An EU Ban on Credit Ratings Agencies?

A man hardly anyone in the U.S. has heard of — Leonardo Domenici, a member of the European parliament — has suggested that the body ban the ability of credit rating agencies to offer “unsolicited” opinions on the sovereign debt of some nations in the regions. He will present his case to the Economic and Monetary Affairs Committee. Afterward, the legislative body may create, and perhaps pass, a law that could prohibit the major credit rating agencies from evaluating the debt of some of the region’s countries and banks.

The parliament will, according to its own press arm:

debate how to reduce reliance on ratings, resolve conflicts of interest, and how the methodology of ratings prepared by rating agencies can be assessed by European Securities and Markets Authority (ESMA).

Put simply, the European Union may stop companies like S&P and Moody’s from offering their opinions on the sovereign paper of nations like Portugal and Italy. The decision would open the door for very small ratings agencies, or perhaps an agency created by the EU, to do most of the evaluation of sovereign and bank debt in the region.

The action would build an unprecedented level of doubt about how safe, or dangerous, debt issued by nations and banks in the region is. It also would lead to the ability of EU authorities to measure “conflicts of interest,” whatever those might be. Perhaps it means that some nations or banks could pay the major agencies for better grades. That sort of conflict probably ended with the probes of the role the credit ratings agencies played in the mortgage-backed securities catastrophe.

There is already a substantial level of mistrust about how countries in the region “game” the rating system by questionable disclosures about the state of their finances. Greece is a case in point. Several times over the past two years, as the nation met with EU and IMF authorities and agencies, it painted an optimistic picture of its plans to cut government costs and thus deficits. In many cases the forecasts were wrong. To some extent that was because they were based on selective disclosure by the Greek government. Without the credit ratings agencies to keep Greece “honest,” global capital markets investors might have been burned worse than they already have been. At the very least, investors who took huge risks would have had a measure of how dangerous those risks were.

The credit ratings agencies hardly have a perfect track record as evaluators of risk. That does not mean that their roles in the evaluation of debt instruments is academic. Those evaluations are almost all that stands between the capital markets and the ability of banks and countries to be selective in what they disclose.

Douglas A. McIntyre