Law reform is the best policy

Stricter credit regulation

Last week's report by the European Commission's high-level group, chaired by former International Monetary Fund managing director Jacques de Larosière, on the supervision of financial markets spells out how credit rating agencies (CRAs) contributed to the current financial market crisis.
It says that instead of providing independent, reliable assessments of the underlying risk profile of investments, they “lowered the perceptions of credit risk”.

CRAs had become more important over the past decade, with the emergence of investments that were more complicated than the traditional corporate or government bond issues which investors knew how to value themselves. But top “AAA” ratings were being given even to collateralised debt obligations, those home and consumer credit loans bundled into a single investment package providing a higher rate of return to investors.

The CRAs underestimated the credit default risk because they failed to see how defaults in mortgage and loan repayments would rise during an economic downturn. The report even suggests that the agencies may have had an incentive to underestimate these risk factors because they made money from the issuers of these risky investments.

The EU has responded by trying to increase regulation of CRAs. Charlie McCreevy, the commissioner for the internal market, made a proposal on 12 November for ratings agencies to register with national financial market regulators. This draft legislation is under discussion in the European Parliament and the Council of Ministers, with the aim of agreeing a final version in April. Differences remain over the powers of the Committee of Securities Regulators (with some MEPs favouring a stronger role for this central regulator), and over whether ratings used by investors in the EU have to be produced within the EU.

Deven Sharma, president of ratings agency Standard & Poor's, said at a conference of European securities regulators in Paris on 23 February: “We believe that appropriate regulations can play an important role in building confidence.” Only six months ago, agencies were warning that planned regulation was “unworkable”. Now they see that the only way forward is to restore faith in financial markets and those supposed to be responsible for assessments of credit. Stricter regulation has become essential.

Simon Taylor