Role Reversal: Ratings Agencies to Face Review from the E.U.

Moody's Investors Service
Moody's Investors Service

Here's a story sure to bring a smile to the face of every banker in the world who's ever faced a credit-rating downgrade from one of the big three ratings agencies.

Financial Times is reporting that the European Securities and Markets Authority, Europe's markets regulator, has begun reviewing how Standard & Poor's, Fitch, and Moody's Investors Service evaluate banks, "to determine if the process is sufficiently rigorous and transparent." Are the big three shaking in their boots? Probably not -- but maybe they ought to be.

That's because, unlike many regulators, ESMA matters. For a credit-rating agency to do business in Europe, it "must be registered and in good standing" with the agency, as the Financial Times puts it. ESMA is only two years old, and this is its first enforcement action, but if things don't go well for the ratings agencies, they could easily be shut out of one of the most important capital markets in the world.

Ever since the financial crash, the ratings agencies have faced withering criticism from the press and politicians. But this is the first time since then that any government agency will get to have a say in how they do their jobs -- or whether they get to do their jobs at all.

Do I Sound Defensive?

"This is not rating the ratings," ESMA chairman Steven Maijoor told Financial Times. "We are not putting restrictions on the methodology. We only ask that their choices make economic sense and be logical."

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Maijoor's tone sounds defensive because he's anticipating the backlash likely to come from the ratings agencies in response to ESMA's action. Why? Recently, Moody's downgraded 15 major global banks anywhere from one to three notches. In Europe, Deutsche Bank (DB), Barclays (BCS), HSBC Holdings (HBC), and Royal Bank of Scotland (RBS) were all downgraded. Credit Suisse (CS) was downgraded three notches, the only bank to receive such a severe credit-rating cut.

"Bank ratings are very important," Maijoor told Financial Times, "because there is an interaction with sovereign ratings and government bonds."

Something is Rotten in the State of Europe

The bond market. There's the rub. Eurozone countries that lose access to the sovereign bond market can't sell the debt that keeps them solvent, and so instead have to be carried by the other members. Ireland and Greece are already shut out of or have limited access to the bond markets and are living off rescue packages to some degree.

Spain is in trouble, too. Within the last few weeks, the cost of its benchmark debt touched 7%, an unsustainable rate. Italy's debt costs have been up and down as well, as investor confidence in the country rises and falls. Is France next? What about the seemingly indomitable Germany? How long can the stable eurozone core remain untouched by the periphery's rot?

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Will They Make the Grade?

Standard & Poor's, Fitch, and Moody's acquired their bad reputations as the financial crash shook out, and deservedly so. Every mortgage-backed security that Wall Street sold had to be rated by one of them, and many of the most toxic received AAA ratings, the highest grade possible. So either the ratings agencies were incompetent, or they knew exactly what they were doing. Banks do pay the ratings agencies to rate their investment products, after all, and the better the rating, the easier they are to sell.

ESMA says it will be finished with its review by the end of this year. Stay tuned to see what that means for the big three ratings agencies.

John Grgurich is a regular contributor to The Motley Fool, and owns no positions in any of the companies mentioned in this column. Motley Fool newsletter services have recommended buying shares of Moody's.

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