Threadneedle warns of unintended consequences of credit rating reforms
The goals of diminishing risk to financial stability, enhancing transparency and improving competition are unlikely to be achieved through implementation of proposals by European authorities to reform credit rating agencies, according to Jonathan Pitkänen, Head of Investment Grade Research at Threadneedle Investments.
In November 2011 the European Commission (EC) announced proposals concerning the regulation of Credit Ratings Agencies (CRAs) – the third CRA reform since the financial crisis. It is aimed at reducing risks to financial stability and restoring the confidence of investors, and other market participants in financial markets, and ratings quality.
Pitkänen says that while Threadneedle fully supports the aims of the EC, if the proposals are implemented in their current form, these goals are not likely to be achieved, and their impact would be materially negative to credit markets.
Threadneedle identifies the key proposals, and assesses their likely impact on the market.
A rotation of CRAs every three years is proposed, with a four year ‘cooling off’ period, or every year if they make more than ten consecutive ratings on the same issuance. If a company has two ratings, one can be retained for six years. Under the proposals, CRAs must review sovereign ratings every six months and justify any rating action.
Most issuers have more than one rating. Under this proposal, it is the issuer who will choose which agency to keep. It seems probable that the issuer will keep the agency which rates it more favourably which distorts the market, encouraging higher ratings and reducing independence. That CRAs will not be able to rate more than 10 issues of an issuer is concerning.
For heavy issuers such as financial services companies, there will be frequent changes in CRAs, ultimately resulting in newly established CRAs being the only ones allowed to rate a new issue. The requirement to justify rating actions is likely to lead to less timely actions as CRAs and their analysts will be reticent to downgrade issuers, particularly sovereign ones. This is exacerbated by CRAs now becoming liable for rating ‘accuracy’.
CRAs will be liable for the quality of their ratings, with investors able to sue CRAs (in national courts) for failure to respect obligations set out in the European CRA regulations. The onus will be on the CRA to prove it was not negligent.
It is generally thought that certain European jurisdictions are less friendly to financial market participants than others. CRAs may be more reticent to provide ratings in jurisdictions that are perceived to be more aggressive towards them. A lack of ratings will not improve investor confidence in struggling European Union nations. Moreover, the threat of litigation may actually serve to increase reliance on ratings due to investors believing that the threat of litigation will act as a guarantee of rating quality. This proposal is anti-competitive as it will deter new CRAs from entering the market.