Friday, October 21, 2011

European Union to Silence Ratings Agencies

Posted on October 20, 2011 at 4:31pm by Becket Adams

Many readers are aware of the financial crisis in the eurozone. Many are also aware of the proposed plans to restructure the banks in order to alleviate the burden of its faltering members.

What readers may not be aware of is this: the European Union’s commissioner for internal markets and services Michel Barnier has written up a draft that proposes to ban rating agencies from publishing their assessments of EU countries in difficulty, the Financial Times Deutschland reports.

When a eurozone country is engaged in bailout talks, Barnier argues that the negotiations become complicated when ratings agencies decide to downgrade that country. A downgrade of a country in need of a bailout would have “negative effects for that country’s financial stability and possible destabilizing effects for the global economy,” Barnier said.

He may have a point. A downgrade of its sovereign debt rating could have enormous consequences for a country, pushing up its borrowing costs and its loan repayments, according to the Sydney Morning Herald.

“I think it’s legitimate to have a special treatment when a country is in negotiation or is covered by an international solidarity program with the IMF or a European solidarity [program],” Barnier said in a recent Wall Street Journal report.

This most recent push to ban ratings agencies probably stems from EU‘s frustration over Moody’s Investors Service, Fitch Ratings agency and Standard & Poor’s downgrade of Greece, Portugal and Ireland, adding to the market turmoil over the spreading debt crisis, writes the Herald.

However, it should be noted that although some EU officials have said that the timing of the downgrades was terrible, they also said that they weren’t uncalled for.

According to the Journal, Barnier said that if the Commission decides that the ratings for any of the countries are deemed as “inappropriate,” “we could ban it or suspend the rating for the necessary timeframe…I am studying this matter very seriously.”

The ban would only be used in a “specific” set of circumstances, according to the drafted proposal. Some of the circumstances would include if the consequences of a ratings downgrade led to “volatility,” a threat to financial stability, or if there were “imminent changes to the creditworthiness of a state because of negotiations” on a bailout program, writes the Herald.

There are, however, some critics who are opposed to the idea.

“The proposal seems odd and I don’t think it will come to fruition,” Marchel Alexandrovich, European Financial Economist at Jefferies International told Dow Jones Newswires.

“Italy and Spain are clearly being supported by the ECB [European Central Bank] and one could easily argue credit ratings are not consistent with what is happening in the market anyway,” Alexandrovich said. “If ratings are banned, it will make it difficult for investors to assess the risk when a country returns to the bond market,” he added.

This raises an interesting question for the United States. Having been downgraded recently, should the U.S. ever consider the option of “banning” ratings agencies during periods of financial instability?

There would seem to be an argument in favor of it. But a total ban would also be opposed because it would involve direct government meddling in the markets (not to mention a possible violation of the 1st amendment).

On the one end, some have argued that the U.S. downgrade “was…absurd.” Once economist claimed that the S&P downgrade was, “political grandstanding . . . and the credit rating agencies which have about the least amount of credibility of any institution in America.” The same critic also said that, “These people should be out of business. The credit rating agencies aren’t the ones who determine the interest rates. That’s done by the global investor community.”

Another U.S. economist wrote, “America is indeed no longer the stable, reliable country it once was. [But] S.& P. itself has even lower credibility; it’s the last place anyone should turn for judgments about our nation’s prospects.”

Some would say that the ratings agencies have proven themselves to be untrustworthy and irresponsible (S&P, for example, was the same agency that gave top marks to subprime mortgages long after the housing market started to collapse). Yet, they still carry the power to downgrade a country’s credit rating.

Should they be banned on the basis that they are are untrustworthy and have the power to cause financial harm?

As Alexandrovich stated in the above, “If ratings are banned, it will make it difficult for investors to assess the risk when a country returns to the bond market.”

The ratings agencies are supposed to serve the purpose of objectively reporting on the health of the financial industry. However, they have come under fierce criticism for being untrustworthy. But this has not diminished their ability to determine a country’s credit rating.

To simply ban an agency’s rating would deprive investors of a way to gauge the financial stability of an entity. And it also raises the question, “who gets to decide what gets banned and when is it ‘appropriate’ to ban an agency?”

So what would be the best solution?

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