financial market’s regulatory framework of any reference to “ratings” as a benchmark for determining prudential standards used for evaluating risk. This applies notably to the criteria for selecting securities eligible as collateral for refinancing operations or in the determination of the appropriate level of capital ratios applicable to different categories of banking assets.
Rather than pursuing a poorly thought out new set of rules governing Rating Agencies, it would be more productive to promote a vast campaign, informing investors of the intrinsic limitations implicit to any service purporting to express a “subjective” opinion. It should be recognised that it is precisely the subjective character of a rating that gives it its main value; competing sound “methodologies” are also appropriate and useful, providing distinctive characteristics between Agencies, a fact that pleads strongly against the compulsory rotation between them.
It might, however, be appropriate to impose on Agencies the obligation to print a “health warning” on the material they publish pointing to the fact that “exclusive reliance on ratings can be harmful to your wealth!”...
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