A Comment by Prof. Dr. Michael Schröder (ZEW) on the Measures Currently Planned by the EU Regarding the Regulation of Credit Rating Agencies

Last week, the European Commission presented its proposals regarding the regulation of credit rating agencies to the European Parliament. Altogether, these proposals constitute a major step forward for an effective regulation of rating agencies and contribute to the solution of key problems. Decreasing the reliance on external ratings regarding their regulatory role for banks and other institutional investors and reducing their mechanistic application for investment decisions, for instance, is a very reasonable approach. Hopefully, the respective regulations (e.g. Basel III and Solvency II) will be adjusted appropriately, giving investors greater responsibility for the assessment of default risks. Rendering country ratings more transparent is a helpful proposal, too. However, there is reason to doubt whether the liability of credit rating agencies will be put into practice, or if it will merely exist on paper.

Fortunately, the intention of temporarily not releasing country ratings was not put into action. Such a measure would clearly have limited investors’ access to necessary information and would have reduced the capital market’s ability to discipline highly indebted countries.

An obligation of the European Securities and Markets Authority (ESMA), as described by the European Commission, is to elaborate a standardized scale as a basis for the agencies’ ratings. This would make the comparison of ratings easier. However, it is important to take the requirements for a subsequent quality control of ratings into consideration right from the beginning. It might be useful, for example, to obligate rating agencies to substantiate their ratings by indicating default probabilities for a prespecified forecast horizon.

Issuers of financial products pay rating agencies directly for the evaluation of these products, which might induce incentives on the part of rating agencies to submit too positive ratings to make future commissions more likely. The proposals of the European Commission do not address this problem directly. The proposal of introducing a rotation system that obligates issuers to entrust a different rating agency every three years could break the oligopoly of the three major credit rating agencies and increase the importance of smaller agencies. But there is reason to doubt if this would reduce the general disincentives caused by the "issuers pay" framework.

For further information please contact

Prof. Dr. Michael Schröder, Phone +49 621/1235-140, E-mail: schroeder@zew.de