Do Europe's Proposals to Curb Ratings Agencies Go Far Enough?

The ratings agencies are under intense scrutiny in the U.S., with superstar investor Warren Buffett testifying before the Financial Crisis Inquiry Commission today. The European Union, on the other hand, is taking a different, less confrontational approach.

The European Commission, the EU's executive branch, on Wednesday proposed to transfer the regulation of the ratings firms into the portfolio of a new EU-wide financial regulator. But critics say the European proposal is toothless and won't fix the problem.

Licensing and Investigative Powers

As in the U.S., the three main credit rating agencies -- Standard & Poor's (MHP), Moody's (MCO), and Fitch Ratings -- have been roundly criticized in Europe for failing to properly analyze billions of dollars of mortgage-backed securities, which plummeted in value in 2008 and 2009, causing a huge hole in the balance sheets of the Continent's banks.

In addition, the agencies have been excoriated by politicians for downgrading the debt of Greece and Spain, which has made borrowing by those governments increasingly expensive.

Under the proposal, regulation of the ratings agencies will be removed from national committees in each member state and taken over in December by a new European Securities and Markets Authority (ESMA). Ratings agencies will have to register with ESMA, which will have the power to launch investigations and perform on-site inspections.

"The changes to rules on credit rating agencies will mean better supervision and increased transparency in this crucial sector," said Michel Barnier, the EU's internal market and services commissioner.

Incentive Structure "Completely Cockeyed"

Richard Portes, economics professor at the London Business School, disagrees: "None of the problems involving credit rating agencies will be corrected by any of the measures currently under discussion in Europe."

Portes says the proposed regulation would be toothless because ratings agencies are only supposed to show the new regulator the models they use to evaluate debt. "No regulator is going to have the expertise to improve significantly [on] the ratings agencies' models, so you can forget that," he notes.

While the agencies will be licensed, Portes says the license criteria won't make "any material difference to the market structure of this industry, which is highly concentrated, oligopolistic -- three firms control 95% of the business -- and whose incentive structure is completely cockeyed."

He says the main issue is pay. The ratings agencies are currently hired and paid by the issuers of the debt, which he says leads to companies shopping for better ratings.

Desire for Greater Competition

A bill currently before the U.S. Senate would change that approach by setting up a board under the Securities and Exchange Commission that would choose which agency gets to rate which bonds. That would not only solve the ratings-shopping problem, Portes says, but also open the market to smaller ratings firms that are currently shut out.

EU leaders are also interested in increasing the number of ratings agencies. German Finance Minister Wolfgang Schaeuble told reporters Wednesday that "we want to come to a stronger breakup of the oligopoly of the three big ratings agencies."

Christian Noyer, governor of the Bank of France, the country's central bank, said he thought European credit insurers such as Coface and Euler-Hermes, should be allowed to compete with the three market leaders.

Noyer told the German business newspaper Handelsblatt: "They have the knowledge and the experience, and they even have to pay if they're wrong,"