Sudip Bandyopadhyay’s Blog

What is the future for credit ratings agencies and how should they be treated under the new system of financial market regulation evolving internationally? These questions have been hotly debated in recent months and a consensus is now emerging. The European Union is close to finalizing legislation to register and regulate ratings firms for the first time in the region, and next month’s G20 meeting in London is expected to affirm the need for a globally coordinated approach to overseeing ratings agencies. The starting point for these reviews is recognition that credit ratings of certain recent structured securities have not performed well.  At the same time, investors and policymakers appreciate that ratings - a common and transparent language for evaluating and comparing creditworthiness - remain important to the efficient functioning of capital markets. They provide useful information to investors about credit risk and help companies and governments access capital.

For that reason, the G20 is right to have called for a globally co-ordinated approach to registering and overseeing ratings firms. To achieve the aim of restoring confidence in ratings, regulation needs to be globally consistent, based on broadly accepted standards.  Given the global nature of ratings and markets, there is a strong desire among users of ratings internationally to avoid conflicting regimes. We should not allow a situation to develop where a rating in one market is seen as meaning something different in another market, as that will have real consequences for issuers and investors in individual jurisdictions.  How, then, should such a regime work in practice? First, regulators should focus on overseeing ratings firms’ policies and standards for managing potential conflicts of interest. Ratings opinions and methodologies, however, should be free from regulatory interference. Second, ratings firms should be subject to robust, periodic inspections by regulators to check they are complying with their processes and policies. If they are found not to be, they should be subject to regulatory sanction.  Regulation should require high levels of transparency about ratings methodologies, models and performance, to help investors compare ratings and form their own view of the soundness of the rating analysis.

The meaning and use of ratings should also be clear, including their limitations and the level of risk inherent in the rating. Ratings on new, complex securities should be differentiated and consideration should be given to requiring issuers of these securities to disclose publicly information about these transactions that is currently provided to ratings firms confidentially. Ratings agencies must be accountable to regulators, which would provide the market with assurance that the ratings process has integrity. That should be the case whatever their business model, as all models - whether investor-pays, issuer-pays or government-pays - carry potential conflicts of interest and different levels of transparency. Policymakers should encourage competition between groups with different business models and investors should be free to decide on the credibility of ratings agencies according to the quality, integrity and performance of their ratings. Finally, governments must look at how ratings are used by regulators and investors. If ratings are used as benchmarks of creditworthiness in regulations such as Basle II, other benchmarks should be considered as well. That would help avoid inadvertently encouraging investors to depend excessively on ratings, rather than treating them - as they should - as one of many inputs in decision making.