Opinion - Editorials

Towards more transparent ratings

The European Union’s proposed law to oversee the performance of Credit Rating Agencies in the 27 member states is part of global moves to address the crisis of confidence in the financial markets. The drive behind the initiative is the widely held perception that conflicts of interest among the CRAs lead to the under-estimation of the inherent risks in the highly complex, structured financial instruments such as collateralised debt obligations based on repackaged sub -prime mortgages. There is unease however that the regulation might be misread as official endorsement of ratings and more rules could restrict competition in a market dominated by few big players. The idea of an alternative business model has been afloat where investors rather than issuers of assets paid for ratings. The Committee of European Securities Regulators (CESR) drawn from member states has even expressed doubts that any law could have tackled the challenges thrown up by the continuing turmoil. The new measure would require rating firms to disclose the assumptions and methodologies that underlie their assessment, submit periodic reports to regulators, and avoid conflicts of interest with clients. Any violation of the law will entail sanctions. Firms would also have to de-link the remuneration of top brass from business performance and deploy a rotating pool of analysts for long-term clients. Although the voluntary code of conduct the International Organisation of Securities Commission has prescribed for the rating companies in the EU does include many of these proposals, there is no enforcement mechanism and, in case of non-compliance, the agency concerned is required only to explain its default.

The CRAs have been generally receptive to making changes in their business practices, even if they have been chary about admitting the poor quality of ratings. The EU’s current bid to enhance transparency and accountability of the CRAs is indeed consistent with its mandate to accelerate economic growth through competition in the internal market. Optimism that this can be achieved to good effect through formal enforcement in the financial services will however be tempered by the knowledge that the United States had promulgated a similar law before the current meltdown. The EU move that has been backed by the bloc’s finance ministers and is awaiting Parliament’s approval is expected to come into force in late 2009. The notable absence of acrimonious divisions at the highest political level that traditionally characterise decision-making in the bloc speaks to a degree of clear-headed thinking on what is an important oversight measure in this time of international financial meltdown.

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