A credit rating agency is a company that assigns credit ratings to institutions that issue debt obligations. A credit rating measures creditworthiness, or the ability to pay back a loan. Opinions of credit rating agencies, which often have greater experience and analytical capacity than investors, have a huge impact on the availability and cost of credit, since investors rely on these agencies to provide them information on the risks of assets.
Criticism over their role in the bankruptcy crisis of Enron, WorldCom, and Parmalat and, more recently, in their contribution to the financial crisis which rocked the euro, has prompted legislative scrutiny of rating agencies, internationally as well as in the EU.
For this purpose, Regulation (EC) No 1060/2009 on credit rating agencies was adopted in 2009 to introduce mandatory registration and on-going supervision for all credit rating agencies operating in the EU. The new measures, which will come into full effect in less than a month’s time, will force agencies to register in the EU and follow certain rigourous rules-of-conduct in order to mitigate possible conflicts of interest, ensure high quality and sufficient transparency of ratings and the rating process.
Until now, most financial supervision has been done at the national level. The regulation calls for the creation of a European supervisory authority to act as a watchdog. This new body would have direct and exclusive oversight of credit rating agencies registered in the EU, including European branches of agencies based outside the EU. This authority, expected to be set up early next year, would have the power to launch investigations, carry out raids on an agency’s premises to probe its work, levy multi-million euro fines and even prohibit agencies from operating in the EU.
Some issues relating to credit rating activities have not been addressed by the Regulation soon to come into force. Those issues relate to the risk of overreliance on credit ratings by investors, the high degree of concentration in the credit rating sector, and the civil liability of credit rating agencies.
Conscious of this, the European Commission is now proposing tighter rules across Europe to monitor credit rating agencies and has opened a public debate on the management of financial institutions to assess whether further regulatory measures are needed.
The new rules will aim to improve the transparency of the agencies, prevent conflicts of interest and increase competition. Credit institutions, banks and investment firms would have to make information available to agencies they do not use, so that those agencies could produce independent ratings on their products.
Agencies could be required to warn governments three days in advance of making a credit score public in order to allow the country to point out any errors in the report.
They would be required to give governments 12 hours notice before issuing a rating. In addition, rating agencies could also be required to disclose for free their full research reports on sovereign debt ratings in order to improve transparency.
Another idea proposed by the Commission would give investors the possibility of suing agencies if they issued incorrect ratings. According to the Commission, the creation of a civil liability regime would improve legal certainty for investors and have a preventive disciplining effect on credit rating agencies.
The consultation is open until January 7, 2011. The public debate will prepare the way for a bout of stricter legislative controls, which the Commission plans to propose next year.
Dr Grech is an associate with Guido de Marco & Associates and heads its European law division.