THE EUROPEAN Commission and its internal market commissioner Charlie McCreevy have taken a lead role in seeking to ensure adequate global regulation of credit rating agencies.
The stricter European regulation that he proposed yesterday provides a basis for wider international agreement. The reform of such agencies is overdue and is intended to restore market and public confidence in how they operate and to increase investor protection. In future agencies such as Moody's or Standard Poor's will require authorisation and will be subject to mandatory EU regulation.
The aim is to eliminate many of the abuses evident in how US rating agencies have operated - as highlighted by their role in the subprime mortgage crisis. The function of a credit rating agency is to provide investors with an independent, informed and accurate assessment of the risk attaching to securities or bonds issued by companies or governments. The question agencies are meant to answer is: are the issuers of these financial instruments likely to pay interest and to repay debt? Securities are rated accordingly to reflect risk.
A major factor in the US subprime mortgage crisis was the failure by the rating agencies to be independent, informed, or accurate in their risk assessment of asset-backed securities. Banks bundled and repackaged subprime and other loans which were sold as low risk investments. These financial instruments were given investment grade status by credit rating agencies that had greatly overestimated the creditworthiness of subprime borrowers. Homeowners, when faced with rising interest rates, falling property prices and negative equity, defaulted on their debt. The failure of the rating agencies to produce more accurate assessments reflected both very poor risk analysis and serious conflict of interest. In many instances the agencies were paid by the issuers of the securities they assessed, whose financial products they rated. In this process, the interests of investors were badly served.
Mr McCreevy has accepted that self-regulation of rating agencies has failed and that there is a need for a better system, untainted by conflicts of interest. If EU lawmakers and national governments accept his reform proposals then investors will be better protected, the methods used in the rating process will be more transparent and conflicts will be identified and disclosed. Mr McCreevy's proposals signal the beginning of the end of what he rightly described yesterday as the "charmed existence" of credit rating agencies.