EuroWire April 2012 by Bertelsmann Foundation

Inspiring People. Shaping the Future.

WASHINGTON, DC 1101 New York Avenue, NW Suite 901 Washington, DC 20005 USA Contact: Tyson Barker Contact: Tyson E-mail: tyson.barker@bertelsmanntyson.barker@bfna.org foundation.org Tel: (+1) 202.384.1993 Tel: (+1) 202.384.1993 www.bfna.org www.bertelsmann-foundation.org

BRUSSELS Résidence Palace Rue de la Loi 155 1040 Brussels, Belgium Contact: Thomas Fischer Contact: Thomas E-mail: E-mail: thomas.fischer@bertelsmannthomas.fischer@bertelsmann- stiftung.de Tel: (+32 2) 280.2830 Tel: www.bertelsmann-stiftung.de/brussels www.bertelsmann-stiftung.de/brussels

Boosting Competition? EU Credit-Rating-Agency Regulation EuroWire is a joint publication of the Bertelsmann Foundation offices in Washington, DC and Brussels. It connects Capitol Hill to European Union policy and politics, and contributes to a common trans-Atlantic political culture. EuroWire is an occasional publication that highlights issues, legislation and policymakers relevant to the Congressional legislative cycle. This publication looks at the European Union from the point of view of Capitol Hill staffers and offers timely operational analysis.

KEY POINTS • Credit rating agencies (CRAs) rate corporate and sovereign debt. While current EU regulation deals with both types of issuers, calls for reform by governments and non-governmental actors have been ignited by the downgrading of various European countries’ sovereign debt in the current economic crisis. • The European Parliament passed a resolution in June 2011 asking the Commission to evaluate the establishment of a European credit rating agency foundation. • The European Commission released a proposal in November 2011 to amend existing EU CRA regulation, but the proposal does not include a provision to establish a European credit rating agency foundation. The European Parliament is currently amending the proposal. • The proposal’s main objectives are boosting competition among CRAs, reducing reliance on ratings, and bolstering transparency and independence. • Member of European Parliament (MEP) Leonardo Domenici (Italy – S&D group) has proposed banning unsolicited ratings and establishing a European CRA. The ECON committee is considering these amendments. • Some conflict-of-interest issues have yet to be addressed in current regulation. Furthermore, some non-governmental actors have called for alternative models to improve the quality of sovereign-debt ratings.

In a European Parliament (EP) debate in December 2011, European Central Bank (ECB) President Mario Draghi told members of the European Parliament (MEPs) that it is time to move away from a “mechanistic interpretation” of credit-rating-agency opinions. He added

that the agencies have overestimated the level of risk in European countries. This hints at mounting frustration in Europe, particularly in Brussels, about the apparent oligopoly of the “big three” US-based

agencies – Standard & Poor’s, Moody’s and Fitch – that have downgraded the sovereign debt of Greece, France, Spain, Italy and others in Europe.1 These downgrades have arguably exacerbated the eurozone crisis.

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ABOUT THE BERTELSMANN FOUNDATION: The Bertelsmann Foundation is a private, nonpartisan operating foundation, working to promote and strengthen trans-Atlantic cooperation. Serving as a platform for open dialogue among key stakeholders, the Foundation develops practical policy recommendations on issues central to successful development of both sides of the ocean.

Increased Competition and Transparency? In an attempt to crack down on credit rating agencies (CRAs), the EP adopted a resolution in June 2011 on future perspectives on the agencies. One provision of this resolution requested that the European Commission, the EU’s executive arm, evaluate the establishment of a European rating foundation. In November 2011, the Commission, led by Commissioner for Internal Market Michel Barnier, introduced a draft directive and draft regulation to amend existing CRA regulation, enacted in 2009. The Commission’s 2011 proposal intends to boost competition among rating agencies, reduce reliance on ratings, and further bolster transparency and independence. These objectives go

Inspiring People. Shaping the Future.

further than the EU’s 2009 CRA regulation, which actually entered into force in December 2010 and granted the European Securities and Markets Authority (ESMA) exclusive supervisory powers over CRAs registered in the EU.2 Although the Commission’s current proposal does not go as far as the EP resolution, the proposal does include the following provisions to bolster competition among CRAs and transparency in their ratings:

BRUSSELS WASHINGTON, DC Résidence Palace 1101 New York Avenue, NW • All EU-registered CRAs should be Suite subject a firm confine its de lacan Loi 155 901 to rotation. This meansRue request for ratings to only one CRAWashington, for a maximum three years 1040 (thisBrussels, does not include Belgium DC 20005ofUSA Contact: Thomas Fischer Contact: Tyson Barker sovereigns);3 E-mail: tyson.barker@bertelsmann- E-mail: thomas.fischer@bertelsmannstiftung.de • Structured finance instruments should befoundation.org subject to a “double credit rating”, or ratings Tel: (+1) 202.384.1993 Tel: (+32 2) 280.2830 from at least two agencies; www.bertelsmann-foundation.org www.bertelsmann-stiftung.de/brussels

• CRAs should adhere to a standard credit-rating scale developed by the ESMA; • Banks and insurance companies should develop their own credit-risk assessments so they

need not rely exclusively on CRAs; • Sovereign ratings should be assessed semi-annually rather than annually; • CRAs should publish a “clear and easily understandable” qualitative and quantitative

report that discloses the rationale behind any change to a sovereign rating; and • Non-EU countries must have “equivalent” rules if their ratings are to be used by EU financial

institutions. The Commission determines equivalency.

