EC outlines proposal to regulate rating agencies

The European Commission (EC) today outlined a formal proposal to regulate credit rating agencies, which it hopes will improve the quality of ratings, restore investor confidence and reduce the conflicts of interest “inherent to the ratings business”.

Rating agencies have come under attack from all sides during the past 18 months. In particular, they have been criticised for assigning AAA ratings to subprime mortgage-backed securities and collateralised debt obligations with subprime exposure; products that have experienced mass downgrades during the financial crisis.

Consequently, the EC wants to bring the agencies firmly under the control of regulators, to ensure they maintain the quality of rating methodologies and act in a transparent manner.

Specifically, the new rules state that rating agencies must not provide advisory services and must not rate financial products if they do not have sufficient quality information. Furthermore, agencies will be required to disclose the models, methodologies and key assumptions they base ratings on, as well as publish an annual transparency report.

Agencies will also need to create an internal function to review the quality of ratings, and appoint a minimum of three independent directors on their boards whose remuneration does not depend on business performance. At least one of those directors should be an expert in securitisation and structured finance.

An EC official told Risk that the proposal would now go through the legislative process; meaning it needs the approval of the European parliament and member states through the Council of the European Union. If it gets the green light, the official said, the proposal would become effective at some stage in 2009, but declined to speculate on exactly when.

“I want Europe to adopt a leading role in this area,” said the EC’s internal market and services commissioner, Charlie McCreevy. “Our proposal goes further than the rules which apply in other jurisdictions. These very exacting rules are necessary to restore the confidence of the market in the ratings business in the European Union.”

There have also been several congressional hearings in the US into the activities of rating agencies. At a hearing of the House Oversight Committee on October 22, rating agencies were blamed for severe oversights and mis-estimates in their ratings, which were a major contributory factor behind the financial crisis. So it would not be surprising if the US authorities introduce their own measures to tighten regulatory controls in the coming months.

See also: Rating agencies "sold their souls"
Ratings agencies must try harder, Sifma says
Restoring ratings