Rating agency reform grinds to a halt

Author: | Published: 15 Sep 2011
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Despite the best efforts of US and European regulators, financial regulation experts say the market is no closer to finding an alternative to credit rating agencies.

In an IFLR web seminar on September 14, Simon Gleeson of Clifford Chance in London and Donald Lamson of Shearman & Sterling agreed that while there is a strong will to reduce the financial market’s dependency on ratings, a viable, concrete proposal has yet to arise.

“The policymakers are between a rock and a hard place on this, while they would like there to be a third option there doesn’t appear to be one,” said Gleeson.

Europe has been following the discussion in the US with some interest, said Gleeson, as the way ratings are embedded in statute means a lot of effort has gone into coming up with other options. But despite this, the US hasn’t yet come up with any viable options.

Donald Lamson agreed. “The lack of alternatives is one of the reasons why the rulewriting on how to eliminate where possible references to the rating agencies in regulations has come to a grinding halt,” said Lamson.

“There are some instances where it happens and the agencies trumpet their success in this, but not a lot in the aggregate.”

Two unacceptable options

While no alternative yet exists, regulators still insist that another way must be found.

In a press conference launching the Capital Requirements Directive 4 (CRD 4) in Brussels on July 20, EC Internal Markets commissioner Michel Barnier stated that the financial system is too dependent on ratings, and that financial institutions should have more of a say.

“We are proposing to strengthen the requirements for banks to carry out their own risk analysis without resting in a mechanical fashion on the ratings agencies,” said Barnier.

According to Gleeson, the debate is similar to the accounting debate after Enron, in that there are only two ways you can arrive at a balance sheet figure. One of them is by reference to an external reference and the other is by letting management take their own judgement.

“Enron reminded the accounting profession that saying to management ‘well you make your own judgement’ isn’t always the most efficient way of doing anything,” he said.

On the other hand, if you pick an external reference, that reference might be wrong.

“We’re oscillating between what they regard as two unacceptable alternatives, but unless someone does come up with a viable third option they’re just going to have to pay their money and make their choice,” he said.

Through Dodd-Frank, US regulators tried an approach where they mandated the ratings agencies to put information on their websites for banks to come up with their own approaches to rating risk. But so far no suitable suggestions have arisen.

According to Lamson, simply providing information to people doesn’t mean they can use it any better.

"It's optimistic to think that they're going to come up with a better approach than the rating agencies on their own," he said.

“Granted, rating agencies were massively wrong in a number of things they did, but at the same time they’re relied upon for a very good reason, because quite often they get it right.”