EU Commissioner for Internal Market Michel Barnier

Among these provisions, the “rotation” rule is most expressly designed to boost competition. However, the Centrum für Europäische Politik (CEP), an EU think tank, and other organizations argue that there is no need to create more regulation to boost competition.

A European CRA to Replace Unsolicited Ratings for Sovereigns? The Commission’s proposal could have an added impact now that the EP is considering it. MEP Leonardo Domenici (Italy – S&D group), the rapporteur responsible for achieving consensus in the legislative body, is working to do just that. The ECON committee will consider amendments until April 24, 2012 and vote on the Domenici Report on May 21, 2012. One of MEP Domenici’s goals is to ban unsolicited ratings of sovereigns, thereby preventing the negative consequences such ratings have on investment in economically fragile countries. He proposes to construct a European CRA that would rate the sovereign debt of EU member states. Prohibiting unsolicited ratings of sovereigns is an idea that has proven controversial among MEPs who believe that step goes too far. French center-right MEP Jean-Paul Gauzes, UK center-right MEP Ashley Fox, Swedish liberal MEP Olle Schmidt and French green MEP Pascal Canfin have all criticized Domenici’s effort to do this.

MEP Leonardo Domenici, rapporteur for CRAs in the European Parliament

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Meanwhile, the current proposal does not address the perceived conflict of interest that arises from solicited ratings, whereby the ”issuer pays” for a hoped-for favorable rating. Banning unsolicited ratings would only perpetuate that perceived conflict of interest. MEP Wolf Klinz (Germany – ALDE Group), former chairman of the Special Committee on Financial, Economic and Social Crisis (CRIS), has continually vocalized the need to minimize conflicts of interest by introducing models other than issuer-pays.

Inspiring People. Difference between “Solicited” and “Unsolicited” Ratings Shaping the Future. Unsolicited

Solicited

• Not Paid

• Paid

• Unbiased data analysis based on public (e.g., OECD, EB, IMF) information

• Biased data analysis based on issuer-provided information

• Chance of lower rating

• Chance of higher rating

• Less conflict of interest

BRUSSELS Résidence Palace Rue de la Loi 155 Suite 901 1040 Brussels, Belgium Washington, DC 20005 USA Contact: Thomas Fischer Contact: Tyson Barker E-mail: tyson.barker@bertelsmann- E-mail: thomas.fischer@bertelsmannfoundation.org stiftung.de Tel: (+1) 202.384.1993 Tel: (+32 2) 280.2830 www.bertelsmann-foundation.org www.bertelsmann-stiftung.de/brussels and the broader public. The report will be with macroeconomic and forwardWASHINGTON, DC

•1101 More of interest Newconflict York Avenue, NW

Improved Quality of Ratings – Proposals by Non-Governmental Actors Roland Berger, a Germany-based international

consultancy, is working to create a European credit rating agency in Frankfurt. This would provide a new model that addresses the conflict-of-interest issues by taking a market exchange approach to payments. The Bertelsmann Foundation is also working on a new framework that challenges the CRA status quo. The Foundation’s overarching objective is to analyze sovereign debt by considering the interest of the investor

launched at the Bertelsmann Foundation’s annual financial conference on April 19, 2012 in Washington, DC. The Foundation’s proposal for an international non-profit CRA (INCRA) focuses only on sovereign ratings. INCRA will provide a new legal framework that will mitigate traditional conflicts of interest. It will also enhance the quality of sovereign ratings by conducting risk assessments

looking indicators that take into account long-term socio-economic and political prospects, and potential political and social constraints on countries’ repayment abilities. These indicators would comprise data developed, tested and included in the Bertelsmann Foundation’s Transformation Index and Sustainable Governance Indicators. INCRA would be unique in incorporating such forward-looking indicators into its ratings methodology.

Standard & Poor’s, Moody’s and Fitch account for 95 percent of the market. The main accomplishment of the ESMA has been the release of a draft on regulatory technical standards for the content and format of ratings data to be submitted by CRAs to the ESMA for supervision. In this regard, ESMA has marginally greater authority than the US Securities and Exchange Commission (SEC) because it can evaluate methodologies and procedures used by the CRAs.

The Franken Amendment in the Dodd-Frank Act attempts to resolve conflicts of interest by directing the SEC to create an independent self-regulatory organization to assign the initial credit ratings of securities to one agency.

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