INTERNATIONAL. Credit rating agencies, criticised for failing to warn investors about the risks of US subprime mortgage-related products, should support a proposed global industry oversight body or face more regulation, European Union market watchdogs said this week.

The Committee of European Securities Regulators (CESR), made up of national market watchdogs from the 27 EU countries, called on the European Commission - the bloc’s top financial regulator - to set up a global body to forge voluntary standards for credit rating agencies and monitor compliance with them.

The new body should “name and shame” agencies that fall short. If an international regulatory body cannot be set up in the short term, a new body at EU level should be created under CESR oversight, the watchdog said in a statement.

CESR said if the industry failed to support the new body, supervisory authorities should step in to ensure, probably through regulation, the integrity and quality of the ratings process.

Credit rating agencies have come under attack for giving high ratings to structured financial products tied to US home loans that saw defaults, leading to a global credit crunch that is crimping economic growth in Europe and the US.

The sector is dominated by three agencies, Moody’s Corp, Standard & Poor’s (a unit of McGraw-Hill Cos) and Fitch Ratings (a unit of France’s Fimalac). They have been abiding by a voluntary code of conduct drawn up by the International Organisation of Securities Commissions (IOSCO), made up of national market watchdogs from more than 100 countries including EU nations and the US.

But the subprime crisis highlighted flaws in that code, critics say. “The events of last year surely merit a thorough re-evaluation of the current self-regulatory regime,” said Ingrid Bonde, chair of CESR’s credit rating agencies task force.

“This leads CESR to believe that there is a strong need to take a step forward in ensuring integrity and confidence in the rating industry and encouraging the effective use of ratings by investors,” Bonde said.

Agencies give opinions or ratings on the likelihood of default on a company’s bonds or financial products.
Investors use such ratings to decide which stocks or financial products to buy. The ratings also have a major influence over how much capital banks must set aside to cover risk on their books.

The CESR also made several recommendations to tighten how rating agencies deal with structured products, whose slide in value forced banks to write down more than US$200 billion in investments.

It said agencies need to take appropriate action to improve transparency by communicating clearly the limitation to ratings of structured products. Agencies should have enough staff to ensure ratings on structured products are of sufficient quality and ensure remuneration structures are appropriate to promote independence and avoid conflicts of interest in the rating process.

It said a clearer international consensus is needed over what is an acceptable relationship between an agency and issuers, and the need to be transparent in the disclosure of fees they received from issuers.

In parallel to CESR, IOSCO meets this month in Paris, where it will adopt a toughened industry code for ratings agencies in a bid to crack down on what it sees as conflicts of interest whereby agencies are paid by the companies whose bonds and financial products they rate.

In the European Union, the final decision on whether agencies should face added regulation rests with EU Internal Market Commissioner Charlie McCreevy, who will base his decision on advice from CESR and IOSCO.

McCreevy will inform EU finance ministers in early June whether he will propose legislation or continue along a toughened self-regulation path. He has said the status quo is not acceptable and that rating agencies will face closer scrutiny, whatever his decision.

He welcomed the watchdogs’ advice and would come up with his own assessment soon, a European Commission spokesman said.

IOSCO is expected to beef up the industry code by banning agencies from giving advice on creating new financial products that they will eventually rate.

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