They need better credit

Regulators on both sides of the Atlantic are taking steps to overhaul the working practices of the credit rating agencies. As Insurance Agenda reported in November, the agencies have been heavily criticised for their part in the global financial meltdown.

The key problem is the inherent conflict of interest in their business models: they are paid by the providers and issuers whose products they are meant to independently assess.

The US regulator, the Securities and Exchange Commission (SEC), has put in place rules to address this conflict and agencies are now prohibited from carrying out certain activities, such as executives providing both rating and advisory services.

The rules also bar those who assess products from discussing remuneration. Agencies must provide more information about how ratings are assigned and how they hold up over time.

Meanwhile, the European Commission has put forward proposals that would make the credit rating agencies subject to regulation and supervision for the first time. Agencies in Europe will be required to register with a central supervisor and disclose information about methodologies. They will also need to take steps to avoid conflict of interest, such as appointing independent directors to their boards.

While these measures have merit, they do not go far enough.

First, buyers rely heavily on the ratings attached to products and companies. SEC rules refer to the credit ratings of products and this, according to the system’s critics, only increases the reliance on them. The forthcoming Solvency II directive could also increase the importance of agencies as the rules will require greater attention on credit risk.

Efforts should be made to reduce buyers’ reliance on ratings. They should not be the only factor to be considered when deciding about the financial strength of a company. The SEC, however, has so far resisted a proposal to drop references to credit ratings from its rules.

Second, ratings should be more comparable – something that many argue is not the case. Regulation must define the processes and policies to be followed when rating a company, so that those delivered by different companies or in different markets and asset classes can be compared. While the SEC and European Commission’s rules seek to increase transparency, they do not appear to address the issue of comparability.

Third, all agency employees should be accredited and regulated. For buyers and investors to have trust in the ratings, they must have faith in professionalism and skills of the analysts.

Finally, remuneration should be overhauled. There will always be a conflict of interest as long as the agencies are paid by the companies they are rating. Some have suggested that the financial markets should commission and pay for ratings. For example, the exchanges could pay the agencies in proportion to the financial values traded on each exchange.

A radical overhaul of the operation and role of rating agencies is needed if trust in the financial markets is to be rebuilt after the severe battering of last year.

michael.faulkner@instimes.co.uk