Europe's Supervisory System for Rating Agencies after the Financial Crisis: a Critical Review

Date01 January 2012
Author
Europe’s Supervisory System for Rating
Agencies after the Financial Crisis: a
Critical Review
RO BERT W YSE JAC KSON *
Reputation, reputation, reputation! Oh, I have lost my reputation!
I have lost the immortal part of myself, and what remains is bestial.
William Shakespeare, Othello.
Introduction
The financial crisis of 2007–2010 cast a spotlight on the activity of credit
rating agencies (CRAs) within the European and glob al financial markets.
Whereas CRAs have long been subject to periodic criticism ,1the financial
crisis and its resulting fall out has led to renewed condemnation of their
influence within the markets and their working practices.2CRAs have been
criticised for failing to foresee the crisis, con tributing to it by granting
investment grade ratings to risky securitised products and exacerbating the
European debt crisis by downgrading the sovereign debt ratings of Greece,
Ireland and Portugal.3
These failures have led the t hree largest CRAs—Moody ’s, Standard &
Poor’s and Fitch—to be besieged by criticism from numerous reports4and
European leaders.5In an effort to remedy their perceived deficiencies during
* LLB (Dub), LLM (LSE). Trainee Solicitor, Freshfields Bruckhaus Deringer. The author
would like to thank Sean McGuinness for his helpful comments on an earlier draft of
this article.
1See Partnoy, “The Siskel and Ebert of Financial Markets? Two Thumbs Down for the
Credit Rating Agencies” (1999) 77 Washington University Law Quarterly 619
2See Coffee, “What Went Wrong? An Ini tial Inquiry into the Causes of the 2008
Financial Crisis” (2009) 9(1) Journa l of Corpo rate Law St udies 1. H unt, “Credit
Rating Ag encies and the ‘Worldwide Credit Crisis’. The Limits of Reputation, the
Insufficiency of Reform, and a Proposal for Improvement” (2009) 1 Col umbia
Business Law Review 109
3O’Brien, “Mor e Regulation Needed to P olice Rating Agencies” Th e Irish Times 26
August 2010
4 See European Securities M arkets Expert Group, Role of Credit Rating Agencies and
ESME’s Report to the European Commission, June 2008
5 Slattery, “Barroso Critical of Move by Ratings Agencies” The Irish Times, 14 July 2011
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the crisis, the Eur opean Commission h as established a dir ect system of
regulation for CRAs in Europe. This will involve setting technical standards
for the industry and subjecting CRAs to a system of supervision by the
recently created the European Securities and Markets Authority (ESMA).
This article will review the first European regulatory initiatives for CRAs,
established by Regulation 1060/2009, as amended by Regulation513/2011.6
It will analyse how effective the new European supervisory system will be in
remedying CRA failur es prior to the crisis. In addition , this article will
consider what additional regulatory measures will be necessary if the new
supervisory system is to ensure the mistakes of the crisis are not repeated.
Before analysing the effectiveness of the new European supervisory
system for CRAs, we must first identify why CRAs failed to accurately rate
structured fin ance products, w hose failure ultimately contrib uted in large
part to the crisis. Num erous reasons have been advanced as to why these
products were not rated accurately, but a review of the literature identifies
three principal co ncerns about the CRA industry that might have reduced
market incentives to issue high quality ratings. They are (1) conflicts of
interest induced the major CRAs to compromise rating standards; (2) lack
of competition in the CRA industry reduced competitive incentives to
improve rating standards; and (3) incorporation of ratings into regulation
and market practice reduced market pressure to rate accurately as the
role of CRAs ch anged from in formational intermediaries to “reg ulatory
licensees”.
This author agrees that the cumulative effect of these three factors was to
undermine the CRAs underlying reputational capital mechanism, which is
traditionally considered as safeguarding rating accuracy. Thus, in order for
Europe’s new supervisory system to be effective in establishing high quality
ratings, it will be argued that all three factors must be addressed, to some
extent, within a European context. In respect of the third factor though, it
is the author’s opinion that whilst w e should look to reduce mechanistic
reliance on CRA ratings by encouraging market participants to eng age
in t heir own due diligence, credit ratings do play a legitimate role in
reinforcing internal credit assessments.
The first section of this article will give a background on the traditional
role of CRAs in the financial markets and explain the reputational capital
theory. The se cond section will explain the role of CRAs in the financial
crisis and discuss how conflicts of interest, lack of competition and the
incorporation of credit ratings into market practice and regulations affected
rating standards in Europe. The third section will g ive an overvi ew of
the new European registra tion syst em for CRAs. The four th section will
6 Council Regulation (EC) OJ 1060/2009 o f 16 September 2009 on Cre dit Rating
Agencies, L302/1, 17 November 2009 and Council Regulation (EC) No 513/2011 of
11 May 2011 amending Regulation (EC) No 1060/2009 on Credit Rating Agencies,
OJ L145/30, 31 May 2011
2ROB ERT W YSE J ACK SON
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consider the conditions for registered CRAs and examine whether they will
be effective in remedying pre crisis conce rns. Finally, the fifth section will
review additional regulatory measures being considered within Europe to
address problems within the CRA industry.
The Role of Credit Rating Agencies in the Financial Markets
Credit Rating Agencies as Informational Intermediaries
The traditional function of CRAs within the finan cial markets is t o act as
informational intermediaries to investors by offering a commercial appraisal
of the c redit-worthine ss of a particular issuer or financial instrument. As
informational intermediaries, CRAs are said to contribute to the efficiency
of the financial markets by rectifying informational asymmetries that exist
between issuers and investors. By virtue of their position, issuers will have
superior information to i nvestors on the credit-worthiness of their debt
instruments. This information advantage may be exploited by issuers who
could exaggerate their credit quality in order to obtain a higher price for
their securit ies. This can be problematic for potential investors who m ust
distinguish be tween issuers wi th good and bad credit quality. If left
unaddressed, information asymmetries can lead to adverse selection; debt
issuers with good quality is sues will be un dervalued as investors discount
the value of the s ecurity to compensate for incomplete knowledge on the
issue quality.7Therefore, to avoid the market deteriorating into a “lemons
market”8it is beneficial fo r th e issuer to d isclose their credit quality to
investors.9
The traditional way that market participants have signalled issue quality
to investors is t hrough the use of e xternal companies , such as CRAs, who
act as information intermediaries by highlighting the superior quality of that
entity’s debt instruments.10 A CRA will evaluate the probability of default
or delayed payment in respect of individual debt instruments. This is done
by adopting quantative and qualitative methods of risk assessment such as
the examination of the rated entity’s revenues, balance sheets and past
7 Gilson and Kraakman, “The Mechanisms of Mark et Efficiency” (1984) 70 Virginia
Law Review 549, at 604
8 A lemons market may occur if there is asymmetric information between a buyer and
seller in the market. If a buyer cannot ascertain the quality of a product he risks being
sold a “lemon” (i.e. a low quality good) by a seller who can take advantage of asym -
metrical information. The buyer will therefore demand a discount on the product to
compensate for the possibility that the product is a lemon. See Akerlof, “The Market
for Lemons” (1970) 84(3) Quarterly Journal of Economics 488
9 Leland and Pyle, “Info rmational Asymmetries , Financial Str ucture, and Fin ancial
Intermediation” (1977) 32 Journal of Finance 371
10 Choi, “Market Lessons for Gatekeepers” (1998) 92 Northwestern U niversity Law
Review 916
Europe’s Supervisory System for Rating Agencies 3
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