Rating Agency Reform - "EU Recommendations for the Regulation of Rating Agencies Will Help Solve Key Problems"

Rating agencies are considered to be partially responsible for the financial crisis, as they awarded excessively positive ratings to highly speculative securities for too long. More recently, rating agencies have come under fire for their role in the European debt crisis, since debt rating downgrades issued by rating agencies have placed various countries under additional strain. The EU Commission recently presented its recommendations for the reform of rating agency regulation. In this Q&A session, Prof. Dr. Michael Schröder evaluates the proposed regulatory changes.

Prof. Dr. Michael Schröder is the head of ZEW's International Finance and Financial Management department. His research interests include the empirical analysis of capital markets, expectation formation in financial markets, sustainable capital investments, and foundation asset management. He completed his habilitation at the University of Stuttgart and received his venia legendi in business administration in 2009. Schröder teaches at the Frankfurt School of Finance & Management in the department of asset management.

Has the European Commission succeeded in devising a plan to curtail the power of the rating agencies?

On the whole, the recommendations are a big step toward implementing effective regulations for rating agencies and addressing key problems. For example, reducing the role of external ratings for banks and other institutional investors is important. Hopefully, this recommendation will be incorporated into regulatory frameworks such as Basel III and Solvency II, thus making investors more responsible for assessing credit risks. The recommendation that the transparency of sovereign bond ratings be enhanced is also useful. As far as the proposal to increase the liability of agencies for improper ratings is concerned, there is reason to doubt whether such a measure, if implemented, would actually be enforced.

Which reforms do you consider to be particularly important?

The Commission should do everything it can to facilitate the adoption of standardised assessment criteria. The EU envisions that the European Securities and Markets Authority (ESMA) will develop a standardised scale to serve as a basis for all credit ratings, thus improving the comparability of ratings. But it is also important to consider at the outset the need to subsequently review the quality of the issued ratings. It would be helpful, for example, if rating agencies were required to specify default probabilities for ratings.

Which recommendations are too weak in your view?

The proposed reforms do not directly address one well-known problem: rating agencies have a false incentive to provide financial products with excessively positive ratings in order to secure future business from their customers, who are the issuers of such securities. The EU has recommended that companies that issue debt be required to change rating agencies every three years. This rule change would likely break the oligopoly of the three largest rating agencies while also bringing smaller agencies into play. Yet doubts remain as to whether this change would actually reduce the false incentives that are built into the existing system.

Initially there was much talk of temporarily suspending the credit ratings of countries in crisis. This recommendation has now been dropped. What do you think?

Fortunately, the recommendation to temporarily ban the publication of sovereign debt ratings was not pursued further. Such a ban would have considerably worsened the quality of the information available to investors and limited the ability of capital markets to discipline highly indebted countries.